This week’s round-up of Wall Street’s smartest guys in the room begins with a bearish Morgan Stanley:
We are now calling for Fire AND Ice. We have been calling for a mid-cycle correction to happen one of two ways:
• Fire: tightening financial conditions as the Fed signals tapering is coming
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•Ice: growth disappointment particularly on the earnings side
•We think it’s increasingly likely these scenarios happen together and we get a >10% correction. The Fed will likely announce its taper plans at its next FOMC meeting just as we expect a disappointment in earnings to materialize.
•Earnings Trouble Ahead. A number of companies have flagged serious supply chain issues in off-cycle earnings reports over the past month. Both forward earnings estimates and price de-rated after many of these reports. We think this will be a pervasive dynamic during 3Q reporting season and expect it to trigger downside in earnings revisions at the index level-a headwind for price. Beyond 3Q, we think the earnings risk comes more from (1) the inability of companies to pass on pricing (2) margin risk related more to higher wages and (3) a reversion (lower) in goods consumption.
That looks about right to me. Though I am less concerned about ongoing wage pressures and think that once the cycle turns down, commodity deflation will deliver some margin pressure relief.
BofA is also still bearish:
The nut: bull case is pandemic ending, bear case is pandemic ending and so is $30tn of emergency policy stimulus, we stay cautious credit& stocks, sell the rips.
Trading Tapering: 18 trading days to go until Nov 3rd Fed taper; simply put QE-era winners have been tech, private equity, US stocks, high yield, while QE-era losers are volatility, cash, commodities, banks (Table 2); 2021/22 transition from QE-winners to QE-losers has begun (Chart 5).
Trading China: Evergrande & property sector reminder China turning ex. growth; China nonfinancial corporate sector debt 160% of GDP (vs 80% in US & other EM’s); but BofA base case = successful ring-fence/controlled GM-like default for Evergrande = positive China HY vs IG bonds (Chart 6–real estate = 71% China HY index); overnight SHIBOR &7 Day repo stable (= liquidity tells).
Trading Stagflation: secular stuff/recommendations albeit topical in ’21…late-60s/70s “stagflation” winners were real assets, real estate, commodities, volatility, cash, EM, allof which held their own vs inflation; losers were bonds, credit, equities, tech, all of which ultimately struggled; note 3 historic phases of the Great Inflation of 1970s were…
1.1965-68: the Birth…post-WW2 period of v low and stable inflation & rates ended driven by Great Society spending, Vietnam, civil rights, unionization, acquiescent Fed…inflation started to rise (Chart 7 – albeit interrupted by Fed-led recession of 1969); note Dow Jones peaked in 1966 at 1000 (a ceiling that held for the next 15 years–Chart 8); as inflation became unanchored in late-60s government bond & credit returns poor but “barbell”of small cap value & Nifty 50 tech performed v well; similarities here with 2020/2021.
2.1969-73: the Reality…inflation and rates moved to new highs as end of Gold Standard/Bretton Woods, failure of price & wage controls, too-easy Fed caused inflation expectations to become entrenched; commodities particularly gold did v well (Chart 3) but in real terms stocks & bonds underperformed while volatility ripped; we see similarities with today.
3.1974-79: the Shock…oil price shocks, power shortages, food price shocks, labor unrest, wage price spirals, major budgetary pressures (e.g. IMF bailout for UK in1976), the period that gave“stagflation” its name; small cap value did v well but no asset class performed as well as inflation over this period; ultimately this type of stagflation arrives once inflation caused lower spending & higher savings (unlikely as global economy reopening); still inflation to remain high in 2022 & beyond driven by wages (minimum wage growth 5-6% at major US corporations), rents, climate change, and possibly Fed turning significantly more“progressive”i.e. shifting from targeting Wall St inflation to Main St inflation…ultimately v US dollar bearish.
I disagree with all of that. This is not the seventies and deflationary forces remain paramount once the COVID distortions pass. We had low 3% unemployment under Trump and wage growth didn’t get anywhere near 5-6%, sadly. As well, in the seventies we did have underlying shortages in many commodities as the Japanese demand shock hit. Today we have gluts in just about everything once COVID distortions pass and they will get worse not better as China goes ex-growth. In effect, BofA’s argument is buy commodities because they are going up.
But nobody does a commodity bubble like Goldman Sachs does a commodity bubble:
Commodities, especially energy related, have been the best performing assets YTD supported by COVID-19 reopening and growing scarcity across physical markets. Despite the strong rally we remain OW the asset class in our asset allocation and, with investors increasingly worried about stagflation risks, w ethink the role of commodities in multi-asset portfolios will become more important into year-end.
Since the GFC, S&P GSCI performance has been closely linked to the ‘RAI PC1:Global Growth Factor’ (the first principal component of our Risk AppetiteIndicator), but since the peak in growth optimism in February this year, commodities have been more resilient. With sticky inflation and supply issues we think commodities could become less positively, or even negatively, correlated to risky assets into year-end.
As the equity/bond correlation has shifted more positive recently, the case for adding commodity exposures in balanced portfolios remains strong. In the1970s, when high inflation came alongside stagnation concerns, commodities helped in protecting 60/40 portfolios and enhanced the Sharpe ratio.
So, buy now for a two-month supercycle? That speaks for itself. There may be some physical scarcity in energy but it is not underlying. It is cyclical and will resolve relatively quickly.
We remain very underweight equities and commodities, long Quality, long US dollar, market weight bonds and ready to buy a decent correction for stocks and top in yields.
Ultimately we see ice dousing fire.