Equity markets prepare for bond markets to go wild

Local market started negative and finished negative despite the decent global investor buying in the middle of the day. The midday bounce was mainly driven in Banks and Tech sector. Beaten up Utilities and Property lead the green sectors while Energy and Mining were the worst of the red sectors.

It was all about the bond market selloff driving US market bashing. Yields are breaking out and Insurance stocks were getting a bite as laggards in the financial sector. US Fed confirmed that they are going to let yields run while inflation is expected to beat both bond yields and Fed fund rate by a margin. ECB, BOJ and BOE have suggested that they are willing to let bond yields run hot for the next 3-6 months. 

Negative real rates are positive for Gold while expanding yields are driving Insurance sector outperformance. It was a massive turnover day as options expiry added to the local market volatility. Just to add to the US volatility, they have their monthly options expiry tonight as well.

It is becoming clear that Central Banks have lost control of the yield narrative to the bond market. Bond market does not care about the Central Bank core inflation. Bond yields are much more correlated to actual inflation. Even the US Fed has accepted that inflation will hit mid 2% for 2021. Let us assume that US Fed is right … yes I know, it is a stretch...but let’s assume that they are right. US inflation in Q1 is averaging around the 1.5% ballpark and we all know it is going to pop in Q2/Q3 as they are cycling weak data. Let’s assume it slides back to 1.5%...which is unlikely…but let’s assume that as US Fed is forecasting, a transitory inflation pop. To hit mid 2% inflation through 2021, Q2/Q3 has to average 3.5% inflation. If you assume that, we are likely to see US 10 year bond yield reach 2.5% in the next 3 months. It will still be negative real yields and negative real rates as US Fed fund rate will still be irrelevantly low for years to come…according to US Fed. The problem is that the bond market knows this is going to play out. The equity market takes a few days to catchup than bond market. Bond market is likely to keep sliding till yields get past 2% and closer to 2.5%. Investors were pricing in NASDAQ multiples on nominal yield below 1% for a long time. 

Equity markets can barely handle 1.50% bond yields with the corporate debt bubble. There was always going to be “yield tantrum” above 1.75% but no amount of jawboning is going to protect the market against a “reflation tantrum” above 2.00%. Bond and Equity markets are currently looking through this outlook and expecting “multiple diarrhea” to bring asset prices back to reality. We are at the early stages of the cycle where “yield tantrum” is being accepted and absorbed. It won’t be long before “reflation tantrum” hits. When investors start to look at bond yields near 2.5%, markets will move to “multiple diarrhea” state as growth investors move from high growth at any multiple to cyclical growth at reasonable multiple. The reflation cycle is likely to deliver multiple reduction and market cap destruction as asset prices come back to economic reality. Prepare for “multiple diarrhea” as bond markets go wild!!!

We are expecting an early Federal election in Q3. Economic mess will become too obvious by Q4 and political mess will not go away till Q2. The obvious time frame is late Q3 and the Federal Government will be planning substantial pork barreling over the next 6 months to hold together a fracturing economy. Despite fantasy job data that even RBA does not believe, we got the latest update on retail sales today and it was weak. Not really a surprise as main street handout ends in a few weeks while corporate handout goes unabated. But don’t worry…there is more pork on the fork over the next 6 months than ever before. Yes…we are talking pork barreling. It’s all on taxpayer’s endless credit card. It’s the government’s favorite dish…pork barrel on a rort. They are unlikely to use the old mantras like “fake jobs and growth” and “endless debt and deficits”. Expect RBA to ratchet QE and even add more QE ahead of the election as asset bubbles start to wobble. Can RBA buy property and/or stock ETF on the market like BOJ? Don’t discount it. Reality is scarier than fantasy!!!

Comments on US market last close… US market was hit hard in the last few hours to be a bash day as bond market was staring down central banks. Bond yields were flying high...10 year peaked at 1.76% and closed at 1.72%. RUSSELL down 3.14% and NASDAQ down 3.02% were casualties of the reflation war. ECB followed US Fed and flagged that they are not planning on yield control despite transient inflation pop. Unlike RBA, they realise the futile nature of the act. The problem is asset bubbles in all classes meant there is nowhere to hide. Bond market is better at risk management and it is doing what it does... resetting the risk/return paradigm. USD and Gold moved up with yield in the US while Oil was bashed and Copper pulled back. Banks was the only positive sector while Energy, Tech and Retail were hit hard. Europe seeing more third wave effects...Paris goes into lockdown. Rising costs are starting to hit EM with Brazil raising rates by 75bps and flagging similar move next meeting. BOE copied the big brothers and delivered more of the same.

We are in uncharted territory with central banks and governments continuing to swim in the river denial. Let me refer to something I wrote in a previous note to give some clarity…

The mess we are in reminded me of the speech delivered in a classic movie called The Big Short. This speech had profound meaning for me. Take the time to watch the movie. I thought I would paraphrase it for Australia. It goes something like this…“We live in an era of fraud in Australia. Not just in banking, but in central banks, governments, regulators, rating agencies, media, tech, insurance, investment, education, religion, food, even cricket...What bothers me isn’t that fraud is not nice. Or that fraud is mean. For fifteen thousand years, fraud and short sighted thinking have never, ever worked. Not once. Eventually you get caught, things go south. When the hell did we forget all that? I thought we were better than this, I really did. And the fact that we are not doesn’t make me feel all right and superior. It makes me feel…sad. I just know at the end of the day average people are going to be the ones that are going have to pay for all this. Because they always, always do.”

Remain nimble, contrarian and cautiously pragmatic with elevated global macro risks!!! Buckle up...it’s going to get bumpy!!!

Full SUNSET STRIP report with end of day market stats are on the attached link.

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