We don't have to wait for the November edition of the BofA Fund Manager Survey to tell you what Wall Street will view as the biggest tail risk: it will no longer be "inflation" but rather "curve inversion/policy error" and perhaps, "recession." That's because the entire financial world appears to have changed overnight, and after central banks had pushed a dovish message for years, that all changed in the past 24 hours when first Canadian short-end rates blew up after the central bank ended QE and brought forward its first rate hike date, followed quickly by Australia which similarly failed to buy 2Y bonds, sending short-end yields from 0.2% to 0.5%, as the RBA effectively ended its Yield Curve Control.
But did the world really change yesterday?
That's the rhetorical question JPMorgan's one time quant and current global head of strategy Marko Kolanovic asked in a note published this morning, and not surprisingly, answered in the negative:
"No. Despite the large move in yield curves, equity factors, and commodities there was no new macro-economic data that would explain such move, no change in COVID trends (the downward trajectory continues), and no new surprise coming from corporate earnings."
That's one way of interpreting what happened; another is that central banks merely confirmed the macro-economic data that was staring everyone in the face for months - i.e., that inflation is not transitory - and that instead of sticking their heads in the sand, central banks are finally admitting they are behind the curve. And, as a result, bond traders - many of whom have never worked in an inflationary environment - scrambled to trade alongside this long overdue admission from the money printers.
But let's assume Kolanovic is right. If so, what would explain the violent moves observed across markets?
According to the quant it was nothing more than technicals - the same technicals we discussed in "96 Billion Reasons Why The Treasury VaR Shock Is About To Get Worse" - and which Kolanovic summarizes as "a significant month-end rebalance flow into bonds and selling of equities, CTA buying of bonds, and various media reports of funds closing their steepener positions at a loss and exacerbating the move in yields."
To reinforce his thesis, Kolanovic points to the big duration divergence in equities - where growth stocks have large positive and cyclicals large negative duration - and notes that despite month-end selling of stocks, "the Nasdaq managed to outperform on account of its long duration exposure, while cyclicals and broad index sold off."
But what about the UK, Canada and Australia central banks which started the selloff in the first place amid what we claim is the long-overdue realization that inflation has arrived? Here, too, Kolanovic completely dismissive of anything that does not comply with this own thesis, and writes that "they are not leading the Fed and are much less relevant than Fed."
Well, yeah... if the much more relevant Fed ended QE unexpectedly, global markets would be down 30% today. Instead, a more reasoned assessment would be not that UK and Canada are "less relevant" but that they are setting the stage for what the Fed will soon have to do. As such their actions have far more significance than the man in charge of JPMorgan's equity research appears to give them.
Of course, there is objective analysis and then there is a premeditated, goalseeked narrative, and this is sadly an example of the latter from the JPM quant who, eager to defend his bullish stance, argues that "in our view it is unlikely that tightening will start early (as priced yesterday), immediately after the taper, and a few months before important elections." We dread to think of what would happen if Marko actually admitted - as his Morgan Stanley colleague Michael Wilson did - that Tapering is Tightening: perhaps a giant Stay Puft man would appear?
And just in case the above is incorrect and there is a fundamental reason for the violent curve repricing, Marko takes rhetorical refuge in the outside case that Powell may be replaced by the Hillary Clinton-supporting, uberdove Lael Brainard:
Also, one should note that other potential candidates for the Fed chairman are more dovish than Powell, indicating the current thinking of policymakers and the administration. Historically, the Fed has not followed other smaller central banks, and we don’t think that will be the case this time either.
Verbal acrobatics aside, where do recent events leave us?
According to the JPM strategist, "the move yesterday was a large technical overshoot that will revert. Month end flows will be mostly done today (the effect tends to be pre-positioned and finish the day before month end), and there should be a strong bounce in equities, yields, and commodities." Meanwhile, his bullish views on cyclical equity recovery, continued decline in COVID, rising yields, and the commodity super-cycle "remain intact."
This is happening as various Value/Growth ratios have now erased a full year of outperformance and are near pre-vaccine levels, while corporate earnings, according to Kolanovic, "continue to strongly surprise to the upside" (if with several major caveats) with healthy Q3 beats both on top line (73% of companies beating estimates) and bottom line (79%). Company guidance remains constructive and investment activity (capex, buybacks) robust.
Finally, looking at supply chain issues, the Croat quant - unlike say strategists at Deutsche Bank - sees them eventually subsiding and he expects top-line growth to further re-accelerate in a number of industries.... which of course would only lead to further persistent inflationary pressures as wages continue to rise at a aggressive pace.
His conclusion: "Investors should buy the dip in cyclical assets, such as value, small caps, energy, financials and EM equities, commodities, and position for yields to resume moving higher. In that regard, we think investors should fade yesterday’s move."