Equity Bulls versus Economy Bears: May be both are right

With the head scratching Jobs report for May, 2020, the endless debate about whether this is a new bull market or a bear market rally has again reignited.

The Jobs report for May, 2020 was a surprise of a historical proportion for sure. But everything about the sudden stop about the Global economy on the back of the pandemic has been of historical proportions. So, once you accept the fact that for all sorts of reasons, including data collection and estimation errors, nobody really knows anything about the economic rebound, it makes the task of investing a lot easier.

 The data is in flux and we will find out the “truth” in due time. May be the task is a little tougher now, but it seems to me that that is the precise challenge with investing at all times.

Getting that platitude out of the way, its quite plausible there may be there is a simpler explanation.

These days, I am all for simpler explanations. I don’t see much point in analyzing data from the Roman empire, or Napoleanic Wars, or the Great Depression to figure out what is likely to happen. Too many things are different today to make that data wholly irrelevant, the admonition about people not paying enough attention to history notwithstanding. They don’t really help me. I put it in the same category as my mother asking the family astrologer about my future when I was young. He didn’t know anything, he couldn’t know anything, but he cited some old grand book and made big pronouncements and it made her feel better.

The simpler explanation could be that both the equity bulls and economy bears are both right. The low interest rate environment helps tie the two together.

It is quite likely that the Global Economy as it starts reopening probably is on a sustainable path of slow growth recovery. The recovery probably isn’t a V-shaped, but it probably isn’t L-shaped either. The growth drawdown was self inflicted and once we start reopening, we get on the sustained recovery path with some long term collateral damage.

If the May jobs report is any guide, we will pretty soon stop gawking at the graphs of the employment reports from March and April and accept them for what they were – aberrations that scared the living daylights out of you, but unsustainable in the long term because the economy was bound to reopen and a lot of the furloughed workers were likely to return to their previous employers.

The fact that the fiscal and monetary response was as overwhelming as it was and on a global basis where the Europeans may be outdoing the US authorities, makes this thesis quite tenable in my view.

So, equity bulls and economy bears may be both correct.

The Economy bears might be right, to an extent. The economic rebound may be starting, but it is a long road ahead. Given the slow pace of reopening, the return to where we were before the pandemic will take a long time. Gaining a few million jobs after you have lost twenty doesn’t imply a quick economic recovery.

The equity bulls may also be right. They see the economy on a sustained growth path and recovering in due time. That due time may be several years, but they are really looking forward. The fact that safe interest rates are close to zero, or negative, in the developed world, makes them look really far and start discounting that to today, and due to low rates, that discount isn’t as large as it was before. If the alternative is to invest at zero rates for safe assets, they might as well take a punt in equities.

The position of economy bears is far easier to accept. It is more correlated to the current circumstance. The position of the equity bulls needs a bit more validation. The Job report certainly provided a bit of support. High savings rate today certainly points to a growth revival under the right circumstance. Finally, if you look at the VIX strips in the out months, it is still quite high – equity investors may not be as delusional as you think.

I feel this is the only simple and logical explanation I can come up with to square the circle. Market participants have been known to get carried away at various points, but never this much in a drawdown, as opposed to a bullish, environment.

If you accept the thesis – that both Economy bears and Equity Bulls are right, to an extent -- there are three broad implications, things that need watching

a)     Pullback on the fiscal support: The massive support to Labor income in the US was one of the biggest game changer in this go around. It was large, it was quick and it got the job done despite the anecdotal evidence otherwise. With the jobs report, now policy makers have already started talking about pulling the support back. That would be a cataclysmic mistake. The economy needs fiscal support, even in an equity bull case. Any signs that it is likely to be withdrawn after July, will make the lives of Equity bulls miserable.

Given that it is an election year in the US and that the EU is dealing with a whole host of issues away from the pandemic makes the likelihood of withdrawal of fiscal support less probable, in my view. But it certainly bears watching.

b)     Pullback on Monetary support: The Fed has been all in since mid-March. It took the ECB a while but by now they too are all in. But given that rates are near zero or negative in an environment where the growth spurt may be quite acute, you have to feel for bond investors. They will try to raise rates higher – it is already happening – and that will be meaningful negative for equity bulls.

 In my view, this is an easier problem to solve because this is a technical as opposed to a political problem and fully under the control of technocrats rather than politicians The Fed should – and will – announce their yield curve control strategy soon. They probably won’t have to do much given the programs that they have already announced. All they have to do is announce that they will cap 10 year rates at say 50 bps and the markets will fall in line quickly. Again, it bears watching but I would assign a high probability to this happening – and soon.

c)      Back to the Carry Trade – If this thesis is correct, we will get back to the carry trade very soon. The global economy is recovering, the equity markets have already priced in a lot of that recovery, central banks are imposing yield curve controls and the fiscal authorities want to support the growth revival. That is the perfect combination for a carry trade – dollar weakness, credit spread tightening, EM Fx doing well, Munis doing well – a redo of 2009 to 2019 in a much shorter time frame. Again, in that environment, carry investors may end up doing much better than equity investors for a while.

The bottomline is that both economy bears and equity bulls are correct – partially. And a lot of that may be already getting discounted in the market. I find that explanation quite plausible. I think it might be worthwhile increasing my allocation to the carry trade as a substitute for my equity allocation.