Readers will recall that I’ve been tracking the contest between three market narratives for months:
- Good news is bad news: meaning reopening and ongoing fiscal stimulus has triggered inflation leading to a market shock.
- Bad is good news: meaning the inflation pop is temporary and ongoing low yields will deliver higher values yet.
- Good news is good news: meaning reopening and fiscal-led growth will lift inflation a little but lowflation will continue to support markets.
The leading bank for the first case has been BofA and doubts are creeping in:
View:1. combo peak Positioning, Policy, Profits (“3Ps”) & rising Rates, Regulation,Redistribution (“3Rs”) = low/negative stock/credit returns next 3-6 months; 2. optimal H2 barbell = long inflation & long quality; 3.secular AA tilts =real > financial assets, commodities > bonds, RoW stocks > US, small > large cap (Chart3), value > growth.V: 1.9bn vaccines (vs 168mn cases), 50% US adults fully vaccinated…relative to pre-COVID-19…US gasoline demand 100%, dining out 86% (OpenTable), hotel bookings 84%(STR), airplane seats filled 69% (TSA)…BofA reopening portfolio completes V-recovery vslockdown portfolio (Chart2)…H2 we think defensives start to work.
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QE: peak liquidity…China, UK, Canada, NZ, Norway, Brazil, Russia all tapering/hiking this year…pace of central bank purchases (Fed, ECB, BoJ, BOE) to fall from $8.5tn in ‘20 to $3.4tn in ‘21 to $0.4tn in’22 = big bond buyer will buy less (Fed owns 21% of MBS market, 24% of Treasuries); Fed MBS buying= soaring house price inflation (Chart 4) worsening affordability & inequality (purchase mortgage apps -23% from Janpeak)…higher inflation = lower spending (& lower H2 returns).
CNY: China lead indicator for virus, lockdown, reopening, tech boom, tapering, yields upin’20, and in’21 China yields down as growth surprising downside; China“fine-tuning” not “slamming on brakes” (hence CNY @ 3-year high); but China lead indicator for global peak profits H2 theme & if US fiscal numbers disappoint ultimately a top in yields.
How fast China is tightening is entirely a matter of perspective. In overall terms, it is “fine-tuning”. In commodities terms, it is “slamming on the brakes”. CNY is a trailing indicator.
As such, BofA’s good news is bad news thesis stops making sense because inflation is about to give way to a global deflationary shock which calls into doubt its entire edifice of being long inflation, small cap, value and commodities plus short bonds.
The doubts are creeping in for BofA.
Then there is Morgan Stanley which is in the same school of thought as BofA but is completely off with the fairies:
Risk management is a tricky business. You find some risks fully priced into markets, and others conspicuously absent. At the start of 2021, we felt upside risks to the growth and inflation outlook were largely absent from market pricing. These risks grew quickly in the wake of the Senate runoff elections in the US state of Georgia. And markets eventually adjusted. As both US real rates and breakeven inflation rates moved higher, the US dollar remained range-bound, consistent with our real yield USD framework. As we consider the mid-year outlook, we see many risks that are priced by markets, and many risks that are not. We think the risks to the consensus view of growth and inflation in the US and globally are skewed to the upside. But–and this is important–we think these upside risks, which represent the base case of our economists, are mostly in the price of markets today. This presents us with a challenge: what should you do when your base case is the market’s base case?
The answer: You try to pick holes in your base case by considering the risks to it that aren’t priced in. In what follows, we consider risks not included in those our economists highlighted or those considered in the Fed’s Financial Stability Report. We think the following risks are worth considering, as we don’t see them priced in at the moment: We describe below our thinking regarding these risks–most of which offer a less sanguine view than that of our economists–because we think the risks could lead to much larger moves in rates and currency markets than our forecasts (predicated on the base case of our economists) suggest. In this sense, we approach the opening of our global macro strategy mid-year outlook in a similar vein to our Top10 Surprises for 2021, some of which are playing out year-to-date.
- PCE inflation that won’t be sustained above 2%.
- New leadership on the FOMC that tightens policy uncertainty.
- Higher commodity, consumer prices that hurt activity.
