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By Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley

Deflating the Safe Havens

Three catalysts for a reflationary overshoot loom over the next month. After big moves in the traditional beneficiaries of better growth and inflation, the risks are now highest for ‘safe havens’ that have outperformed their defensive brethren sharply. Weakness in these assets, such as gold, the Swiss franc and US real yields, would go a long way towards resolving a still-unanswered question in market pricing: will the future be better?

Let’s start with those three catalysts. Over the next two months, we see specific developments that could support confidence that growth and inflation can improve on a sustainable basis.

1. Falling COVID-19 cases/hospitalisations: Warmer weather and increased rates of vaccination mean that our US biotechnology team believes US COVID-19 cases could fall by ~50% by the end of April. The impact on hospitalizations could be even more significant, as vaccination rollouts will increasingly cover the most vulnerable segments of the population, and vaccine efficacy against severe COVID-19 cases remains significantly higher than its ability to prevent transmission of the disease.

2. Passage of US fiscal stimulus: Morgan Stanley’s public policy team expects the Biden administration’s American Rescue Plan (ARP) to pass by mid-March, when current unemployment benefits expire. Our economic forecasts assume the plan ends up at US$1.0-1.5 trillion; a larger package would imply upside to our forecasts.

3. Accelerating global growth: Why are Morgan Stanley’s economic forecasts above consensus? In part because we think the recovery starts sooner than others do. Our global economics team expects global data to accelerate from March/April (i.e., before the impact of US fiscal stimulus is felt), the first step toward our expectation of a ‘high-pressure economy’

If they materialize, these catalysts would be significant and should emerge imminently. But will they be ‘too much’ and lead to less supportive monetary policy? And are they already in the price? The first is a question of timing; the second, of location.

There’s often a delay between better economic news and a policy response. This is especially true after recessions, e.g., in 1992, 2003 and 2010, when policy remained quite easy even as growth was clearly improving. Meanwhile, the still-raging pandemic provides another reason for the Fed, ECB and/or PBOC to wait a little longer, even if all three developments come to pass.

Then there are inflation expectations, where the ‘rubber meets the road’ for an overheating economy. As inflation expectations have moved higher, they’ve also inverted, with expectations for the next five years higher than for the next 30. This is unusual (it’s never happened before) and also ideal for Fed policy, consistent with the idea that inflation will temporarily move higher, but then moderate over the longer term.

In short, policy should eventually respond to these three catalysts. But it seems reasonable that this response will take several months.

Which brings us to the second, and probably more important, question: aren’t these catalysts already in the price?

Many reflationary trades have moved significantly. Small-cap and cyclical equities, copper prices and the US 2s10s curve have all seen one-year performance that is near a two-standard-deviation event. But equally unusual, amid all this apparent optimism, some safe havens have barely moved or, even more remarkable, have been stronger.

Over the last year, gold prices are still ~9% higher. US 10yr yields are 20bp lower, and 10yr real yields are 75bp lower. The traditional safe havens of the Japanese yen and Swiss franc are up ~6% and ~10%, respectively, against the US dollar. Global growth equities, seen as safer and less impacted by COVID-19, have outperformed Value by ~22%. All this has happened despite extreme moves to the upside in those reflationary assets, and underperformance in other defensive assets like consumer staples and utility stocks.

It’s here – in safe, expensive, low-yielding places – where we think the risk from these three positive catalysts is highest. In our cross-asset top trades, we are short gold versus copper, and my colleague Susan Bates still has downside to her end-2021 gold forecast. We remain underweight duration and long the Canadian dollar versus the Swiss franc and the Chinese yuan versus the Japanese yen, both of which are key ideas from our global macro strategists, who also believe US real yields will move higher and the 5s30s real yield curve will steepen.

Instead of ‘looking up’ for the biggest beneficiaries as growth improves, the more pressing issue for the market may be ‘looking out’ to havens that have so far ignored the improving economic story.