MAX WIETHE: Hello, everyone. Welcome to the Real Vision Daily Briefing. It is Wednesday, January 20 at 4:00 PM just after market close here in New York. I'm going to be talking with Ed Harrison today, but before I speak with Ed, let's kick it over to Jack Farley with today's stories.
JACK FARLEY: Thanks, Max. Today the S&P 500 reached new all-time highs. Gold rallied alongside oil, the VIX eased a sigh of relief, and Treasury yields barely budged-- this as Joe Biden was sworn in as the 46th president of the United States. President Biden called on the nation to, quote, "start afresh," saying simply, "without unity, there is no peace."
Our very own Peter Cooper was actually in the nation's capital and captured this historic day from the streets. Today was an important and historic day in many ways. It's the first time the US has had a female vice president. It's the first time since 1869 that a president didn't attend the inauguration of his successor.
It's historic in many ways, but can I be honest? I can't stop thinking about the banks. Today Morgan Stanley reported winds across the board, revenues of $13.6 billion for the fourth quarter. That's 18% above the 11 and 1/2% expected, and is up 16% year-over-year. Its equities trading division grew its topline by 30% year-over-year, which is good, but actually is on par with its competitors.
Keep in mind that Morgan Stanley is the kingpin when it comes to trading equities. So its results in FICC, or fixed income commodities and currencies, was actually much more impressive, which grew 31% year-over-year. Remember, Morgan Stanley more than almost any other bank focuses on Wall Street banking, not Main Street banking, so it's not so much taking deposits from grandma and lending to the grandson, giving him a mortgage so he can buy a house.
It's more about trading, more about buying and selling, about making markets making deals, underwriting loans-- that sort of thing. So interesting-- Morgan Stanley had an uninspired jump on earnings, but it's actually down on the day. Maybe the good news is priced in or maybe the investors think that the days of this trading bonanza are numbered.
Who knows? All I know is that the Main Street banks today, US Bancorp and BNY Mellon, had horrible trading days. As I'm recording this now, they're actually down the most within the S&P 500, meaning that, for today, they're literally the worst stocks in the entire index. It's interesting, because the loans on commercial bank balance sheets have actually fared miraculously well.
Just looking at US Bancorp, credit card delinquencies were down as consumers use stimulus money to pay down debt. The utilization of commercial lines of credit was also down, as companies were paying down debt themselves. And even the losses in commercial real estate don't look too cataclysmic.
But for non-investment banks, two problems loom large-- number one, declining volume of loans, and number two, shrinking net interest margins. That's all for me. Back to you, Max--
MAX WIETHE: Thank you for that, Jack. Well, Ed, it's Wednesday again. I'm glad to be here. Thank you for having me.
ED HARRISON: Well, thank you for having me is what I should be saying to you, actually. It's great to talk to you again.
MAX WIETHE: Well, I might be the host, but we all know who sets the schedule here. So it's been good to do these Wednesdays, and we get to catch up on a weekly basis about how you're looking at the market. Last week we went through three scenarios-- I think it's more like 3 and 1/2, four scenarios, if you really get down to it, but we kept it at three just to keep it simple-- surrounding the reflation trade and your three scenarios.
So I think, just for everybody who missed that, let's quickly run through what those three scenarios are, and then we can do a little bit of updating, and then we have some news which really plays into it.
ED HARRISON: Excellent-- let's do that. And also, it just occurred to me that last time you took it easy on me. You didn't give me the pushback that you like to do, so feel free to bring the brass knuckles this time.
MAX WIETHE: All right, well, I'll give you a little bit.
ED HARRISON: So the three scenarios are the flattening of the yield curve-- that's a scenario in which basically, the growth rate sucks and the yield curve flattens as a result of that. The second scenario is one where the steepening that we saw earlier in the year continues to a point where there's a breaking point of some nature.
And we don't know what that breaking point is and exactly what would happen, but that's a steepening before the economy actually recovers-- because we still have a number of months before everyone's vaccinated and we can get out of this hole COVID era. And then there's the last one, which is that the COVID era is over and we get to the vaccinations, and only then, once we get to the promised land, if you will, do we have the steepening of the yield curve. We remain in that 110 level that we are now. Maybe we go up slowly, but there's no abrupt break up higher.
MAX WIETHE: OK. And so then, which of those scenarios are we in right now, and what are the potential outcomes? And then, how will that affect markets?
ED HARRISON: So right now, we're in one of the last two scenarios. That is, we've seen the yield curve steepen over time. There was a bit of an uptick in terms of the steepening in the beginning of the year. We've come back from that. We were at 119 on the 10-year. Now we're at more like 108 on the 10-year.
That's completely within the realm of reason. There's nothing to get alarmed about in that case. If we were to stay and chop around in that level, great. We could do that for months and then come out on the other side. But there's still the potential that 119 is a precursor to something that's going to happen going forward.
