Position for “another bout of weakness” in stocks

US payrolls surprised well and truly to the upside in June, although the BLS does not seem to have fixed undercounting issues with furloughed workers. Credit Suisse strategist Damien Boey notes that the economy’s aggregate wage bill is falling by 4.1% in the year-to-June, compared with weekly GDP readings from the NY Fed of -7.6%. Unit labour cost inflation is running at close to 4%, mathematically putting upward pressure on core CPI inflation. Boey is neither a hawk or dove on inflation – but he simply highlights that there is significant inflation uncertainty here, because labour costs are not doing what they are supposed to in a high unemployment environment. Also, fiscal stimulus is moving in and out of the numbers, creating an additional layer of volatility in growth and inflation dynamics, together with new waves of COVID-19. All of this matters to Boey because volatility in itself is what passive and risk parity investors need to fear. Indeed, the Fed, as the new passive investor will struggle to credibly contain volatility, given that its very reaction function is a source of it. Should risk parity and passive investing implode like it did in March, expect a fire sale of assets, requiring some very nuanced factor exposures.

  • US labour market report for June surprises to the upside. Non-farm payrolls came in well above expectations, rising by 4800K in June, with upward revisions to prior months’ data.  Sectorally, job creation was led by leisure and hospitality, reflecting reopening efforts. The unemployment rate fell to 11.1% from 13.3%, despite an increase in the participation rate to 61.5% from 60.8%. Job creation was the primary driver of the decline in the unemployment rate, with the Bureau of Labour Statistics (BLS) seemingly not making upward adjustments for uncounted furloughed workers, presumably for the sake of consistency with their treatment in prior months. Aggregate hours worked rose by 3.6% in June, taking year-ended growth higher to -8.9% from -11.9%. Average hourly earnings fell by 1.2%, partly reflecting a compositional shift back towards lower income earners in the sample on the back of job creation (especially in leisure and hospitality). Year-ended wage inflation on this measure slowed to 5% from a downwardly revised 6.6%. Year-ended growth in the economy’s total wage bill picked up to -4.1% from -6%.
  • Productivity rises moderately, but unit labour costs continue to rise strongly. According to the New York Fed’s weekly gross domestic product (GDP) tracker, based on high-frequency partial indicators, year-to-end-June growth is -7.6%. Real GDP growth is ahead of growth in aggregate hours worked, consistent with growth in labour productivity (real GDP per hour worked) of 1.3%. This is below the long-term annualized trend rate of 2%, but better than negative rates recorded earlier in the year. We estimate that year-ended growth in unit labour costs (the total wage bill per unit of real GDP), is now running at around 3.8%, slightly down from prior months, but still quite high by historical standards. Indeed, noting that unit labour cost inflation drives the lion’s share of variation in core consumer price index (CPI) inflation in traditional inflation models, we would expect upward pressure on core CPI inflation if these labour market trends keep up. Also, we highlight that unit labour cost inflation is currently running well ahead of CPI inflation, mathematically implying a rising labour income share of GDP and a falling profit share, despite the conventional wisdom that wage bargaining power should be declining in a high unemployment environment, helping corporates to cut costs. We think that this state of affairs is ultimately unsustainable in a high stimulus environment, where large fiscal deficits must inevitably boost private sector saving, and especially corporate saving when households choose to spend rather than save. Put differently, firms should be experiencing a degree of pricing power in the presence of large-scale fiscal stimulus, enabling them to pass on higher labour costs through higher headline iflation. But nevertheless, it is interesting to observe that conventional wage-unemployment dynamics are not playing out, and to think about reasons why. Further, to make matters more complicated fiscal stimulus is dropping in and out of the numbers. So regardless of how hawkish or dovish our priors may be, there is incredible uncertainty about inflation dynamics at present.
  • We all want to believe in conventional recovery dynamics but … The immediate response of investors to the upside payrolls surprise is “risk on”. Equities are rallying, while equity market volatility (VIX), bonds and the US dollar (USD) are falling slightly, and the yield curve is steepening. It all looks very conventional—slightly higher bond yields being a sign of good growth, with the Fed acting sympathetically in the background. However, we think that the room for “risk on” is limited, because there is not much room for the VIX to sustainably fall from current levels, and equities are very expensive on through-the-cycle valuation metrics relative to bonds. Even allowing for artificially low bond yields and earnings recovery, equities are still looking extremely expensive, with the main game in town—VIX suppression—come dangerously close to the point of exhaustion. Intuitively, we are concerned that inflation uncertainty is grossly understated in cross-asset pricing. It needs to show up in higher term risk premia and bond yields, as well as higher volatility. And this is even before we consider the risks from new waves of COVID-19.
  • Long quality, short momentum and even shorter on value. We are positioning for another bout of weakness in passive and risk parity investing. This might seem counterintuitive to some, because the Fed in its quantitative easing (QE) efforts is trying to support passive investing. Or perhaps more accurately, the Fed is becoming the new passive investor. Therefore positioning for a passive or risk parity implosion is akin to fighting the Fed, and one does so at their peril. But we can fight the Fed at a factor level, without necessarily fighting it at an asset allocation level. Our problem is that truly effective stimulus is inflationary, and inflation is a problem for anyone positioned for lower-for-longer rates and lower-for-longer volatility, like passive or risk parity investors. On the other hand, ineffective stimulus undermines the confidence investors have placed in the Fed since the beginning of the equity market rally in late March. Either way, there is not much room for error. The saving grace in recent times is that up until now, the VIX has been extremely high relative to “break-even” or fair value, enabling investors to give the Fed the benefit of the doubt in suppressing the pricing of risk. But now, the VIX is below critical levels, and has no more room to sustainably fall. Yet uncertainty is still as high as it ever has been … Should risk parity or passive investing implode again like it did in March, we would expect the most favoured positions to get unwound, to the detriment of momentum factor investing. We would also expect to see de-leveraging pressure from financial market turbulence, making fundamentals too fluid to anchor asset pricing. In turn, this would undermine value investing. But unloved, uncrowded quality exposures should prove relatively healthy. Within the Australian market top 100 (ASX 100), the long basket of our factor portfolio includes several resources names, which either screen well for quality, or help us to capture reflation potential, protecting us in VIX undershooting scenarios.
David Llewellyn-Smith

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