In July 2007, Chuck Price the former CEO of Citi infamously proclaimed, “as long as the music is playing, you’ve got to get up and dance,” he said. “We’re still dancing.” By mid-2006 the FOMC had already increased the policy rate to 5.25% and there had already been a material deterioration in the underlying housing market and homebuilder equities. Of course, the broad stock market did not peak until the third quarter of 2007. While it is impossible to forecast the future, it is still important to have a sense of where we are in the macro cycle. What we do know is that after a long period of low interest rates and super-abundant liquidity, there will be levered investors and entities that have taken advantage of those conditions. It is pro-cyclical or correlated with the macro and market cycle. Put another way, there is an intimate link between liquidity, leverage and volatility.
The good news today in the context of the current market and macro cycle is that the Fed has only just started the liquidity withdrawal process. Indeed, as we noted yesterday, with the upper bound of the nominal Fed funds rate at 0.25%, the “real” policy rate is -6% and around 20 basis points lower than the peak policy error in the 1970s. Clearly the real funds rate has been deeply negative for some time, but the current inflation data has taken “real” FOMC policy to a new low. The big picture point is that the policy settings now seem wholly inappropriate for current conditions. For markets, volatility tends to rise at the turning point in policy conditions and returns on risk assets tend to moderate given the valuation starting point.
The good news in the context of the outlook for equities is that they ought to still rise as long as higher rates are accompanied by sustained growth and profits. However, the starting point for total leverage is already considerably higher than it was in previous cycles and valuations have already priced in a lot of the future growth. Stated differently, highly levered entities could be challenged by a smaller increase in rates than in previous cycles. Recall that an increase in the real funds rate to 1% in the last cycle was enough to cause a disorderly correction in equities in Q4 2018.
The other important implication for investors is the potential change in the role of sovereign fixed income as a diversification for equities. Earlier this year we highlighted the concept of the “Texas Hedge” – a financial instrument that increases exposure to risk, rather than reducing it. Over the decade or more since the 2008 crisis, Treasuries have been an effective diversifier for equities. Indeed, the entire logic of “risk parity” was that fixed income was an effective hedge for equity. Of course, the rationale for that approach only holds if Treasuries remain inversely correlated to equity. Put differently, fixed income is a hedge for equities in a recession or growth scare, but are not an effective hedge in an inflation-driven shock. If inflation remains persistent next year driven by housing costs and a wage-price spiral, that could change the relationship with equity and performance within the equity market. This is a key reason why we hold bank equities as an inexpensive, positive carry hedge on higher yields.
A question we have often received over the past few months is why gold has lagged given the rise in consumer price inflation expectations. It is a good question because the performance of bullion this year has been poor relative to its explosive gains during the 1970s. From our perch, this likely reflects the starting point, recent dollar strength in contrast to post-Bretton Woods era and potentially the role of crypto assets in the current episode which have also likely been a beneficiary of record low real policy rates on the competing asset. On the positive side, if the Fed remains behind the curve, spot gold appears under-appreciated relative to real rates (chart 1). We would also note that gold mining equity trades at a 42% discount to world equities and inexpensive on a free cash flow basis.
In conclusion, the persistent nature of the inflation data this week, breadth of the data and the fact that key categories (housing and wages) are still likely to rise in the quarters ahead, suggests that the Fed is behind the curve. An increase in the policy rate will not end the macro cycle if it is accompanied by robust growth and profits. However, the valuation starting point and elevated leverage in some entities, suggests that the tipping point on higher rates and liquidity could be lower than it has been in the past. The diversification role of sovereign fixed income could also be challenged.