Why we see downside risk to rates --> Analysis shows "rate of change" GDP and inflation breakevens drive rates, less CPI

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• SKIP THURSDAY
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STRATEGY: Why we see downside risk to rates –> Interest rates track “rate of change” of GDP and Fed inflation breakevens, less so CPI
Last Friday, we made a course correction by upgrading FAANG to OW (from UW) and downgrading Financials to N from OW. There were several reasons, but the two primary drivers were:

– Financials outperformed FAANG at a pace not seen for nearly a decade
– Unless, structural factors are at play, “mean reversion” argues to buy FAANG

– Interest rates, in our view, have downside risk
– Financials are the prime beneficiaries of higher rates, while FAANG suffered worst headwind

Perhaps not surprisingly, we faced quite a lot of backlash over this sector course correction. Many of our clients simply do not agree that there is a fundamental reason to downgrade Financials. Moreover, many of our clients believe because inflationary pressures are building, interest rates need to rise.

…Mean reversion time? Or is this time different?
Financials have outperformed FAANG by 4,000bp in the past 6 months and this is nearly a historic degree of outperformance. The last time this was seen was 2012 and at that time, NYFANG+ staged a massive rebound.

– so the question is whether structural factors argue for Financials to keep trouncing FAANG
– if not, time for a rotation

Economic escape velocity? YES
reflation? YES
Higher rates? NOT CLEAR
Relative to consensus views, we think interest rates will undershoot. Fundstrat does not have a target for interest rates, so I am not able to give you a range of where the 10-year is by year end 2021. If anything, our Global Portfolio Strategist, Brian Rauscher has a better insight and even Brian does not think this is really that forecastable.

– thus, the key question, in my view, is whether US rates are above or below consensus
– we think rates will undershoot

Why?
– CPI does not influence rates, despite this being the central factor for consensus seeing higher rates
– Rate of change matters more (aka ROC)
– ROC of GDP growth and ROC of inflation breakevens
– If ROC is flattening, rates have downside risk, not upside

…CPI YoY, even ROC of CPI does not really impact rates as much as you think
Many clients have told us that interest rates are set to rise because inflation is rising. Intuitively, this makes perfect sense. In fact, if you asked me what drives rates, it is two components:

– real cost of rate (Fed, deficits)
– inflation

But the “inflation” in the above equation is actually the forecasted inflation, matching the duration of the interest rate. So arguably, CPI doesn’t matter, unless that is the level of future inflation rates.

In other words, current/contemporaneous CPI should not drive interest rates. And the below chart shows this to be indeed true. CPI, or rather ROC of CPI has little impact on interest rates.

– so unless one believes current CPI YoY inflation is sustained for the next 10-years
– CPI YoY has little impact on interest rates

…5-year inflation breakevens have a stronger influence on interest rates
In our view, future inflation expectations should impact rates more than current CPI. And analysis below seems to bear this out. The 6M change in 5-year inflation breakevens seems to have a greater impact on the 6M change in interest rates.

– this makes sense to me
– the key is the rate of change, ROC, of inflation breakevens
– if inflation breakevens are 2.4% now, and 2.4% in December, that is ZERO ROC
– that would imply interest rates stabilize, not rise

…ROC of GDP forecasts also seem to influence 10-yr rates
Similarly, the change in GDP forecasts seems to influence interest rates as shown below. This makes sense. Over the cycle, the level of real interest rates should track real GDP. And thus, higher growth = higher rates:

– the key is the rate of change, ROC, of GDP forecasts
– if GDP forecasts are 6% SAAR now, and 6% in December, that is ZERO ROC
– that would imply interest rates stabilize, not rise

…GDP growth needs to further accelerate, or inflation rate needs to accelerate to drive higher rates
In other words, if the rate of change is constant over the next 6 months, ROC = zero. And therefore interest rates have less pressure to rise. We illustrate this point below:

– if GDP growth is 6% now and 6% in December, ROC = 0
– if inflation breakevens are 2.4% now and 2.4% in Dec, ROC = 0

Thus, our analysis suggests that pressure for higher rates, versus Consensus, needs to come from growth accelerating further or inflation accelerating further. But consider that ROC might be slowing:

– While GDP growth forecasted to be strong, ROC may not accelerate further
– Commodities like lumber are down 40% from their peak, suggesting some inflationary pressures waning
– Supply chain bottlenecks likely ease, leading to decreased inflationary pressures later

STRATEGY: If interest rates have downside bias versus Consensus, Technology/FAANG outperforms Financials
In short, if ROC is slowing, this is the downside to interest rates relative to consensus. And central to our take is that current CPI matters less for rates than future inflation. In turn, history strongly argues that a slowing of interest rates is a headwind for Financials vs Technology.

