Has the Game Changed?

THU 24 FEB 2022

Abstracting from the short term price action, a key big picture question for investors is whether the game has changed? Put another way, has their been a genuine regime shift in markets? Of course, the short answer is that no one really knows. However, what we do know (with reasonable odds) is that the low rate super-abundant liquidity regime has probably drawn to a close and markets are adjusting to the reality of a higher discount rate.

As we have often stressed, higher interest rates typically do not end a macro cycle until they are well above neutral (i.e. tight). We are still a long way from that level. However, clearly the shift in psychology has been challenging for some assets that had become used to the previous (low rate) regime. The evolution in this cycle is particularly challenging given how much capital had been allocated to the prior winners and given the rapid nature of the shift in short-term rate and liquidity conditions. Factors that have been exacerbated by crowded positioning and leverage.

On the positive side, we would also caution on extrapolating the recent phase of market volatility, but it is plausible that recency bias (the behavioural tendency to overweight recent information) has had a non-trivial impact on investment decisions. A key element of our process is making a judgement on whether price and volatility has been driven by emotional factors leading to capitulation, forced selling or de-leveraging rather than fundamental ones. Stated differently, is the current correction an emotional overreaction to events such as the potential conflict in Eastern Europe, inflation or policy conditions?

From a broader macro perspective additional risk premium related to the episode in Europe is probably something to fade. To be fair, clearly there is an element of correlation due to the impact of the former on energy prices. While inflation driven by a supply-side shock is not something that the Fed can control, policy has been exceptionally loose for far-too-long and that has likely exacerbated the inflation episode and the current pressure on short-term interest rate expectations.

Perhaps even more challenging for equities is the potential for a deterioration in growth momentum at the same time or the growth/inflation trade off. While I our sense is that some investors have become too pessimistic on growth and profits later this year, some leading indicators such as the yield curve and consumer expectations are close to signalling a recession. As we noted above the reason why that might be an overreaction is that actual policy tightening has not even started yet and typically a macro cycle does not end until policy conditions are tight relative to equilibrium.

The good news is that some of our tactical indicators such as investor sentiment, demand for protection and price itself are close to outright panic (capitulation). Moreover, risk compensation is also considerably more attractive in Asia Pacific in outright terms and relative to the United States. It is also probably too early to call the end of the macro and market cycle. However, it is also important to note that interest rate and liquidity conditions are no longer what they were over most of the last decade. While our sense is that headline inflation is also somewhere near peak velocity, interest rate settings are completely inappropriate in the context of current price pressure.

 

In conclusion, the correction in the equities most sensitive to a higher discount rate has already been material (60-70% in some cases) and more than half of the US stock market has corrected by more than 20%. However, the final capitulation phase is probably underway and could carry the broader indices down another 5-10% into March.