Vaccines For Reflation
by Diego Tremiterra
Nov 17, 2020
- The surprise gridlock between the presidency and the Senate (to be revisited in January) resulting from the US elections decreases the likelihood of higher taxation, increased regulation and of a reflationary environment boosted by unprecedented fiscal spending.
- What the US elections result has taken away from the reflationary narrative has been more than offset by the vaccines headlines. Recent news from Pfizer/BioNTech and Moderna have ignited one of the biggest rotations towards value in the history of financial markets, as well as potentially present a case for a continued steepening of the US yield curve. That being said, it is far from certain that the move will be sustained.
- Whilst it flew below the radar of many of us given the number of new developments over the last month, we’re in the process of closing a strong earnings season with a general level of earnings beats and positive news in the form of margin expansion and management teams highlighting increased confidence going into 2021.
THINKING ABOUT FINANCIAL MARKETS
Financial markets are driven by narratives.
At Lykeion, we believe that financial market narratives are primarily driven by three forces: events, consensus and flows.
Events are widely covered by financial news and are easier to understand and digest. This is the part of the narrative that is most widely discussed by the broader audience given that the causes and consequences of current events are frequently wide open for interpretations.
Consensus is the aggregated opinion that participants have about something, be it the result of the US election or the future performance of the US Dollar. Consensus is the reason why financial markets are a game of meta-analysis. In order to outperform the market, you need to deviate from consensus and be correct. Should you end up being wrong (the majority of cases), you’ll underperform. Should you not deviate, then your performance will replicate market returns (positive or negative). Borrowing from Howard Marks’ The Most Important Thing:
Lastly, whilst it is clear that assets react to news and to the change in the opinion of financial market participants, it is flows and positioning that should be considered as a more important driver of price action (opinions are what they say, flows are what they do). Whilst we like to think that flows tend to follow opinions (i.e. if one believes an asset will be worth more tomorrow, he/she will likely buy it today), the reality is that a large portion of flows are dictated by market structures that are independent of the opinion of market participants, and the simplest example of that is
In summary, we would love to break down the narrative of financial markets as the flows which represent the opinion of market participants (consensus) with regards to the most recent events.
But this would be oversimplifying. The reality is that relationships of causality between those three different forces are much less clear and static than most market practitioners (including ourselves) would ever admit. Flows can change the consensus opinion of market participants, and the opinion of market participants can also impact the development of current events. As such, the way we visualize the three main forces that drive the narrative of financial markets is something like this:
This brief introduction on the way we think about markets is timely because in the last month we certainly had a surplus of developments and news action: US elections results, Pfizer/BioNTech and Moderna vaccines, value rally, European lockdowns, Bitcoin, economic surprises and earnings results…to name a few. When we have information overload, we frequently refer back to the above-mentioned drivers and think about how new information affects the way those three drivers interact with each-other to shape the narrative of financial markets.
The developments of the last month are forcing consensus to reconsider certain assumptions like the expectations of unprecedented fiscal stimulus, the occurrence of a Blue Wave, the emergence of a vaccine only well into 2021 or higher general taxes for corporations next year, and flows have been quick to react as we’ll see below. But it is also important to highlight that it’s quite early to say with a high degree of confidence that the central narrative of the market, which has been in place for a while now, is really changing. With that, what we know has not changed in the past month, despite all these new developments, is that:
- Financial markets do not represent the state of the economy. Velocity of money, whilst clearly at an extreme low that will mechanically rebound in the short term (as GDP rebounds), is still incredibly depressed.
- A quarter of US small businesses have not come back.
- Meanwhile, US equity markets are trading at all-time highs once again, with the main indexes in the US and the Global MSCI (ex-US) now all in the green for 2020, something that will doubly change before 2021.
- Passive investing continues to be one of the most determinant drivers of flows and thus price action, and its price insensitivity will continue to support the market.
- We’re in the midst of an US tech equity bubble that is fundamentally justified as (1) Central Banks have significantly impaired price discovery mechanisms, and (2) those are the few companies that have been able to continuously generate growth and cash flows, even amidst the pandemic. Whilst the performance differential between FAAMG mega-caps and the rest of the market should narrow into year-end, we should only expect a full-blown reversal if Covid vaccines developments do not bump into any bottlenecks (unlikely).
