MON 31 JAN 2022
From our humble understanding of the Zodiac, the Tiger is a symbol of strength and bravery. Those traits will likely be needed for investors this year after what has been a torrid January. What started as a sharp correction in bond prices (rise in yields) spread to a rapid and impulsive correction in speculative “growth” equity and financial assets more broadly. Curiously, despite sustained US dollar strength, commodities are at the highest level since 2014; that might be a sign that the stock-market turmoil is not spreading into some sort of generalised crisis or growth scare. Of course, there are some ominous parallels where an energy/commodity price shock has been followed by crisis.
In chaos theory, the edge of chaos with maximum complexity occurs between paradigm shifts. The good news is that the markets now acknowledge and have moved a long way to price a swing from the super-abundant liquidity regime to a much less accommodative one. On the negative side, inflation likely remains a constraint on a reflexive rebound in equities by lowering the strike on the Fed put or capacity of the Fed to pivot.
While we are not a big fan of historical or naïve overlays, there are clear parallels to the macro, policy and liquidity conditions during equity market correction in 2018 (chart 1). Similarly, the Fed’s recent hawkish pivot (or tacit acknowledgement that they are well behind the curve) has contributed to a significant shift in short-term interest rate expectations and beliefs on normalisation of the Fed’s balance sheet. The good news, as we have noted, is that this shift is now well appreciated and better priced.
On the negative side, it is plausible that equity prices face a further 10% drawdown after a phase of consolidation over the next few weeks. While our sense is that goods price inflation is somewhere near peak levels, underlying (wage and shelter) inflation remains high and much more elevated than it did in the 2018 episode. During that phase, the drawdown in the S&P500 (the global risk proxy) was close to 20% or approximately double what we have experienced so far. Therefore, while key investor sentiment indicators and demand for protection (put/call, skew, vol-of-vol and spot VIX) are near contrarian extremes, our sense is that the correction phase could extend further into March.
As we also noted last week, the impact of the recent drawdown in equities has had a fairly limited impact on financial conditions and credit spreads (so far -chart 2). Stated differently, the cost of protection for the potential payoff in credit remains inexpensive, particularly if the normalisation in short-term interest rate expectations and liquidity contributes to an inverted yield curve and potential growth scare later this year.
The good news for Asia is that; a) relative liquidity and credit conditions now favour regional equities compared to the United States (chart 3); and b) Asia Pacific now trades at a 65% discount to the S&P500 or the largest since the crisis in 1998. The relative outperformance over the decade coming out of that episode was material and while Asia is a “value” region, our sense is that secular growth stocks also trade at a meaningful discount. For example, our Asia Technology basket trades at 14 times current earnings and 0.7 times sales. Although that includes some of the hardware and semiconductor names, the platform or secular growth stocks also reside in the basket. The best trades are often made when you feel deeply uncomfortable and that is a very good description of how we feel today. The strength and bravery of the tiger is required. Best of luck for everyone. We hope it is an auspicious year!