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Oct 28, 2021

The Gap Between Beliefs & Reality

Written by
Damien Hatfield
Written by
Dalton Street Capital

Following the mini growth scare over the northern hemisphere summer, culminating with the (mini) correction in the S&P500 (the global risk proxy) in September, there has been an encouraging rotation back into value and cyclical sectors. Our sense is that this is durable. However, further reflation and inflation is likely to contribute to ongoing discomfort about rising rates over the next 18 months. That was heightened overnight after a hawkish taper by the Bank of Canada. As we have noted before, those concerns are unlikely to end the equity bull market, but the gains will likely moderate and volatility will probably be higher. Critically, there is also likely to be a sustained shift in relative performance within the equity market.

One of the key developments since late September has been the rise in future expected short rates. Both the 2 and 5 year Treasury yields have risen another 25 basis points (or so) in October. While the policy rate is likely to remain anchored until the middle of next year, the fixed income markets are obviously forward looking. Historically the 5 year yield has tended to lead the Fed Funds Rate, through the cycle (chart below). Overnight there has been a material flattening of the curve as well after the hawkish move by the Bank of Canada to end QE. The magnitude of the move in the US 2s/10s curve was also likely exaggerated by the timing of the Fed rate hike expectations and the asset purchase program that has artificially supressed the long end of the yield curve.

While the early stage of a macro recovery typically sees the fastest equity market gains in an economic cycle, this is the stage where macro strength is unambiguously positive for equities (as there is little impact on inflation). However, as the cycle matures and the output gap (or unemployment gap) closes, capacity constraints tighten and macro strength increases concern about rising inflation or rising rates. The big picture point is that equities continue to rally in this phase, but the pace of gains slow, and corrections (consolidations) are more likely. The additional support for equities is that the equity risk premium is still abnormally high, particularly in Asia.

It is of course difficult to see a sustained move higher in long end yields if the recent deceleration in growth persists. Moreover, if there was an extension of the energy driven inflation should that might lead to demand destruction and growth disappointment. It is notable that GDP revisions (based on the Atlanta Fed) have slowed close to zero in Q3 (chart above). All measures of consumer confidence have peaked, the purchasing manager surveys have rolled over and as we noted above the yield curve has started to flatten. On the positive side, some of the negative influences on growth such as the credit impulse in China and the delta variant should start to improve over the coming months.



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