- Further monetary easing accompanied by fiscal support are likely to support the performance of financial markets going into 2021, a continuation of the status quo.
- We continue to be in what is likely the largest monetary debasement experiment in financial history.
That being said, there’s so little visibility on what the future will hold that it could very much be the case that in a couple of months, the opposite of everything we said here ends up happening. One thing is assured though: markets are likely going to stay interesting for a while.
We won’t elaborate too much on this as we all have US election fatigue by now.
What has really changed with the results of the US elections? Well, whilst consensus believed that the odds favored a “Blue Wave” (i.e. seeing the Democrats take both Senate and presidency), the Republicans were able to hold on to the Senate (for now, more clarity in January 2021). This means that:
- The extreme fiscal stimulus will still materialize (both parties wanted more fiscal stimulus), but it can be expected to be more moderate than in a “Blue Wave” scenario given the political gridlock between Joe Biden and Mitch McConnell. Realistically, we would expect a “moderate” fiscal stimulus to still look insanely large on a historical basis, and we would expect inflation expectations to continue to trend higher. Ultimately, the strength of the reflationary argument supported by large fiscal bills looks a touch weaker post US elections results, but still meaningful.
- The new narrative also argues that given the political gridlock, the probability of higher taxes and increased regulation is smaller than pre-election.
Thanks to a study performed by a CFA group of academics, we know that gridlocks tend to be good for bonds and bad for equity markets (especially worse for small companies). We quote:
- “Our results show that political gridlock is associated with lower equity returns than the returns associated with political harmony.”
- “On average, large companies’ returns exceeded the returns of small companies by 3.22 percentage points during gridlock in the sample period. In contrast, the performance difference between small and large companies is immense during periods of political harmony, with small companies returning 27.03 percent versus 8.78 percent for large companies.”
- “In contrast to equity returns, we found bond returns to be significantly higher during periods of political gridlock. We observed return differences (of “gridlock” returns minus “harmony” returns) of 7.17 percentage points for long-term government bonds and 6.28 percentage points for corporate bonds.”
It is unclear if the narrative will change from reflationary expectations to a continuation of the status quo as there are strong cases to be made for both camps. Nonetheless, what we can expect is a lowering of global trade tensions, a return to compliance to global accords (like the Paris Climate Agreement) and a significantly less entertaining Twitter feed. For the stock market, we believe it will likely move independently from the US elections noise as there are stronger narratives to listen to (new QE stimulus, vaccines, improving economic fundamentals), unless Donald Trump is able to unleash chaos before Joe sets foot in the White House (so far, the market doesn’t believe that to be the case and we agree with consensus).
We tend to see the US elections as a smaller event than what we previously envisioned, but its developments are still far from over.
We won’t speculate on the likelihood of being the one that finally enables us to go back at standing in line in front of local nightclubs, hopeful of the goodwill of bouncers to allow us in, only to overpay for Tequila shots and sweat 1,200kcal to the sound of OutKast’s ”Hey Ya!” whilst trying to (unsuccessfully) get the attention of a potential mate. We’re not scientists and we have trivial knowledge of how vaccines work.
The vaccine headlines, though, are important given they’re the first of its kind, in a way. It is really the first time, since the virus outbreak, that we all became a little bit more hopeful about the closure of this chapter of our life. And the market surely is riding this wave of optimism.
The vaccine headlines changes the outlook for rates at the long end of the yield curve (which tend to follow price inflation expectations rather than monetary policy) as the market continues to price in higher inflation expectations on the back of a faster than expected return to a normalized life (i.e. we start consuming a lot more stuff other than toilet paper and hand sanitizer). Whilst the move has been noticeable, our view continues to be that it’s unlikely that Central Banks will allow the Yield Curve to move dramatically higher.
Mikael Sarwe at Nordea wrote an excellent article that breaks down the drivers of a continued steepening of the US yield curve. He argues that whilst macroeconomic data still appears depressed, it is the consensus view that rates can’t go up (i.e. The Fed will not allow them to via Yield Curve Control). That being said, cyclical upswings, continued stimulus and the vaccine could bring potential upside risk to the outlook for rates on the longer-end of the curve:
- Business Cycle indicators highlight that “a cyclical upswing in long yields is long overdue no matter if we look at US or global data. In the aftermath of the financial crisis, with leading indicators fairly in line with where they are today, the US yield curve was already 150-200 basis points steeper than it is today.”
