April '21 Macro Commentary
Markets are at a Disparate Crossroads….
Goldilocks or Disruption
by Sanjay Khindri, CFA on April 15, 2021
The consensus is clear: the U.S. is set up for an extremely robust economic rebound as the daily vaccination rate runs sustainably above three million and consumers sit on a record $2 trillion of excess deposits, or almost 10% of GDP[1]. The extraordinary level of government transfer payments to support the incomes of both the employed and the unemployed, combined with Federal Reserve/Treasury backstops for business credit, mean that the economy overall will not be starting from an impaired base like it would after a normal recession. The rebound will be robust and swift.
But markets have been trading off this consensus for a time now. While the economic picture is set, markets face a crucial crossroads. This bifurcated backdrop revealed itself during the first quarter as bond yields rose rapidly causing disruption to growth stocks, and at times, equities overall. More recently, yield volatility has subsided, but it would be a mistake to assume that investors can now breathe. The inflation outlook is highly skewed to the upside and growth stocks remain materially overvalued relative to the level of interest rates. What has gone from an inflation scare just weeks ago to now broad record equity highs leaves markets at a critical point: are we in a goldilocks environment or is there more disruption to come?
The Goldilocks Scenario
It was natural for markets to become concerned about sustained higher inflation given the record money supply growth that made its way on to consumer balance sheets. As we have mentioned before, the inflation potential now is much greater than it was during the quantitative easing period following the great financial crisis. The congruence of Federal Reserve balance sheet and government deficit expansion means that the incremental money supply has primarily ended up in the real economy, as opposed to circulating directly back to excess reserves at the Fed (as it did a decade ago). One only needs to notice the 20% plus year over year expansions in bank deposits to differentiate this cycle from the last.
Further, longer-term bond yields were sitting well under 1.00% at the beginning of the year with real yields firmly negative. Given the consensus narrative at the beginning of this note, bonds were not priced correctly. The initial rise in yields to a fairer level coincided with investor uncertainty about how the inflation picture would play out; after all, we are in unprecedented territory. What investors have been primarily grappling with is how much of the upcoming rise in inflation will be cyclical as opposed to secular. To their credit, Fed board members have done a highly effective job of talking down the risks of runaway inflation.
What the Federal Reserve is attempting to do is to prevent near-term cyclical inflation from driving longer-term inflation expectations to unpalatable levels. The Fed wants higher inflation, but not too high, because what they understand is that inflation can be psychological and self-fulfilling…a very fine needle to thread. If they can successfully accomplish this task, though, then the neutral level of real interest rates is lower than pre-pandemic levels while economic growth will re-converge with its pre-pandemic path. For markets, then, investors need not worry about premature Fed tightening, thus cementing early-cycle earnings dynamics while also allowing the government to maintain higher deficits and service its debt: the goldilocks scenario.
At a cursory level, it could be concluded that both growth, value and cyclical stocks should continue to realize positive returns in this environment. But even accounting for the lower interest rate/goldilocks paradigm, growth stocks remain materially mispriced. This overvaluation is made very clear by discounting the real value of GDP by long-term treasury yields, a model that strongly captures and accounts for the impact financial suppression has had on equity valuations.
Continued Disruption
An alternative scenario is that the Fed loses control of inflation expectations and psychological drivers take over. One can find numerous hard and survey data indicating that the economy’s supply side is significantly tighter than is indicated from backward looking indicators such as employment. While part of this is due to Covid-19 related supply constraints which should eventually ease, we need to also weigh heavily the current money stock and further fiscal spending in the pipeline (i.e. infrastructure bill). Furthermore, consumer inflation expectations are driven by energy and food prices, not just by core goods and services pricing. This is important because in a strong economy inflation expectations drive wages, which in turn drive inflation (i.e. the wage-price feedback loop). While outside the scope of this note, we believe Covid-19 has permanently impaired parts of the energy supply-chain, raising the marginal cost of some key commodities and driving higher equilibrium pricing compared to pre-Covid levels.
We’ve also written previously about the long-end of the yield curve detaching from the Fed’s policy stance, and this remains our central assumption. Consider the rationale for the Fed continuing to grow its balance sheet by $120 billion per month given the strong economic outlook? The factors and developments that would cause the Fed to pull-back on asset purchases are the same factors and developments that would drive inflation premiums, term-premiums, and the longer-term neutral Fed Funds rate higher. In this context, the move in the 10-year treasury yield from .90% to the current 1.65% was the tip of the iceberg: a disruptive scenario.
In our previous macro note (January 2021), we highlighted the new policy paradigm and specifically proposed a rationale for structurally higher valuations, particularly for cyclical/riskier stocks. So “disruption” as we put it should not be synonymous with broad equity market losses, but rather associated with a continued rebalancing within the equity market itself. We are generally contrarian in nature, but this time, we think the well discussed theme of the “reflation” trade is only in the early innings. Where bond yields eventually settle-out (i.e. the goldilocks versus disruption scenario) will effectively determine what types of cyclical stocks perform the best and the magnitude of the overall intra equity market rebalancing.
About Gallatin Capital Management, LLC
Gallatin Capital Management is a registered investment advisor specializing in long-short, market-neutral equity portfolios. Gallatin manages separate accounts and is the General Partner and Investment Manager for GCM Absolute Return Fund, L.P., a long-short equity hedge fund.
Gallatin’s investment approach relies on fundamental analysis of companies, economies and macroeconomic variables to build liquid and low-volatility portfolios consisting primarily of equity securities.
[1] Board of Governor’s of the Federal Reserve System, as of 4Q 2020; increase in checking, savings and time deposits since the beginning of 2020
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