There’s a battle going on in the economy and markets that is epic enough to compare with the great Mohammed Ali bouts of the 1970s, versus Joe Frazier and George Foreman.
This time, the two imposing warriors are the current reigning champ, blooded in the Great Financial Crisis—“The Japanifier”—and a menacing newcomer trained in the state-of-the-art Modern Monetary Theory Gym known to all as “The Stimulator.”
Tactics
The Japanifier weighs in with disinflation and below-trend growth that persists even in the face of unprecedented monetary and fiscal policy aggression, high employment and ever-higher public-sector debt. He leaves the yield curve as flat on its back as his opponents in the ring, pummels the profits out of the banking sector and freezes the money multiplier with a high savings rate. His experienced support team are structural disinflationary forces and demographics.
The champ’s ring tactics never change: he is long in duration assets, carry, credit and quality dividends; and short in value and cyclical assets, as he crushes anything that dares to try and be volatile while he reigns supreme.
In the other corner, The Stimulator is a modern-day chiseled contender whose keen young eye has observed that the champ never gets punished for any level of indebtedness, and is therefore convinced that if he keeps throwing devastating Modern Monetary Theory punches, he will eventually lift the Inflation Belt in victory. He has a powerful ally in his corner, the best cut man and the greatest healer of wounds in the business: Mr. Central Bank. With his magic sponge dispensing limitless liquidity he has vowed that The Stimulator need never fatigue—and the fans are too busy enjoying their profits from Zoom and Docusign to notice that he is stealing from their children to keep his fighter going.
The challenger’s tactics? He stays punchy with cyclicals, value equities, banks, emerging markets stocks and bonds and commodities, while keeping secular growth and its lofty valuations at arm’s length.
Active Tilts vs. Passive Allocations
Watch this bout carefully, because the winner—or even just how the fight goes over the next few quarters—is likely to be the most important determinant in successful portfolio structuring for some time to come.
It is the nature of this battle that explains why inter-sector and inter-factor moves are currently more volatile than beta-related index moves, even though they are relative and should therefore be less volatile. That means active allocation tilts in portfolios will most probably drive medium-term performance more than decisions about relative passive beta allocations. In other words, the decision whether to favor growth or value, for example, may be more consequential than whether to favor equities or bonds. This is a significant shift in the decision-making process that investors have had to address over the past 10 years.
So, who is winning and what does it mean for portfolio structuring? Figure 1 shows the performance of the yield of the nominal 10-year U.S. Treasury against that of a selection of cyclical assets: the 10-year U.S. breakeven inflation rate, the Goldman Sachs Cyclicals Versus Defensives Index, and the spot rates for AUDJPY and copper.
Figure 1. Cyclical Assets Have Detached From the 10-year Treasury Yield
Source: Bloomberg. The chart shows the yield of the nominal 10-year U.S. Treasury and the 10-year U.S. breakeven inflation rate (rhs), plus the Goldman Sachs Cyclicals Versus Defensives Index and the spot rates for AUDJPY and copper (lhs, re-based to 100). Data as at September 9, 2020. For illustrative purposes only.
To quote one of my daughter’s favorite Sesame Street songs, “one of these things doesn’t look like the other.” Since late March, every cyclical asset has reacted to recent stimulus measures and an improved economic outlook. In contrast, the 10-year Treasury yield has been stuck on the canvas.
If you believe the market is convinced that the Federal Reserve can cap 10-year yields while these cyclical assets continue to rally, it suggests a complete and persistent breakdown in the relationship that was in place until March this year. In this environment, where nominal yields remain suppressed even as inflation expectations move higher, the implied further decline in real yields has the potential to push equity index valuations higher and higher.
Reversion
But what if the 10-year Treasury yield reflects a weaker longer-term growth and inflation outlook, while the cyclical assets merely reflect the impact of current stimulus measures? Or what if, conversely, the 10-year is wrongly priced and needs to correct back up to 1.5% to come back in line with the rest of the markets?
If you expect the first reversion scenario, that argues for underweighting cyclical and value assets at some point when the stimulus fades, and therefore selling into any subsequent cyclical strength. Experience from the persistently low-yield environments of Japan and Europe suggests that cyclical exposure outperforms only over short periods while value keeps on trending lower.
If you expect the second reversion scenario, while it would be hard to argue for further multiple expansion (given higher real rates), one could certainly envisage a fairly flat overall equity market where underperformance from secular growth is balanced by continued outperformance by cyclicals. The caveat here is that we have already seen cyclicals regain more than 75% of their losses from January levels; similarly, a nominal 10-year yield of 1.5% with today’s level of real rates would imply breakeven inflation at 2.5%—which we haven’t seen since 2013.
Knockout Blow
Think of it this way. The cyclical assets represent our challenger, The Stimulator. The 10-year Treasury represents our reigning champ, The Japanifier. Since March, The Stimulator has been throwing huge punches and has The Japanifier on the ropes. But the champ’s tactics are still intact as the bookies' odds change with every punch. Is The Stimulator on the verge of a knockout blow? Or is The Japanifier deploying Ali’s old trick, the “rope-a-dope,” sapping The Stimulator’s energy before re-asserting his dominance?
Right now, while we may only be halfway through the bout, our bet is for the champ to come through in the final round. His forces may be just too great to counter as the never-ending liquidity of the magic sponge eventually overhydrates the challenger’s balance. But keep a close eye on those cyclical assets and in particular nominal U.S. longer dated yields: they may provide an early sign of any reflationary cracks in his armor. Good luck!