Maybe it's not just that people are thinking, OK, we have a new administration-- we're going to get lots of stimulus, we have these vaccines, light's at the end of the tunnel, and therefore, we can discount that positive economic scenario. They're also thinking inflation, and as a result, we need to get out of Treasuries now, because yields are going to go up. So that's the last scenario, where actually, the steepening that we saw in early January continues in some capacity.
MAX WIETHE: OK. Well, I guess the big risk that I think you've been highlighting is the potential that that steepening turns into flattening, because the reflation is not real-- that this is the market may be getting ahead of itself. And part of that is based off of negative real economic outcomes in relation to the damage that's already been done due to COVID, which the market has underpriced, and the potential for continued economic damage due to COVID, which is not priced at this point. So I know that you are keenly focused on this new variant that's coming out and why you think that that could do more damage.
ED HARRISON: Yeah. I think that the reflation trade is basically-- it's not about inflation. It's about reflation, meaning the economy coming back. The way the markets are priced now, by and large, across a wide swath of different assets is that we're going through a temporary lull, but governments, both from the fiscal side and the monetary side, are going to throw the kitchen sink at this thing.
And then, when we get to the other side of that, there's a lot of pent-up demand because people have a lot of savings. They haven't been able to go out and do things that they want to do. They're going to do that in great number, and it's all going to be well.
So this reflation bidding up asset prices-- that's the narrative that's happening now. The problem with that narrative is, what happens if actually, the tunnel that we were looking at before we get the full rollout of the vaccine is long? What also happens in that tunnel in terms of inflation, instead of reflation, might be a big problem, because just because you have nominal GDP growth going up doesn't mean it's going up for good things.
Just because inflation is going up 3% or 4% doesn't mean that the earnings-- me as a company, my top line going up as a result of that increased inflation is going to fall to the bottom line. So it's not necessarily something that's positive for shares for income, and certainly, it's not good for yields.
And yields or the discounts for those earnings, and I think that's where the rubber hits the road in terms of how we think about where the vaccine variables come into play. So these two variants that I was talking about-- that is, the South African variant and the British variant-- the latest news that I saw, which is from the Guardian-- a study that they did-- they said that coronavirus vaccines may actually need to be redesigned to boost protection against these variants, particularly the one that emerged rapidly in South Africa.
Research by the South African government scientists revealed that mutations of this particular variant, which is known as 501YV2 or B1351, it makes the variant substantially resistant to antibodies in blood plasma donated by COVID patients. Ergo, the vaccines that we have now may not protect you against that variant, and they may not protect you against the British variant. So that is a scenario where the tunnel actually lengthens. And in that period of time during the tunnel lengthening, a lot of bad things can happen.
MAX WIETHE: OK, so it's a double-edged sword really, in that you have yields higher, which is affecting the multiples that the equities could be trading at. So you could have this effect on multiples. But then you could also have the effect on earnings, which in its way plays back into multiples. So earnings could be hit hard by the negative economic outcome, and then the rising yields are affecting the DCF models that people are using to come up with what is a fair price for these equities.
I myself have always struggled a little bit with the difference between inflation and reflation-- why, say, a company can-- is not going to be as affected by reflation-- in fact, it is going to benefit from reflation, whereas inflation-- the company is not able to pass that on to, say, the consumer, and it affects the bottom line. But why is inflation so much more detrimental to a company's bottom line than the reflation narrative, which people tend to say is positive?
ED HARRISON: If you look at nominal GDP growth and you say that it's going up by 2%, as an example, you could have that 2% be the result of a real increase of 2% in GDP growth or as a result of inflation. So if the 2% is a result of real GDP growth and we say that the S&P 500 is going to be affected in the order of 2% on average, let's just say, then we would expect the top line to go up by 2% without a concomitant increase in their tax base-- in their cost base.
So a lot of that profit then falls to the bottom line, whereas, on the other hand, if you have inflation, their cost base goes up sometimes maybe even more than their revenues go up. And so they're somewhat constrained, and they still have to deal with the fact that the discount rates are higher. So scenario number 2 is worse than scenario number 1. So inflation is not necessarily the same thing as reflation, from my perspective.
MAX WIETHE: OK. So you asked for a little bit of pushback, and I'll give you some. My thing is the scenario that you're-- that isn't included in your framework is yes, we price in this positive economic outcome, the end of the tunnel. And yeah, maybe it takes a little bit longer and we get ahead of ourselves-- markets get ahead of themselves-- but we're not too far off.
And the predictions, the market being a forward-looking mechanism, is reasonably right. And so no, we don't have a big rally on the positive economic outcomes after-- when they finally do come through and we're out the other side, but it has been priced in this period. And so this is where the money is to be made is pricing in this economic outcome.
