Revert to the Mean

For more than two weeks we have seen
Risk assets all polish their sheen
But now has the bar
Been raised much too far?
And will we revert to the mean?

I read today that recent price action (+42% since March 23) has been the largest 50-day rally in the S&P 500’s long history. Think about that for a moment, the economy has cratered (the Atlanta Fed GDPNow forecast is currently at -52.8% for Q2), unemployment has hit levels not seen since the Great Depression with more than 40 million Americans losing their job in the past three months and the stock market is flying. Well, at least the S&P 500 index is flying as the value of its five largest constituents continues to rise, seemingly inexorably, thus dragging the index along with them. The disconnect between the performance of risk assets and the data representing the economy is truly stunning. And while I understand that equity markets are discounting ‘instruments’ looking ahead to the future, it still beggars belief that most of the companies in the index are going to see earnings recover in anywhere near the time anticipated by the market. Remember, the CBO just published an analysis describing the most likely outcome being a 10-year timeframe before the US economy gets back to the levels seen in 2019.

Part and parcel of this movement in risk assets has been the dollar’s decline, with the Dollar Index (DXY) down more than 5% during the same period. While that is not historic in nature, it is still a very large move for such a short period of time.

And so I must ask, is this movement in risk assets sustainable? Clearly the driving force here has been central bank, (mainly the Fed) largesse as they have pumped trillions of dollars of liquidity into the economy, much of which seems to have found its way into stocks. But remember, the Fed started its unlimited QE by buying $75 billion A DAY of securities. That number is now down to less than $5 billion each day and declining on a weekly basis. In fairness, the Fed got ahead of the curve, recognizing just how devastating the situation was going to be. But the Treasury has caught up and has been issuing debt as quickly as they can. Now the Fed’s liquidity is being funneled directly to the Treasury, rather than finding a home elsewhere, and unless Powell reverses course and starts to increase daily purchases again, there is every chance for equity markets to begin to suffer instead.

One other thing that is missing from this market, and which has been a key driver of the long bull market, is share repurchases by companies. Stock buybacks represented nearly all of the net stock buying seen during the rally. And I assure you, that ship has sailed and is not likely to return to port for many years to come. In fact, it would not be surprising if new laws are enacted that limit or prohibit repurchases going forward. The point I am trying to make is that there are numerous reasons to believe that this remarkable rebound in the stock market, and risk assets in general, is overdone and due for its own correction.

Is today that correction? Well, for a start, it is not an extension of the rally as equity markets in Asia were little changed (Nikkei +0.35%, Hang Seng +0.2%, Shanghai -0.15%) and those in Europe are all in the red (DAX -0.7%, CAC -0.6%, FTSE 100 -0.3%). The DAX performance is quite interesting given the announcement by the German government that they have agreed on a €130 billion stimulus package, 30% larger than anticipated. Meanwhile, US futures are all pointing lower as well, down between 0.2% and 0.5%.

Bond markets continue to lack any informational value as they have become entirely controlled by the central bank community. While yield curve control is only explicit in Japan (for the 10-year) and Australia (for the 2-year) the reality is that every central bank is actively preventing government interest rates from rising out of necessity. After all, given how much borrowing is ongoing, governments cannot afford for interest rates to rise, they would not be able to pay the bills. Perhaps the only exception to this rule is the very long end, 30 years and beyond, where yields continue to rise as curves continue to steepen. (Remember when an inverted yield curve was seen as the death knell of the economy? The reality is the problem comes when it steepens like this! Steepening curves are not so much about future economic growth as much as about higher future inflation.)

And then there is the dollar, which is broadly higher this morning, albeit not in any dramatic fashion. As the market awaits word from Madame Lagarde and her 24 colleagues, we have seen the dollar rise modestly vs. both G10 and EMG counterparts. The biggest retreats have been seen by PLN (-1.25%), where the government just announced an expected 8.5% budget deficit, and MXN (-0.9%), which is suffering as oil sells off a bit. However, both those currencies have seen significant rallies in the past two weeks, so a little reversal is not surprising. As to the rest of the bloc, EEMEA currencies are underperforming APAC currencies, but generally they are all lower.

In the G10, the movement have been much more muted, with GBP, AUD and SEK all lower by 0.4% or so and the rest of the bloc, save the Swiss franc’s 0.1% rally, lower by smaller amounts. Again, it is difficult to point to any one thing as the cause for this movement, arguably it is simply position reductions after a long run.

At this point, all eyes are on the ECB, where expectations have built for an increase in the PEPP of as much as €500 billion. While they have not come close to using the original amount, it seems clear they will need more before the end of the year, and so the market has latched onto the idea it will be announced today. One potential problem with this action is it could reduce pressure on the EU to actually go ahead with their mooted €750 billion fiscal support program that includes joint borrowing, a key feature for the euro’s future. It is clear that as much as the frugal four don’t want to see the ECB distort markets further, they are even more disinclined to give their money to the Italians and Spanish directly. However, in the end, I believe Madame Lagarde will give the market what it wants and raise the PEPP limit.

Today’s data picture brings Initial Claims (exp 1.843M), Continuing Claims (20.0M), the April Trade Balance (-$49.2B), Nonfarm Productivity (-2.7%) and Unit Labor Costs (5.0%). With the monthly NFP report tomorrow, it seems unlikely the market will respond to today’s data in any meaningful way. Earlier we saw Eurozone Retail Sales decline 11.7%, not as bad as feared but still the worst outcome in the history of the series dating back to January 1998. And yet, as we have seen lately, the data is not the driver right now, it is the central banks and sentiment. While we have paused today, sentiment still seems to be for a further rally, but my take is that sentiment is getting old and tired. Beware the reversion to the mean!

Good luck and stay safe