- We can still expect a significant level of stimulus in 2021, independently of the gridlock in the US government, which should support inflation expectations and GDP growth.
- Georgia Senate races in January are also far from a sealed deal, meaning that Democrats still have a shot at controlling the Senate. If for any reason that ends up turning Blue, then the case for a reflationary environment on the back of a larger fiscal stimulus package becomes significantly more compelling.
- Higher oil prices also mean higher long-term inflation expectations.
Whilst he might be a little early due to the uncertainty of the vaccine, the resurgence of lockdowns and the uncertainty about who holds the Senate in the US (and hence, about the fiscal stimulus package), the case for higher long term rates is definitely one to keep an eye on going into next year.
GMO wrote an excellent piece on the comparisons between the current market and the one in 1999 in which they highlight many core ideas aligned with our beliefs.
First, both stocks and bonds are trading at rich historical valuations, even if the multiple paid for stocks relative to bonds is as cheap as it has been in financial history.
In our view, what this really means is that the multiple paid for bonds is so high that it makes a very expensive asset (equity markets) look cheap on a relative basis. Ultimately, the relative valuation of equity vs bonds doesn’t speak to how cheap the stock market is, but to the magnitude of the distortions that result from the efforts of central banks to bring bond yields lower.
Relative valuation aside, the high premium from a historical perspective for stock and bonds currently means that the conventional 60/40 portfolio should be avoided as it should have been in 1999 given that such high valuations are historically a warning for depressed market returns going forward. GMO highlights that lost decades, meaning a period of time in which the conventional portfolio’s real returns are flat, are more common than one might think of and that price (intuitively) tends to be a key indicator of when those decades start.
So, with the CAPE ratio (Cyclically Adjusted Price to Earnings) topping the 30x level, which highlights the current outsized equity valuations and therefore the increased risk of owning a 60/40 portfolio, which segments of the market should we look into to find potential returns? One potential alternative is Value.
There Is No Alternative (TINA) is one of those slangs used in financial markets that describes the inter-subjective notion that very few things are cheap in markets today, a force that leads many participants to pile into the same assets. For the younger Stonks generation, this term has been coined by Dave Portnoy as “Stocks only go up”, independently of the price paid.
There are two ways to look at valuation: one is in historical terms (i.e. what has been the multiple paid for Quality, Value or Growth in the past?), the other is relative to alternatives (i.e. what is currently being paid for Quality, Value or Growth relative to each other?).
Whilst Quality and Growth are expensive both from a historical and relative perspective, Value at least looks cheap on a relative basis.
For generations, value investing has been the preferred school of thought of investing legends like Benjamin Graham and Warren Buffett, but given the current underperformance of this fundamental approach vs. alternatives like growth, the whole school of thought has come under scrutiny (rightfully so). Whilst this trend was already in motion pre-pandemic, the bear market rally that started on March 23 and went on for 113 days led Growth to outperform Value by more than 30%, an event that should statistically occur once every 403 years (about the same statistical occurance of a carbohydrate entering Tim’s diet routine…that’s low, to quite low).
Whilst it is not the purpose of this article to prove that one type of investment strategy is better than the other, it is important to highlight the value (*Nerd giggle*) of Graham and Buffet’s strategy given the potential new narratives that might take hold in the near term:
- Value underperforms in economic contractions but outperforms when there’s a simultaneous “Growth” bust, like it did in the 1970s and early 2000s with the bust of the “Nifty Fifty” and Dot-com bubbles. The current set up is similar, although comparison between tech companies in the dot-com bubble and now should be taken with a grain of salt: the FAAMG are truly global companies with incredible growth and ability to generate profits, whilst in the late 90s, many tech companies hardly made any revenue and had less sophisticated software than we have at Lykeion. Nonetheless, if you think that the growth move is overdone, value could serve you well.
- Value is also the only factor that currently correlates with higher yields and lower bond prices, something that has been recently confirmed after the US 10-year yield moving closer to the 1% level. If you believe that Central Banks and governments are likely to lose control of the yield curve, and that we start seeing higher levels of inflation (remember that the Fed has shifted its monetary policy to average inflation targeting, meaning that it will likely allow inflation to overshoot the 2% target level), then value investing could offer some upside.
