The global economy seems to be setting up for a strong recovery. We are seeing a combination of easy monetary policy, slimmed-down supply chains, and a rebound in consumer confidence.
The cyclical and reflation trade is becoming the consensus view. However, there may still be time to board that train. Futures positioning in the reflation trade is rising, but levels are not excessive.
What are the bull and bear cases?
The bull case
The bull case is relatively easy to make. The global economy is showing signs of recovery after the COVID Crash of 2020. Economic momentum is rising, but levels are not overheated.
Commodity prices are recovering, both on a liquidity-weighted and on an equal-weighted basis. The cyclically sensitive copper price rallied to a new recovery high.
The equal-weighted ratio of consumer discretionary to consumer staples stocks, which reduces the market cap distortion from Amazon, is rising steadily. This ratio is both an indicator of cyclical strength, and equity risk appetite.
Full speed ahead! What could possibly go wrong?
There are a number of key risks to the cyclical and reflation thesis.
- Another wave of COVID-19 infections;
- A loss of economic recovery momentum;
- The uncertainty of additional fiscal stimulus; and
- The effects of rising inflationary expectations on Fed policy.
First, the global cyclical rebound is showing signs of stalling. Regional Citigroup Economic Surprise Indices, which measure whether economic data is beating or missing expectations, are all turning down after initial surges indicating a recovery.
Additional COVID-19 Waves
Another risk is the threat posed by additional waves of COVID-19 outbreaks. Europe is rapidly experiencing a second wave, and the US is seeing a third wave. The pandemic will not be globally controlled until it is suppressed or eradicated everywhere. Otherwise there will always be reservoirs of the virus that will spark periodic outbreaks.
The European outbreak is a sign that the virus thrives in colder weather, and the situation is spiraling out of control. Germany’s daily case count has reached record highs. Ireland, Wales, and the Czech Republic have announced full lockdowns, and Ireland’s measures are expected to throw 150,000 people out of work.
In other words, people are afraid. The IMF found that the voluntary component is far more persistent than any government mandates or guidelines.
Even with a highly successful vaccine rollout—the bull case—the public will still be wearing masks, maintaining distance, and avoiding crowds for many months after regulatory authorization. In fact, the public will likely be taking these precautions into the second half of 2021 or longer. Testing, tracing, and continuing efforts to reduce the severity of the disease with therapeutics will also remain crucial. If the rollout is less successful—the base and bear cases—such interventions could stay in place for 15 more months or longer.
Waiting for fiscal stimulus
In the US, negotiations between House Democrats, the White House, and Senate Republicans over a fiscal stimulus package have broken down. Even if House Speaker Nancy Pelosi and the White House were to come to an agreement, it is unclear whether the bill would receive sufficient support in the Senate for passage.
Fed Governor Lael Brainard made another plea for additional fiscal support in a speech to the Society of Professional Economists Annual Online Conference on October 21, 2020:
Apart from the course of the virus itself, the most significant downside risk to my outlook would be the failure of additional fiscal support to materialize. Too little support would lead to a slower and weaker recovery. Premature withdrawal of fiscal support would risk allowing recessionary dynamics to become entrenched, holding back employment and spending, increasing scarring from extended unemployment spells, leading more businesses to shutter, and ultimately harming productive capacity.
In the last few weeks, the market has pivoted to a consensus view that the Democrats would sweep the election in a Blue Wave by capturing control of the White House, Senate, and the House of Representatives. However, recent polling has seen the race tighten, and the odds of a Democratic sweep at PredictIt has plunged.
Should the election be resolved with a divided government, such as a Biden Presidency and a Republican-controlled Senate, fiscal austerity becomes the most likely outcome. In the absence of additional spending, can the cyclical rebound continue?
Rising inflationary expectations
The last risk facing the cyclical and reflation trade is the idea of “catastrophic success”. What if the cyclical upturn is too successful? How would the market react?
Already, we are seeing inflationary pressures rise. Gold prices are consolidating at the metal’s long-term breakout level, and the bond market’s inflationary expectations have staged an upside breakout through a falling trend line.
In addition, the yield curve is steepening, and bond yields are rising. The 10-year Treasury yield has decisively breached the 0.80% level and surged to 0.86%. The 30-year Treasury yield has risen above its 200 day moving average.
If history is any guide, the 10-year Treasury yield is poised to rise even further. It is following the same path as past global slowdowns.
These conditions beg a number of important questions. What’s the Fed’s reaction function to rising inflationary expectations? The 10-year yield has decisively breached the 0.80% level. In light of the Fed’s commitment to hold short rates down almost indefinitely, will it tolerate a 1.2% rate? What about 1.5%? At what point do rising yields act to significantly restrain the economic rebound?
Resolving the risks
In light of the bullish potential of a cyclical rebound, and all of the risks, how should investors position themselves?
My Trend Asset Allocation Model readings are in neutral, but they are on the verge of turning bullish. The model was created based on the belief that real-time market prices are the best indicator of future expectations, and the application of trend following principles is the best way of capturing long-lasting economic changes. The model is picking up in the shift in consensus thinking, that the global economy is shifting from recession to recovery, as shown by the latest BoA Global Fund Manager Survey. If that consensus assessment is correct, further sustained returns lie ahead for investors who adopt a risk-on position.
By design, the Trend Model has a single-dimensional focus, and knows nothing about risk. Plenty has to go right for the bullish scenario to be realized.
- The momentum of economic recovery has to be sustained.
- The pandemic has to come under control in the face of a second wave infection in Europe and a third wave in the US, both of which could crater growth.
- The US electoral outcome is unknown, which will affect the path of fiscal policy, the likelihood of additional stimulus, and therefore the growth outlook.
- Investors have to grapple with the Fed’s reaction function to rising growth and inflationary expectations.
Under these circumstances, investors need to recognize that the sources of alpha are multi-dimensional, and so is risk. While we can always hope for the best, bad outcomes are very possible in these conditions. It is important to repeat the adage that the only free lunch in investing is diversification, and only a diversified portfolio can weather this diverse array of risks. As well, investors can creatively conduct scenario analysis in order to mitigate any risks specific to their investment objectives, situation, and investment capability.
As an example of a creative approach, Bloomberg reported that Boaz Weinstein of Saba Capital is arbitrating the spread in equity and bond market volatility:
Never in his 22-year career has Boaz Weinstein seen such a disconnect between the complacency of credit investors and the anxiety of equity investors, and he predicts it could unravel in an “incredible move” around the Nov. 3 U.S. election.
While the stock market is pricing in turmoil with the CBOE Volatility Index close to 30, corporate bond spreads have almost recovered to pre-pandemic levels. To Weinstein, the founder of Saba Capital Management and one of the biggest winners in the pandemic selloff in March, something has to give. He’s anticipating a new bout of credit chaos and hoping to add to the 80% return through September in his flagship hedge fund.
“It’s like a calm before the storm,” he said in a Bloomberg Front Row interview. “Equity volatility is almost inescapably high. Is that a good form of insurance? The payoff profiles are nothing like they were back in January. Whereas in credit, we’re almost back to where we were in January.”