– if US 10-yr is 1.5% today and 1.5% in December, ROC = 0
– Technology should outperform Financials

– if US 10-yr is 1.8% by December, 6M ROC falls from 1.3% to 0.3%
– Technology should outperform Financials

– if US 10-yr is 2.8% by December, 6M ROC flat at 1.3%
– Financials should outperform Technology

I don’t think Consensus sees 10-yr at 2.8%. So you can see, interest rates need to rise above Consensus for Financials to outperform FAANG before year-end. Hence, we are favoring FAANG over Financials.

Energy remains our favorite Sector
But our top sector remains Energy. The oil market has favorable supply/demand dynamics and demand should see upside surprise in coming months as travel further resumes

– international travel
– business travel

Both would push global oil consumption back towards 100 mbpd. In fact, Standard Charter’s Paul Horsnell believes much of this surge in demand will take place in the next few months:

– demand surprise coming in oil
– Energy stocks benefit from positive oil demand surprise

Hence, we continue to see strong upside in Energy stocks. Good proxies are the ETFs XLE-0.30%  and OIH-0.03%

Source: Bloomberg and @BurggrabenH
And lastly, stick with the Epicenter trade broadly. FYI, a Neutral rating for Financials just means it tracks the S&P 500. Thus, we do not see Financials subtracting from index or a portfolio manager performance.

– Energy is our favorite Sector
– FAANG (NYFANG+) should also lead S&P 500 next 6 months

ADDENDUM: We are attaching the stock lists for our 3 portfolios:
We get several requests to give the updated list for our stock portfolios.  We are including the links here:

– Granny Shots  –>       core stocks, based on 6 thematic/tactical portfolios
– Trifecta epicenter  –> based on the convergence of Quant (tireless Ken), Rauscher (Global strategy), Technicals
– Violence in USA –> companies that are involved in some aspect of home or personal security. We are not “recommending” these stocks, but rather, bringing these stocks to your attention.

Granny Shots:
Full stock list here –> Click here

Trifecta Epicenter (*):
Full stock list here –> Click here

Power Epicenter Trifecta 35 (*):
Full stock list here –> Click here

Violence in USA:
Full stock list here –> Click here

(*) Please note that the stocks rated OW on this list meet the requirements of our investment theme as of the publication date. We do not monitor this list day by day. A stock taken off this list means it no longer meets our investment criteria, but not necessarily that it is neutral rated or should be sold. Please consult your financial advisor to discuss your risk tolerance and other factors that characterize your unique investment profile.

POINT 1: Daily COVID-19 cases 10,830, -2,249 (ex-FL) vs 7D ago… Steady decline in daily cases persists…
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Current Trends — COVID-19 cases:
– Daily cases 10,830 vs 14,263 7D ago, down -3,433
– Daily cases ex-FL 10,830 vs 13,079 7D ago, down -2,249
– 7D positivity rate 1.9% vs 2.1% 7D ago
– Hospitalized patients 15,128 down -12% vs 7D ago
– Daily deaths 312, down 21% vs 7D ago
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– As we noted previously, Florida stopped publishing daily COVID stats updates on 6/4 and we switched to use CDC surveillance data as the substitute. However, as CDC surveillance data is subject to a one to two-day lag, we added a “US ex-FL” in our daily cases and 7D delta sections in order to demonstrate a more comparable COVID development.

– The latest COVID-19 daily cases came in at 10,830, down -2,249 (ex-FL) vs 7D ago. Given the relatively lower daily case figure compared to a few months ago, the slow down of the decline in daily cases (measured by 7D delta in daily cases) is understandable. Besides, the more important news is that we have not seen the cases surge following the Memorial Day holiday. We believe this is the result of the high penetration of vaccines. And with continued efforts for higher penetration of vaccines, the steady decline in daily cases is likely to persist, similar to the COVID path in Israel.

7D delta in daily cases has remained negative since the spike due to Memorial Day data distortion…
The 7D delta in daily cases has turned negative following last Monday’s spike. Although the decline in daily cases seems to slow down, the daily cases remain on a downtrend and we haven’t seen the case figure surge yet (even following the Memorial Day holiday). As the data suggests, we expect the steady decline in daily cases to persist.