We quote GMO’s final thoughts:
“The final parallel between today and 1999 is painful to write about. Asset Allocation positioning is looking stupid today. Our Value bias, our underweight to U.S. equities, and our overweight to EM equities have not worked as we had hoped, as expensive assets have gotten more expensive and cheap assets have gotten cheaper. Our clients are losing patience, exactly as they did in 1999, that eerily similar and painful episode in GMO’s history. In fact, this late 90s episode was featured at the Harvard Business School, which teaches its classes using the case method. GMO literally became a case study because Harvard was so intrigued by GMO’s insistence on sticking to its conviction about overpriced Growth stocks and internet dot.coms even though the firm had been fired, ridiculed, and pilloried in the financial press. Clients were tired of hearing about mean reversion, tired of hearing about prices and valuations mattering. And they lost patience. Though many held on, just as many fired us. At exactly the wrong time.”
We’ve already seen some rotation in the market away from growth (although still at the early stages) into value on the back of vaccine developments, and as inflationary narratives continue to ramp-up we should see headlines about the opportunities within Value to continue to pop-up.
Market participants are now asking themselves if this rotation away from FAAMG-like stocks into value will be sustained. That, in part, will be a function of the developments of the vaccine, which face the logistical challenge of distribution and the ethical challenge of who gets access to it first. But the rotation signals coming from the vaccine headlines should not be dismissed. As explained by John Authers on his daily Points of Return newsletter, whilst in the US the headlines led investors to take profits on their FAAMG positioning, for Europe, the Pfizer BioNTech vaccine headlines led to much more pronounced movements. “For another example of how big a deal Vaccine Monday was for the European stock market, this next chart from Lapthorne shows the degree of negative correlation between prior 12-month returns and returns on Vaccine Monday. The worse a stock had done over the previous year, the better it did, to a far greater extent than had ever been seen before. The chart on the right shows the strength of the correlation, and shows that on this measure, this was the most powerful rotation in three decades, roughly twice as powerful a turnaround as anything that had preceded it.”
The risk of rotation is real, but only time will tell if it will last. What we do know is that there is plenty of room for recovery in the hard hit sectors:
A QUICK THOUGHT ON…
- 84% of S&P companies that reported earnings so far (less than 10% of companies have yet to report) have beaten consensus estimates. Whilst in a regular earnings season beating consensus estimates would reward the average stock with a 100bps outperformance of the S&P500 the trading day after reporting, this quarter the outperformance was just 9bps given how focused investors were on other catalysts (namely, the US elections and the vaccine headlines).
- Surprise primarily came from margin expansion rather than revenue numbers, according to David Kostin at Goldman Sachs, which implies that companies were focused on optimizing costs by laying off workers or reducing other Opex.
- Broadly, earnings calls showed some significant improvement in the sentiment of management teams but their ability to deliver on that optimism will be watched closely through the next season.
- The threat of insolvencies across the market is decreasing. This is a combination of government intervention, of countries having found ways throughout summer to re-open their economies at acceptable levels, and of a better understanding of the virus and how to diminish fatality rates.
- As reported by John Authers at Bloomberg, “Citi Private Bank divided high-yield bonds into “Covid cyclicals” (such as travel and leisure, which are worst affected) and “Covid defensives” (such as technology and consumer staples). Defensives, thus measured, are almost back to their tightest spreads, recorded before Covid struck, while even the cyclicals are now trading at lower spreads than they did five years ago, when worries about China were at a high. Even perceived risk for real estate, which suffers the considerable threat of unpaid rents, has returned almost to normal”.
- Keep an eye out for the way the solvency narratives change with the vaccine (positive impact) and with the new round of lockdowns (negative).
Goldman’s EPS forecast through 2024:
- According to David Kostin, “economic growth is the primary driver of earnings growth. Our US economists expect annual average real US GDP growth of 5.3% in 2020, 150 bp above consensus (+3.8%).”
- The forecast assumes that one Covid vaccine is approved by January, and then distributed broadly around the US in 1H2021. Whilst this could optically look optimistic, positive headlines like the ones from Moderna could force earnings expectations to move closer to GS outlook.