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Morning Notes — Outlook


July 10, 2020

Economy: The Economic Surprise Index (ESI) hit another record high of +225.90 today vs a prior cycle high of +84.5 reached in December 2017. The ESI measures the upside or downside difference between the reported number and the consensus estimate. The massive gap between the previous cycle high of +84.5 and the current +224.10 can be partially blamed on the variance between estimates given the unprecedented nature of the March/April slowdown but the dispersion still exists and speaks to the momentum of the recovery. A normal recession has a fairly predictable lifespan based on a negative feedback loop that exists between weaker labor data>weaker output>weaker corporate profits>weaker labor data. A normal recession lasts 9-18 months, but we already know this isn’t a normal recession. Of course, COVID-19 infection rates are the key variable and labor markets are the key input for the aforementioned feedback loop. Holding infection rates fairly constant, we currently see far too much momentum in US macro data to assume that weaker labor market conditions will persist much longer.

SPX: Fed liquidity measures and monetary/fiscal policy stimulus have been the two biggest supports for the ~40% rally off the March 23 low. At the end of May, US money supply was growing 23.1% year-over-year. Liquidity is booming and a 10-year Treasury is yielding ~0.61%. Financial conditions have never been this easy and equity Discounted Cash Flow (DCF) math has never been more favorable. Using the Dividend Discount Model (DDM) to estimate a current equity risk premium depends on your inputs, but we can derive a very conservative estimate close to 9%. Keep in mind, the largest pools of investment capital allocate across different asset classes and the decision between an investment with a return of ~0.61% and one with ~9% has never been this easy.

Virus: We think markets are currently mispricing COVID-19 risk. New case and hospitalization data from AL, CA, FL, NV, SC and TX are showing early signs of peaking momentum and if the outbreaks in these states follow curve dynamics present elsewhere, case counts should begin to decelerate as early as next week. That scenario isn’t priced into markets and a risk that few are considering is a reacceleration in the recovery causing a rotation out of growth/momentum (think FAANG) and into value (think Financials and Materials). I’m not that convinced any upside in value has to come at the expense of growth, I’m just pointing to the possibility. And the valuation spread between growth and value has never been wider.

Factors: Macro uncertainty is leading to very light equity positioning amongst professional and individual investors. The same uncertainty is leading to elevated bearish equity sentiment and higher than normal volatility. The higher volatility is part of the reason for light equity positioning on the part of systematic funds (Volatility Targeting, CTAs) and any future decline in volatility will have these large pools of capital at least returning to average levels. Measuring the upside from such an event is difficult, but my guess is ~3400 in the SPX.

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