Current hospitalization, daily deaths and positivity rate are at all time low…
Below we show the aggregate patients who are currently hospitalized due to COVID. After a mini-surge in March, the number of patients currently hospitalized rolls over again. Positivity rate is also following the similar pattern. Currently, all three metrics – current hospitalization, daily deaths and positivity rate – are at their all time lows since the start of the pandemic.

POINT 2: VACCINE: Vaccination pace seems to have speed up again… Daily vaccination about 1.1 million doses (~35 million per month)…
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Current Trends — Vaccinations:
– avg 1.1 million this past week vs 0.9 million last week
– overall, 43.4% fully vaccinated, 52.1% 1-dose+ received
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Vaccination frontier update –> all states now near or above 70% combined penetration (vaccines + infections)
Below we sorted the states by the combined penetration (vaccinations + infections). As we commented in the past, the key figure is the combined value >60%, which is presumably near herd immunity. We have overlaid our case progress with that of Israel several times to demonstrate what should happen to cases once immunity reaches a certain critical level in the population. That is, the combined value of infections + vaccinations as % population > 60%. The persistent and rapid decline in cases suggest that the US is following a similar path to Israel (see our prior notes) while nations with less penetration continue to struggle more.

– Currently, all states are near or above 70% combined penetration
– RI, SD, MA, ND, CT, NJ, DE, NY, IL, UT, MN, NM, NE, AZ, PA are now above 90% combined penetration (vaccines + infections)
– So gradually, the US is getting to that threshold of presumable herd immunity. So long as a vaccine resistant variant doesn’t spread widely, the continued retreat of cases should continue.

Below is a diffusion chart that shows the % of US states (based on state population) that have reached the combined penetration >60%/70%/80%/90%. As you can see, all states have reached 60% and 70% combined vaccination + infection. 80.5% of US states (based on state population) have seen combined infection & vaccination >80% and 54.1% of US states have seen combined infection & vaccination >90%.

There were a total of 1,311,703 doses administered on Monday, down 11% from 7D ago. After the daily number of doses administered fell below 1 million, the vaccination trend (dashed line: 7D average) seems to be reversing higher. This increase in vaccination speed coincides with the recent efforts by the Biden administration to get more people vaccinated by the fourth of July. With continued efforts for higher penetration of vaccines, it could prevent the renewed outbreak and ensure the economy safely reopen.

95.5% of the US has seen 1-dose penetration >40%…
To better illustrate the actual footprint of the US vaccination effort, we have a time series showing the percent of the US with at least 35%/40%/45% of its residents fully vaccinated, displayed as the orange line on the chart. Currently, 88.3% of US states have seen 35% of their residents fully vaccinated. However, when looking at the percentage of the US with at least 40% of its residents fully vaccinated, this figure is 65.0%. And only 44.5% of US (by state population) have seen 45% of its residents fully vaccinated.

– While 95.5% of US states have seen vaccine penetration >40%, 78.7% of them have seen 1 dose penetration >45% and 58.8% of them have seen 1 dose penetration > 50%.
– 88.3% of the US has at least 35% of its residents fully vaccinated, However, only 65.0% of US has fully vaccinated >40% and 44.5% of US has fully vaccinated >45%.

This is the state by state data below, showing information for individuals with one dose and two doses.

The ratio of vaccinations/ daily confirmed cases is generally trending higher (red line is 7D moving avg), but this is largely due to the decline in daily cases.

– the 7D moving average is about ~80 for the past few days
– this means 70 vaccines dosed for every 1 confirmed case

In total, over 300 million vaccine doses have been administered across the country. Specifically, 173 million Americans (52% of US population) have received at least 1 dose of the vaccine. And 144 million Americans (43% of US population) are fully vaccinated.

POINT 3: Tracking restrictions lifting and subsequent effects in individual states

Point #3 focuses primarily on tracking the lifting of restrictions, as states have eased the majority of mandates. Keep in mind, easing/lifting restrictions are contingent upon state of emergency ordinances being renewed.

GROUP 1: States that lifted restrictions in 2020…
The daily case trends in these states are impressive and it is difficult to say that lifting restrictions has actually caused a new wave of cases because the case trends in these states look like other states.

GROUP 2: States that have lifted restrictions in 2021 to now…
Similar to the list of states above, the daily case trends in these states are impressive and it seems that lifting restrictions hasn’t caused an increase in cases.

GROUP 3: States that are still easing restrictions in 2021…
These states have begun to lift restrictions, but have yet to ease all restrictions. The date of each state’s most recent restrictions lifting is indicated on each chart. The case trends in these states have been mostly positive.