Fighting the Tape(r)

Updated: Oct 19, 2021

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A key question we always try to ask is; what is our quarrel with price? Stated differently, what do we think we might know that the market does not already appreciate. On a macro or single stock basis, it could be considered profoundly bold arrogant to claim that we have a better insight than the prevailing bias. To be fair, markets can still be macro inefficient when asset prices diverge from un-derlying fundamentals for liquidity or emotional reasons. As we have often noted, the virtuous self- reinforcing cycle of credit and liquidity during an economic boom can cause a legitimate overshoot in asset valuations. Similarly, the withdrawal of liquidity during a crisis or recession can lead to an emotional overreaction and undervaluation on the downside. As investors, they only element we can really assess is the potential margin of safety and even that is conditional on future cash flows and balance sheets.

Asset Management - Monthly Return in August
Asset Management - Monthly Return in August


In the current episode, equity markets have clearly been supported by super-abundant liquidity. Indeed, the Fed’s policy settings (the monthly QE purchases and rates) are still at emergency levels designed for one of the greatest deflationary shocks in recent history. That no longer seems appro- priate with the S&P500 (the global risk proxy) just under the record high and most macro indicators (with the exception of payrolls) back to or above pre-pandemic levels.

Index Price on 17th September 2021
Index Price


Of course, the Fed has signaled that they will start the taper in November and finish in mid-which is slightly faster than the prevailing bias. The forward projections in the infamous dot plot also implied faster-than-consensus normalization on policy rates as well. Although the way price (in equities) has responded suggests that there is skepticism that the Fed will achieve this goal.




While Asian equities have generally corrected around the initial shift in policy from the Fed, the relationship between yields and Asian equities is more complex. The correction in 1994, 2004 and 2013 were in the 15-20% range. In the most recent episode, the 2013 taper announcement, was a (relative) shock to markets and the increase in real yields was a non-trivial and rapid 200 basis points (chart 1).



However, in the medium term, Treasury yields tend to be positively correlated to growth and profits. Therefore, if higher yields are accompanied by reflation and stronger growth, that is typically posi- tive for Asia and equities more broadly (chart 2). From our perch there have been four key challeng- es for Asian equities in the current episode; a) macro conditions have already passed peak growth; b) while the level of real rates remains extremely low, markets have also past peak liquidity support, especially in Asia where there has been a slowdown in the China credit impulse; c) China regulatory tightening has also clearly weighed on domestic and regional equities; and d) valuations started the episode from optimistic levels. Critically, further de-rating might be required to take the margin of safety back to an attractive level.

In conclusion, the good news is that macro vulnerabilities in South East Asia are less than in 2013. Moreover, Asia Pacific has already corrected by 13.5% from the February high (at the recent low in August) and the regulatory risk in China is now much more widely appreciated and priced (around 75% of MSCI China has already been affected). The bad news is that the North Asian markets appear more fragile from a leverage and valuation perspective and might experience further de-rating. US nominal and real yields have also started to move impulsively higher again over- night. From a tactical perspective that could lead to further upward pressure on the US dollar and downward pressure on liquidity beneficiaries globally and in the region. However, if yields rise because cyclical conditions are improving that is ultimately positive for equities and the region. An inexpensive diversifier is the banks which benefit from higher yields. That is part of our long exposure.


 
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