- The stock market has rallied in October despite ongoing uncertainty on a number of fronts.
- To Peter Cecchini, the rise is being driven by three “flimsy” narratives — and investors should be careful.
Despite ongoing uncertainty on a number of fronts — and a sharp September sell-off — markets seem to have found their stride in October.
For example, markets had long feared the prospect of a Joe Biden presidency because of the former vice president’s plans for increased taxes and the fundamental threat his party poses to a number of industries, like energy and health insurance.
But that narrative seems to have changed in recent weeks.
Investment banks like Goldman Sachs, UBS and Barclays have all published notes touting the boost to markets a Biden presidency would bring — one reason being the heightened likelihood of a more robust stimulus package being passed under Democratic leadership than is likely with Republicans in power.
Secondly, there seems to be some renewed faith in the strength of the economic recovery.
“Our economists believe there is enough momentum in the recovery to keep the US economy on pace to return to pre-Covid (4Q19) levels of real GDP by the middle of next year,” Morgan Stanley’s chief US equity strategist Mike Wilson said in a recent note. “Bottom line, a near term fiscal deal would be nice insurance but not necessary for economic recovery to continue.”
With this in mind, Wilson added that investors should begin looking to small-cap and cyclical stocks.
For the seemingly many optimists on Wall Street in the past few weeks, all is going swimmingly.
For Peter Cecchini, on the other hand, all of it is nonsense.
“Sometimes, markets rally on the flimsiest of narratives,” the chief strategist at AlphaOmega Advisors and former global chief market strategist at Cantor Fitzgerald said in a recent note. “How durable are the current narratives? Not very.”
He added: “Rallies based on nonsensical narratives are often relatively short-lived.”
Cecchini is bearish on the market’s upward path, and warns that it is being driven by three “nonsense narratives” in particular. He unpacks each below.
(1) The Biden narrative
First, Cecchini is bearish on the narrative that Biden being elected will benefit markets. Cecchini said the tax implications of a larger stimulus package — and Biden’s plan to increase corporate taxes by at least 7% — will outweigh the economic benefits of fiscal support that markets have become so exuberant about.
“Irrespective of party, the next several Presidents will likely raise taxes to attempt to close the budget gap. U.S. debt-to-GDP is now over 130%. However, corporate taxes will likely rise more under Biden than Trump, but that also largely depends on the composition of the legislature,” Cecchini said.
He added: “The Biden plan articulates a corporate tax rate increase from 21% to 28%…and it will likely be more than that. That’s bad for earnings. Larger deficits also make the risk-reward to Treasury ownership (longer dated) highly asymmetric so close to zero.”
Still, Cecchini doesn’t completely discount the importance of stimulus for markets, stating his worry that a contested election might mean a delay in stimulus. Indeed, some of the most influential players in finance and economics — like Federal Reserve Chairman Jerome Powell — have made their voices heard on the crucial role another round of stimulus will play in the economic recovery and the health of financial markets.
(2) The reflation narrative
Another narrative Cecchini is casting aside is that long-term bond yields are rising because of reflation — or the resurgence of economic activity due to government stimulus — which would mean good news for small-cap stocks.
There have been widespread calls around Wall Street for a shift into stocks that benefit from the early stages of an economic cycle — namely cyclicals, value stocks, and small-caps.
But Cecchini said that reflation is actually not occurring, and that long yields are instead rising because of the heightened supply of treasury bonds. Therefore, bullishness around small-caps is misguided and “bogus.”
“For 2019, S&P 500 earnings growth year-over-year was flat for large caps and down about 15% for small caps. The prospects for a quick turnaround in earnings growth seems utterly dim,” Cecchini said. “Maintaining low rates can’t support ever-rising equity prices when earnings remain challenged and credit quality continues to deteriorate.”
He added that a contraction in consumer credit is getting underway, citing credit shrinkage in August after growth in June and July, and a tightening of lending standards by banks.
(3) The dollar narrative
Third, Cecchini said he doesn’t buy the narrative that low interest rates and big deficits in the US will lead to a weakening of the dollar.
“Our rate differential models show (and have been showing since mid-July) that the dollar is slightly undervalued relative to other developed market currencies. Our view has been that the DXY’s downside fair value is about 93 – a floor of sorts (currently ~93.50),” Cecchini said.
He continued: “The bottom line is that an easy Fed implies easy policy in all major DMs, including Japan and Europe. There remains a global, structural shortage of dollars, which we can see in currency basis markets, which continue to require a premium for dollar ownership (above and beyond the rate of exchange). Indeed, the risk is to a stronger dollar after the 2020 election, even as yields fall on a potential resurgence of COVID-19 in fall.”
