WED 19 JAN 2022
Earlier this week we highlighted that a key element of a behavioural episode is when market participants become focussed on a single story. In the current phase that is the obsession with inflation and the potential policy and market consequences. A related question is to ask is: where is the pivot, capitulation or reversal point? For that it is important to have a sense of intrinsic value or price relative to fundamentals. That is clearly not simple in practice, especially in markets that have been distorted by super-abundant liquidity for an extended period. However, judging when price becomes impulsive, rapid, emotional and non-linear can signal a capitulation in beliefs. It is also important to note that non-linear price action can be on the downside (a waterfall) or it could be euphoria (fear-of-missing-out) on the upside.
As we also noted earlier this week, the price action in a range of markets suggests that we might be approaching peak inflation fear, at least in terms of velocity. There has been a sharp re-pricing in nominal yields (with the 2 year Treasury breaching the psychological 1%) driven by a impulsive shift higher in real yields (chart 1). In turn that has likely contributed to a large decline in hyper-expensive “growth” equities, with levered balance sheets and hopes and dreams of cash flows well into the distant future.
Of course, the challenge for these assets and long duration fixed income, is that the Federal Reserve hasn’t actually started tightening yet. By contrast, the large correction after the 2000 technology bubble occurred when the policy rate had already increased over 6%. Moreover, a number of the most sensitive companies that have already corrected 50-70% still trade at 8-10 times sales. The key point here is that while the downside risk and the reason for the episode is much more widely appreciated, it is still plausible that Fed policy, liquidity withdrawal and the associated rise in cross asset volatility is still under-priced. There is an additional reflexive or self-reinforcing element as well now that many investors are under-water on the related positions. Stated differently, capitulation phases in major asset booms often reverse the entire bull trend before the correction ends.
In conclusion, the good news is that participants clearly are focussed on the single story of inflation, the policy and market consequences. There has been a capitulation in the prior belief that low rates and super abundant liquidity would remain a permanent state which is reflected in the impulsive price action in related assets.
On the negative side, the capitulation still feels more focussed on near term policy conditions. In contrast, terminal rate expectations still appear relatively well anchored. Moreover, the Fed hasn’t actually started tightening yet and a lot of the “growth” equity universe based on “hope” is still heroically priced on plausible valuation measures. In the very short term, there will likely be a counter-trend relief rally at some point soon. However, the Fed will likely be forced to normalise policy, withdraw liquidity and tighten financial conditions. A clear difference in this episode is that consumer price inflation is 7% today compared to 1.9% in 2018. That is a genuine constrain on a near-term dovish pivot. Put another way, the potential “policy error” was leaving the policy tightening too late. All of this suggests that investors should retain a preference for companies with high free cash flow, low balance sheet leverage and growth at a reasonable margin of safety.