Far From Benign

Was yesterday’s market decline
A flash or a longer-term sign
Of things gone astray
That might well give way
To outcomes quite far from benign

Is this the end?  Have we seen the top in the equity markets?  That seems to be the question being asked this morning as both traders and investors try to determine if the first risk-off session in a number of months is the beginning of a trend, or merely a symptom of some short-term position excesses.  While Asian markets (Nikkei -1.0%, Hang Seng -0.85%, Shanghai -0.1%) continued along the theme of greater problems to come, Europe is not quite as worried, at least not in the equity space.  Interestingly, despite the rebound in Europe (DAX +0.1%, CAC +0.4%, FTSE 100 +0.3%) European sovereign debt has continued its rally with yields there lower by a pretty consistent 3 basis points across the board.

Meanwhile, after a tremendous rally in the Treasury market yesterday, where 10-year yields fell 10 basis points and the 2yr-10-yr spread flattened to below 100bps, buyers are still at large with the 10-year declining a further 1.2bps as I write.

It seems the narrative that is beginning to take hold is that the economic rebound from the Covid recession has reached its peak and that going forward, growth will quickly revert to trend.  This newer narrative has been reinforced by the spread of the delta variant of Covid throughout Asia and Europe (and the US, although lockdowns don’t seem to be on the agenda here) and the renewed closures being imposed around the world.  For instance, half of Australia has been put back under lockdown, as has New Zealand and growing parts of Southeast Asia including Singapore and Indonesia.  Europe, too, is feeling the pressure with rising caseloads n the UK, Spain and France resulting in calls for further restrictions.   The upshot of this is that earnings will struggle to rise as much as previously expected and that inflation pressures will quickly abate, and the concept of transitory inflation may be proven correct.

Chair Powell and friends are quite sure
Inflation, we won’t long endure
But pundits abound
Who’ll gladly expound
On why it’s the problem du jour

This brings us back to the big question hanging over markets, is inflation transitory or persistent?  Certainly, the recent trend in the data might argue for persistence as we continue to see higher prints than both the previous period as well as than forecasted.  As long as that is the case, it will be more and more difficult for the central banks to declare victory.  While commodity futures markets are well off their highs, a broad index of basic materials prices, things where there are no futures markets, is at all-time highs and rising.  Wages continue to rise as well, as the disconnect between the number of unemployed people and the number of job openings is forcing business to increase pay to get workers to come on board.  All of these things point to continued higher prices going forward, as do surveys of both consumers and businesses who virtually all agree higher prices are in our future.

However, the evidence from the bond market, the market that is historically seen as the most attuned to inflationary pressures, would argue that the inflation scare has passed.  With yields tumbling, US 10-year yields are more than 60 basis points off their late March highs, and the yield curve flattening.  All indications are that bond investors are sanguine over the inflation threat and are actually more worried about deflation.

The argument on this side remains that temporary bottlenecks have resulted in price pressures during the reopening of economies from the Covid lockdowns.  Economists’ models point to those very price pressures as the impetus for increased supply and, thus, lower prices in the future.  The problem is that the timeline for increasing supply is very different across different products.  Perhaps the most widely known shortage is semiconductors which has led to reductions in the production of cars, washing machines and consumer electronics.  But it takes at least 2 years to build a semiconductor factory, so it is quite possible the shortage will not be alleviated anytime soon.  Similarly, with mined raw materials, it takes multiple years to open up new mines, so shortages in copper or tin may not be alleviated for a number of years yet.  Of course, if growth is slowing, demand for these items will diminish and price pressures are likely to fade as well.

Let’s consider a few things about which we are certain.  First, securities prices do not travel in a straight line, and in fact, there are many short-term reversals involved in long-term trends.  Thus, if inflation is indeed persistent, the recent bond rally may well be the result of short-term factors and position reductions.  Recall, higher yields were the consensus Wall Street forecast three months ago, with expectations for the 10-year to be yielding between 2.0% and 2.5% in December.  Large fund managers were on board with that idea and built large positions, which take time to unwind.  It is entirely possible we are seeing the last throes of those position adjustments right now.

Another thing about which we are (pretty) certain is that during the Fed’s quiet period, we will not hear from any Fed speakers.  This means that in the event the market really does continue yesterday’s declines and starts to accelerate, the Fed will be hamstrung in their ability to try to jawbone things back to a smoother path.  Would Powell break the quiet period if markets fell 5% or 8% in a day?  My sense is he might, but that is exactly the type of thing that markets like to test.

Finally, let’s not forget that markets are hugely imperfect forecasters of the future.  After all, it was only 3 months ago when markets were forecasting much greater inflation while anticipating no change in Fed policy until 2024.  So, just because the current market view points to a potential slowing of economic growth and reduced inflation pressures, the economy behaves independently of the markets, and may well show us that the views from March were, in fact, correct.

Having already touched on equity and bond markets, a quick look at the FX markets shows that the dollar continues to power ahead vs. its G10 counterparts with NOK (-0.7%) and NZD (-0.65%) the laggards this morning.  NOK continues to suffer from oil’s remarkable 7.5% decline yesterday, while New Zealand is suffering on renewed lockdown fervor, and this after the RBNZ just last week explained they were about to tighten policy!  But we are seeing weakness in the pound (-0.45%) and AUD (-0.35%) both of which seem to be Covid shutdown related, while JPY (0.0%) is the only currency holding up in the bloc today despite further negative news regarding the Olympics and athletes contracting Covid as well as sponsors pulling out.

Emerging markets have been more varied with losers in Asia (SGD -0.35%, KRW -0.25%) on the back of Covid lockdowns, while gainers have included TRY (+0.4%), INR (+0.35%) and RUB (+0.3%).  The ruble seems to be reacting to the end of oil’s decline, unlike NOK, while INR saw equity market inflows driving the currency higher.  TRY, which is on holiday today, is benefitting from a higher inflation reading than expected and expectations of further policy tightening by the central bank there.

On the data front today we see Housing Starts (exp 1590K) and Building Permits (1696K).  We all know the housing market remains hot, so these data points are unlikely to move markets.  Rather, watch carefully for a continuation of yesterday’s risk off session and a stronger dollar.  I have a feeling that this morning’s price action is more pause than trend.

Good luck and stay safe
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