- A fiscal impulse that will reverse or underwhelm.
- Productivity-enhancing reforms and fiscal adjustments that help EM.
Honestly, a dozen pages of risk analysis for 2022 and nowhere is Chinese credit mentioned, the number one driver of inflation worldwide. China is tightening fast. If it persists then a deflationary shock is bearing down on the global economy and none of MS’s thoughts make any sense.
The second narrative I have tracked this year is bad news being good news. It has been represented consistently by Goldman Sachs but it, too, is having its doubts as the inflation panic builds:
From a markets perspective, after the strong run for US equity markets so far this year, while we think the macro environment going forward should still support valuations that are much higher than normal, we think the macro support for equities given historically high valuations is set to weaken going forward, especially if the market is unwilling to view the recent rise in inflation as transitory or the recent slowing in jobs growth is more persistent than expected. On a relative basis, we expect rising bond yields and higher inflation expectations will be supportive of value parts of the equity market, which continue to look attractive, in our view, and see better valuation and return opportunities in Europe and select EMs. And despite rising inflationary pressures, corporate margins have so far remained resilient. This, combined with strong liquidity, supports our existing down-in-quality stance in corporate credit (i.e.,overweight recommendation to HY,vs.IG).
Again no cognisance of the importance of Chinese credit and the headwaters of global inflation.
The MB Fund positioned for the inflation-spike and value-rotation across this year, and it has delivered portfolio outperformance as result. But, as we head into H2, US inflation is going to come off with a dramatic fade in its fiscal impulse just as very fast Chinese credit tightening lands on its activity. European reopening will still be supportive but not enough.
My base case now is that this weakening US/China convergence will lead off the unwind of global supply-side inflation bottlenecks and prices cascade lower across production inputs and then production outputs into 2022. Try CornerstoneMAcro:
Yes, This Inflation Spike Is Transitory: Look At Lumber & Iron Ore. Our point has been, and continues to be, that today’s highly-visible price pressures are a function ofa)demand fueled by the post-recession Global V-rebound, and b) supply constrained by pandemic disruptions–both commodities (e.g. lumber) and certain goods (e.g., used cars). There are now early signs that demand is moderating, and supply is starting to catch up, helping explain some cooling commodity prices, a pattern we expect to continue, followed by a similar sequence in goods inflation. Look attwo micro examples of the above, i.e., U.S. mtg apps/lumber, and China’s heavy hand on credit impacting iron ore and copper.
Slowing Mtg Apps Confirm U.S. Housing Momentum Has Moderated . A Headwind To Lumber Prices. Housing activity will continue to increase, but at a more sustainable pace, supported by massive pent-up demand, healthy consumer balance sheets, and low mtg rates. But the sharp V-rebound is over, as highlighted by mtg apps shifting down, and the NAHB index stabilizing. For lumber, the downshift in housing growth, and increase in wood production (as supply chains begin clearing), help explain why lumber prices have hooked down. Housing led the way in the broad virus-demand boom/virus-supply constraint pattern the economy experienced over the past year. Look at the data: Lumber new orders surged above production, collapsing inventories and igniting a price surge. using), surging, again, reflecting lumber new orders increasing faster than supply. But now, production has caught up with orders, and lumber inventories have stabilized. We expect this pattern to repeat elsewhere in the economy, as supply catches up with demand, and price spikes roll over.
Beijing’s Heavy Hand Cooling Metal Prices. Commodities are also under pressure from Beijing’s heavy hand–particularly iron ore, and also copper–with Beijing repeatedly warning that commodity prices are too frothy. Indeed, China’s banking regulator has asked lenders to stop selling commodity-linked investment products to mom-and-pop buyers.
In short, my base case is still good news is good news. But it’s no longer a value play. On the contrary, it’s time to rotate for a tradable rally into longer-duration equities and bonds, as well as sell commodities with both hands.
The risk case is that this all happens so fast that it disrupts global equities long an inflation shock that goes into violent reverse. Stocks could correct sharply seeking more Fed (and Chinese fiscal) support. This is what has happened every other time we’ve been through this cycle:
To my mind, the Wall Street narrative is almost as awry today as it was going into COVID in early 2020.