Reflation on the brain
Summary: US cash markets were closed overnight for the Presidents Day holiday, but ended last week on a firm footing, with all 3 major indices trading higher on the week. We discuss the ongoing reflation thematic and look ahead to potential pathways should yields continue their march higher.
Despite a quiet week ahead, reflation remains firmly in focus, oil prices are at 13-month highs, and global growth is rebounding as vaccination programmes roll out.
Equities broadly remain supported by combination of factors. The economic recovery is accelerating and becoming more broad based, add in a consistent supportive policy trajectory, and the inflection in the earnings cycle, and we have a trifecta of drivers underpinning an ongoing melt up with markets hitting sequential all-time highs amidst a fiscally fuelled reopening. Business conditions are recovering, focus has shifted to the widespread vaccine rollouts and what lies the other side of the pandemic with earnings corroborating cyclical allocations.
The VIX Index closed below 20 on Friday for the first time in 246 days and the VXN continues to break lower. As volatility breaks down, this provides just 1 more of the many reasons for stocks to rally. With the USD and volatility on the decline asset managers will gross up positioning.
Fed policy remains in a sweet spot and will remain historically accommodative whilst the Fed focus primarily on the full employment side of their mandate. Chair Powell confirmed last week, the labour market is a key determinant for policy and central banks are actively looking for inflation, particularly within the remit of average inflation targeting (AIT) regimes. Given the abundance of labour market slack that is likely to still be in existence as inflationary pressures build, the Fed are set to remain on easy street for a prolonged period.
In conjunction with last week’s US CPI print giving a modest read on inflation, providing leeway for further stimulus and the confirmation from Powell’s speech that the Fed will run the economy hot, this pillar of support for markets remains intact but continues to fuel deep societal imbalances. Wealth inequalities are chasmic, the cratering divides between Main Street and Wall Street are palpable and the increasing wealth transfer to those already asset rich, aided by unconventional monetary policies, is fraying our social fabric.
A recovery in corporate earnings is another pillar of support for the reflation thematic. More than 80% of the 373 S&P 500 companies to report so far have beat expectations and earnings growth is coming in at 6.42% yoy vs. -7.44% in 3Q. As comparisons ease into 1Q and 2Q yoy earnings growth will continue to accelerate to the upside. 4th quarter reports in the US are indicating the earnings cycle has inflected and we are looking ahead to a multi period earnings uptick.
In Australia, the trend is similar, earnings have surprised to the upside so far and more importantly forward outlooks are being upgraded, confirming our aforementioned view of earnings becoming a catalyst for a continued upgrade cycle.
Coming out the other side of the pandemic many resilient companies have adapted in response to the crisis and are now positioned to leverage the inbound and accelerating economic recovery. Balance sheets have been bolstered, cost structures have been optimised and leaned out, and demand is rebounding with vaccines now being rolled out on a large scale and pandemic fatigue setting in.
Finishing last year with a laggard tag, the more cyclically orientated nature of the ASX 200 should support index performance throughout 2021. This could see the index shifting from underperformer to outperformer in the year ahead. Particularly as various commodities rev-up into 2021 with a vaccine rollout, demand bounce back weighed against supply deficits and fiscal spending boost, alongside tailwinds of a weaker USD and higher inflation.
However, the bond market is responding to this reflation theme, and will continue to do so, with the 10yr yield continuing to breakout hitting new cycle highs and yield curves steepening. For now, the prospect of inflation with a commensurate pickup in growth is not a problem for stocks. And is an ideal environment for real economy stocks, cyclicals, and commodities. All preferred overweights.
Yields globally are rising - When does this become a pain point for markets? The problem here is the impact on the equity complex with the current market regime heavily skewed toward liquidity & multiples. In due course inflationary pressures and higher yields brings volatility risk for risk assets. A continued march higher in yields can eventually lead to multiple contraction, hitting speculative portions of the market like bubble stocks that rely on low rates to propel their infinitesimal valuations.
What happens if inflation really surprises, and back end yields rise in a disorderly fashion. If inflation gets hotter than the Fed’s new AIT regime banking on, it could trigger widespread duration selling sending shockwaves through risk assets if yields spike.
However, the Fed’s pain threshold is likely to be low because the nascent economic recovery will be vulnerable. The reaction function of central banks is now very different, with emphasis firmly on the risks of premature policy withdrawal and there is very little escape velocity from current policy settings. As growth recovers, how does the Fed pull the plug especially with another round of stimulus propelling markets further into the stratosphere. Ultimately, if this trend were to derail markets, policy would reach for the accommodation lever once again. The Fed would move to cap long-duration yields, resulting in deeply negative real yields underpinning asset prices once more, but we’re not at that point yet. For now, the Fed’s messaging seems to be to let long-duration yields rise until the level causes market distress, so before curve control higher bond yields and steeper curves are likely.