Fri, 17 DEC 2021
A day after the Federal Reserve released its less-hawkish-than-feared revamped forecast profile, the Bank of England delivered a surprising, but not shocking, rate hike. December 2022 UK interest rate futures sold off on the hike, but then proceeded to rally back close to flat in price. As Public Enemy once said: don’t believe the hype hike. The broader point is that the prevailing bias among market participants suggests that the macro conditions are likely to return to the pre-pandemic low trend growth, low inflation and low rate regime. Moreover, as we noted yesterday, beliefs and market pricing in the Eurodollar curve imply that more tightening now equals less tightening later and less tightening overall.
The prevailing bias that macro conditions will return to the pre-pandemic regime may or may not be right. However, tactically one of the key questions for investors next year will be how to navigate an environment of reduced policy accommodation. The good news is that policy and broad financial conditions remain extraordinarily loose. But markets also care about the rate of change.
While the absolute level of financial conditions (as measured by the Goldman Sachs index) is below 2005 and pre-pandemic trough levels, the year on year change implies that growth momentum will start to decelerate next year. The change in financial conditions is a decent leading indicator on the rate of change in activity and corporate profits (chart 1). In addition, the Fed has signalled a much faster withdrawal of liquidity (QE) relative to the last cycle.
Not surprisingly, there is also a link between financial conditions (liquidity) and the pricing of both credit risk and equity volatility. The time series below is normalised as a z-score based on data prior to the 2008 episode (chart 2). The data highlights that financial conditions are still more than 2 standard deviations below the average over that time period and High Yield credit risk premia is one standard deviation below average. In contrast, implied equity volatility based on the VIX index is modestly above the mean and pre-pandemic levels.
Of course, there is a reflexive feedback loop between broad financial conditions, credit spreads and equity volatility. Given the extremely low starting point, financial conditions have the potential for a material shift tighter, in rate-of-change terms. From our perch, risk is most under-priced in “levered credit” that is high yield, but investment grade credit is also vulnerable given duration (interest rate) risk as well.
History shows that equity markets almost always de-rate when the Federal Reserve tightens. However, that does not necessarily imply negative returns as corporate earnings are likely to continue to grow in an expansion phase. As we noted yesterday, equity returns tend to be positive in the months leading up to and following the first Fed rate hike. The real damage from higher rates tends to occur later in the cycle when tighter policy flattens or inverts the yield curve.
The key for investors is to limit exposure to highly levered entities with expensive valuation and no profits, if there is a faster-than-expected withdrawal of liquidity and increase in discount rates. In contrast, companies with strong cash flow growth, low balance sheet leverage and reasonable valuations ought to perform well next year. That is core to our exposure.