The Most Convoluted Macro Environment Ever

You’ve probably heard it before, and you’ll doubtlessly hear it again: It’s the rapidity of rate rise that matters to equities, not necessarily the absolute level of yields.

We often talk about thresholds. “How high can 10-year yields go before stocks notice?”, for example. I’ve mentioned repeatedly that 1% on 10-year reals in 2018 was the breaking point for stocks.

But at least locally, it’s the speed of the move that determines stocks’ reaction. “The recent move in nominal rates was a 1.5 standard deviation event on a monthly basis, but reached the two standard deviation threshold on a 10-day basis,” Goldman’s David Kostin wrote, in his latest, adding that “equities will likely continue to struggle if real rates jump further.”

This dynamic is as intuitive as it is easy to observe (figure below).

In addition to speed, the composition of rate rise matters. Rising breakevens aren’t necessarily a bad thing. In fact, under certain circumstances, they’re a referendum on the Fed’s success.

There are two ways to think about the recent surge in crude vis-à-vis breakevens. One is that they’re decoupling, the other is that rising oil prices are supporting breakevens, preventing the rise in real rates and accompanying dollar strength from pulling down market-based measures of inflation expectations.

At present, this debate is so convoluted as to be scarcely worth having. Even more so given the prospective impact on TIPS as the Fed starts to taper. Consider TD’s view, for example. The bank expects 10-year yields (nominals) to rise to 1.75%, driven in part by greater supply to private investors as the Fed steps back. “There is even more evidence of the [QE] flow effect in TIPS,” the bank said, in a note dated September 30. “This was particularly the case during COVID QE due to the significant decline in the supply TIPS to the private market,” Rich Kelly and Jacqui Douglas added, noting that “this is set to change in 2022 and beyond, and is a key reason behind our short 10-year real rates trade.”

That said, there are myriad growth headwinds, most of which are well-documented. China is facing a severe slowdown due to, among other things, property curbs and an acute power crunch. There are also questions about the resiliency of the US consumer. Joe Biden’s fiscal agenda is in jeopardy and while Democrats will likely come to a compromise after another few weeks of party infighting, that compromise will surely limit the scope of new spending compared to the loftiest top line figures. And that’s just the world’s two largest economies. There are problems elsewhere, too (see the figures below, from TD).

What does all of this mean? Well, that’s the multi-trillion-dollar question and answering it is akin to positing a unified theory of everything.

A benign take is that a global growth slowdown and a compositional shift at the Fed will mean officials (and markets) push liftoff well into 2023. “With the implications of the Fed’s FAIT policy and a softer growth outlook, we’re fading the selloff in five-year rates,” TD said, in the same note. “Tapering is starting and this implies higher rates overall, but we expect Fed speakers to emphasize the distinction between tapering and tightening.”

If liftoff timing is the floor for five-year rates, additional efforts to emphasize that the taper and the first rate hike aren’t linked, combined with further evidence of a growth slowdown, could lower the floor. That, as opposed to the kinda/sorta consensus view that if anything, the floor is moving up due to the “coin toss” 2022 odds implied by the September dots and Jerome Powell’s remarks around finishing the taper by mid-2022.

Any “pushing out” of liftoff timing argues for less in the way of a tightening impulse (in financial conditions) going forward. But, again, there are myriad factors that could entail higher real rates notwithstanding policymaker efforts to obfuscate around the timing of the first hike.

In a kind of muddle through, middle ground scenario, the Fed manages to thread the communications need while executing the taper, ameliorating the tightening impulse, while inflation runs hot enough to blunt the loss of overall growth momentum, but not hot enough to constitute stagflation. In that scenario, macro cross-currents and a Fed that’s successful in creating some space between the end of the taper and the first hike can limit dollar upside.

Obviously, there are all manner of deviations which could lead to less benign outcomes. “The global growth/inflation mix has deteriorated in the third quarter, fueling investor concerns on stagflation,” Goldman’s Christian Mueller-Glissmann noted, calling breakeven inflation “sticky.” Goldman is among the hodgepodge of banks which recently raised their price targets for crude. Investors could protect themselves in that environment by overweighting commodity-related assets.

While a growth slowdown would ostensibly bode well for big-cap tech, rising real yields would almost surely pull the rug out given stretched valuations. “Deflation to inflation means financial assets to real assets, credit to commodities, large to small, tech to banks,” BofA’s Michael Hartnett said late last week.

In the same note, Hartnett wrote that it’s “rare to see commodities up 20% and the dollar up in the same year.”

The table (above, from BofA) underscores that anomaly, but also speaks to the convoluted (and potentially perilous) nature of the macro conjuncture.

For “regular” investors — i.e., anyone who lost the plot 800 words ago — the concern is everywhere and always the same. Most of the macro permutations appear unfavorable to mega-cap tech. And what’s bad for FAAMG is bad for the “broad” market, precisely because the “broad” market isn’t very broad.

Last week, for example, Alphabet, Amazon, Apple, Facebook and Microsoft lost some $300 billion in combined market value thanks in no small part to concerns over rising rates. That kind of underperformance is a risk to the benchmarks when those five names are so heavily weighted.

In the same September 30 note quoted above, TD was diplomatic about it. “Value/growth equity valuations should rotate as real rates rise, with the potential to disrupt overall equity sentiment.”

If it’s an early warning you’re looking for, don’t expect it from tech analysts. “Wall Street remains overwhelmingly bullish on mega-cap tech,” Bloomberg noted. “All 58 analysts who cover Amazon have buy ratings, despite the fact that its shares are now flat for the year [while] Apple, the second worst-performer in the group with a 7.5% advance since the start of the year, has buy ratings from three-quarters of analysts.”