And yeah, you are taking some risk in the potential negative economic outcome, but that's the game. That's the game of markets is making predictions and forecasts. If it was all perfectly priced, then it would be nice flat straight lines for us to talk about on our charts. And so how are you thinking about that potential, that yes, we are ahead of ourselves, there is risk, but if we come out the other side and those risks don't materialize, the money will have been made in this period?
ED HARRISON: So buy the rumor, sell the news is what I'm thinking.
MAX WIETHE: Yeah, essentially.
ED HARRISON: Right. I think that there's some possibility that that's the existing scenario. And so what are the two biggest risks to that scenario? Again, I would say that the risks are, one, the lengthening of the tunnel relative to expectations, and two, the risks of what happens within that tunnel when-- relative to expectations.
And then finally, the biggest risk-- and this is one that I think David Rosenberg was talking about-- is the risks of what happens after we've gotten through the tunnel. What is the new normal going to be relative to expectations? So those are three risks.
And when people talk about white swans and black swans, there's also gray swans. To use Rumsfeldian news, we would say the known, unknowns, and the unknown unknowns. These are things that we know are lurking out there, but we don't know what the answer is. Those are the things that you and I are talking about as realistic risks. But of course, there are also the unknown unknowns, like COVID itself back in March of 2020, when we went into the shutdowns.
MAX WIETHE: Yeah. I think about what we've seen so far from markets over this COVID period, and I think clearly, pricing risk hasn't been the feature of this market. It has been ignoring risk and looking forward. And so my question is, how likely is the market to react to those risks until they are acutely unignorable?
And so until it's a year later and the unemployment rate is still where it is, until it's 2022 and we're talking about vaccine rollout number two, how long can it go on? How long can all of this go on? And that's really the big question, and that's something that I want to-- we sometimes do these teases, these plugs on what's coming up on Real Vision, and I think that's what we're going to try and do in February is answer that question.
One, is this underappreciating the risk? Is this a bubble? Is this market froth? And if so, how long can it go on, and what potentially could be its undoing? And we want to bring on a whole bunch of different people to look at that question. I'd love to get your take, Ed, on, what do you think about that question? Is this a bubble? Is everything a bubble? What makes it so?
ED HARRISON: What I think of it-- and I was asking Raoul this-- we didn't have enough time to go into it, because this is somewhat of a philosophical argument. But I think it is-- there's some math to it. Economics and finance has become very mathy, and when you and I-- we're talking about risk, and what I think of risk and I think of COVID, I think of uncertainty also.
And I think that this is really what we're talking about it, and I think that the maths of finance aren't able to deal with uncertainty. There was a guy by the name of Frank Knight, who was a University of Chicago economist, and he came up with this way of thinking about things called Knightian uncertainty.
And let me just read from what he had to say that I think makes a lot of sense in the context of what you're talking about. He said that uncertainty must be taken in a sense radically distinct from the familiar notion of risk, from which it has never been properly separated. The essential fact is that risk means, in some cases, a quantity susceptible of measurement, while at other times it is something distinctly not of this character.
And there are far-reaching and crucial differences in the bearings of the phenomena, depending on which of the two is really present and operating. So I think that we're actually in a period of uncertainty, where we're talking about things that are not susceptible to measurement.
You have digital outcomes, a or a 1. So when you talk about the market not pricing in risk, I would say that the market's not pricing in uncertainty because they can't, because it's impossible to do that. How do how do we price then the potential that the new variant in South Africa is resistant to the existing vaccines?
How do we do that? We can't. So I think this is the basic problem that we're dealing with. So basically, you just have to continue on until that uncertainty becomes certainty-- that risk, if you will, crystallizes. And then that's when all hell breaks loose.
And I think that's sort of what happened in March of 2020-- that it was clear that-- to a lot of people that we were in the middle of a pandemic. The WHO didn't call it a pandemic until much later, but then, when the pandemic happened, when the economic impact of the pandemic started to become real, suddenly it crystallized, and all at once, the market went into a panic.
MAX WIETHE: Yeah. So from somebody who's interested in what does that mean for somebody trying to invest, the question is, is the money to be made in making sure you don't get caught up in that pricing of the risk, in pricing of the certainty? Or is it in ignoring that uncertainty for long enough to build up gains that you can get out when it crystallizes?
And yeah, you might lose some in that initial sell-off, but you've made so much on the way on the way up that you still have the profits there. Which way do you go? And then the other side is just waiting until the certainty realizes itself and acting like a distressed investor, going in and buying.
There were incredible buying opportunities in March, if you were sitting in cash. You didn't have to get short in March and make it all on the way down to take advantage of that opportunity. So there are multiple ways to skin the cat. And that's the big question for me is, taking a scenario like this, what are the different ways that you can play it?
And I think that's one of the things that we're going to try and talk about