BROAD MARKET ANALYSIS| DXY | YIELDS & SPREADS | EMERGING MARKETS

I'll try to keep this idea short with plenty of detailed charts. With the pricing in of the recent events, I think we're at a pivotal point of what happens next, based on some of the upcoming events (earnings season, Bidens' tax plan etc). Here's why...

1. It's quite obvious from the chart, that the vaccine and election news gave a boost of confidence to investors globally, reflected by the VIX currently sitting near the long-term mean ~19.5.
The trading strategy that followed was a rotation into countries/sectors/factors that were underpriced due to the additional cashflow uncertainty. Essentially, a shift from min-vol into value, shift from developed into Emerging Markets, and a boost in inflation expectations as the dollar continued to weaken due to the expected EM recovery potential.
However, how long will this strategy work? At some point all strategies reach of point of self-correction, mostly due to overcrowding. Let's start by analyzing US yields first.
2. As it can be observed from the US10Y chart, treasuries picked up selling momentum as the probability of Biden and a Democrats trifecta increased (also helped by FEDs comments about potential selling of long duration assets, fred.stlouisfed.org/series/WSHOMCB) Finally we had a breakout after these probabilities realized.
Besides, here too there is a self-correcting mechanism, a threshold where yields actually become detrimental to the market. For two primary reasons: 1) Discounted cashflows at higher rates yield lower PV for equities, 2) Increasing (Re) financing costs for deeply indented companies. This threshold was ~3.25% in 2018, however the debt levels are much higher in comparison to 2018 (fred.stlouisfed.org/series/BCNSDODNS). Of course, we can't know the threshold level until it happens, but considering the chop in the SPX while the US10Y spiked around 1.2%, this implies that the threshold is could be in the range of 1.2% to 1.5%. Considering the amount of US corporate debt that is set to retire in 2021, the sensitivity of US equities to T-yields is something to be carefully watched. Although, knowing that the FED could easily go the Japanese path of YC control, high yields shouldn't cause an enormous sellout, perhaps at most ~-10%-15%.
3. Lastly, the dollar weakness has been one of the drivers behind equities returns globally. Except for the EU, a weak dollar is beneficial to practically all economies. However, considering the increasing amounts of net short dollar positions, the dollar bears had it coming, judging by the short squeeze last week.
On a longer time frame, the dollar is near a structural support, implying that the dollar will trade horizontally with a potential upside. Dollar strength should slow down or even put a break on future EM rallies.
However, if the dollar continues to weaken backed up by the fiscal and monetary stances, this will furthermore increase the reflation potential for the US. Therein, comes a risk of too high inflation, where the FED would have to step in, where even a single rate hike could turn the leveraged loans market to shreds. Although, judging from the muted reaction in the short end of the yield curve, the market doesn't think that any inflation surprise would force FEDs hawkish hands.

Finally, what's not priced in? Firstly, it's hard to say how much Bidens' Tax plan is priced in, but what's certain is that in any case it will dampen the growth in corporate earnings. Considering that currently equities are far above the long term means in the PE and CAPE ratios the question is what are the chances that the multiples will keep expanding for the market to yield similar returns to the last 5-10 years? Likewise, this earnings season we should get a glimpse at the potential of recovery for small caps and value stocks, to see whether the market is overextended or the bullish expectations were rightly priced in. There many other potential quantitative factors to analyze, for now this is it for the broad market analysis.

-Step_ahead_ofthemarket
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