Rotation Continues

In Asia trade, all eyes were on the run-off elections in Georgia, the decider for control of Congress. As the Georgia votes are counted it looks increasingly likely that the Democrats will take both seats and with them control of the US Senate – VP Kamala Harris will have the deciding vote.

The potential for a Democratic sweep set off a topside break across Treasury yields. The US 10-year yield rose ~3bps as the initial numbers trickled in and continued to push higher through the session closing in on the all-important 1.0% level. A big psychological level with the potential to send ripples through asset markets. 

With a Democratic-controlled Senate, the expectations of big fiscal, higher taxes and anti-trust scrutiny for big tech come back in to play. A kicker for already prevalent reflation trades. Low inflation underwrites record valuations across multiple asset classes and a shift away from this regime has big implications for portfolios - Commodities and bets on higher inflation are the place to be.

The bond market now, in anticipation of the eventual enactment of more stimulus, $2,000 cheques back on the table and more should the Dem’s take a double win on both seats, sees upward pressure on longer dated yields. The US yield curve hitting its steepest levels in years with more weight behind the big fiscal and Yellen Treasury/Dem Senate MMT inflationary push that comes with the Democrat sweep scenario. For demand side inflationary pressures, the incumbent MMT-lite regime will be key, with money printing directed at demand generation as opposed to asset purchases, bringing increased inflationary pressures. Particularly framed against a backdrop of righting wrongs of past policy, rectifying wealth disparities and inequalities perpetuated by asymmetric crisis responses – all dynamics which have been supersized by the COVID-19 crisis. Bitcoin, an asset uncorrupted by central bank/government intervention, perhaps catching a whiff of these policy shifts also powering higher in Asia trade. 

As nominal yields ticked up, real yields also climbed (weighing on gold and tech stocks). Precious metals do not like real rates rising. The shift up in longer dated yields also pressuring multiple highflyers and long duration stocks, Nasdaq futures selling off sharply in Asia trade. Rising yields are a threat to mega cap tech valuations, the long earnings duration profiles with high forecast future cash flows rely on low discount rates to justify rich valuations. The valuation of those compounding cash flows will change as yields rise, altering the outperformance profile for this sub-sector of asset markets.

For that reason, long duration tech stocks are very sensitive to rising yields, plus the added threat of tax hikes and antitrust scrutiny. Low inflation and falling yields have underpinned aggressive valuations across the technology sector and the building blocks are in place for these trends to reverse in 2021, causing a fundamental shift in market leadership.

Just as the tech heavy Nasdaq feels the pinch of higher rates, the reflationary regime sends Russell 2000 futures higher, with economically sensitive small caps boosted by the rotation to reflation.

With the risk off tone came marginal USD strength as the haven bid took charge. However, beyond the initial bounce the USD should continue its precipitous slide with the prospects of more aggressive spending and printing continuing to rampantly debase the USD. Good news for non-US stocks (and commodities, bitcoin etc.).

The reflation rotation is on, and with the passing of this hurdle for risk sentiment, these trends will resume with the proverbial wall of worry being climbed sustaining gains as economic recoveries resume into Q1 against the backdrop of free reigning accommodative monetary policy and ongoing fiscal spending with a vaccine rollout.

Despite the ongoing pandemic, the economic recovery has begun and the inflation uptick is already here. Recent PMI surveys point to inflationary pressures with supply bottlenecks, increasing input costs and demand rebounding. Commodity prices continue to push higher. Indeed, the US ISM Manufacturing gauge released last night points to these very trends - All 18 industries surveyed reported paying higher prices in December. The gauge of prices paid for materials rose to the highest since May 2018 with rebounding demand, falling stockpiles and COVID related supply chain disruptions pressuring prices.

2021 is set to be a very different year to 2020. The shift in Western economies’ fiscal policies has been profound and fiscal orthodoxy will be hard to bring back. A vaccine rollout coupled with the extraordinary and unprecedented monetary and fiscal policy responses, alongside COIVD-19 related supply bottlenecks, pent up demand and green policy agendas will boost inflation and push longer dated bond yields higher. This dynamic will be difficult for richly valued mega-caps to navigate and has the capacity to shift market leadership toward real economy stocks, non-US markets and commodities.

Again, with the hurdle of the run-off elections and short term froth/retracement risk aside, there is little change in our overarching view of late 2020 that Emerging markets, Asia, Commodities and bets on higher inflation (base effects, pent up demand and supply crunches) are the place to be. Alongside a shift in market leadership toward more cyclically orientated stocks, sectors (energy, materials, industrials, financials and travel and leisure stocks), and geographies, with 2020’s highflyers hampered by rising long end yields. Factors which are a positive catalyst for the cyclically weighted ASX 200 index in the year ahead.