The Correlated Shock

THU 20 JAN 2022

A question we often ask is; “what is your quarrel with price?” In our humble opinion markets are not efficient in a macro (or micro) sense because emotions, liquidity and credit can distort or cause self-reinforcing feedback loops between price and fundamentals. The US Information Technology sector would probably not trade at 8 times sales (similar to 1999/2000) if there was a more appropriate discount rate applied to future cash flows. However, it is a heroic statement to argue that a particular price signal is “wrong.” Rather it is probably better have a sense where there might be a divergence between price, consensus beliefs and fundamentals.

As Macro Man noted overnight, while it is important for investors to analyse the macro news flow or policy developments, sometimes it is just as useful to ask what price itself is signalling on key markets and whether that is inconsistent with the facts or fundamentals. Historically the 10 year Treasury yield used to tell you a lot about overall macro conditions and risk perceptions.

Clearly that signal has been distorted over the past decade or more by the actions and promises of central banks. Nevertheless, the direction of yields still tends to be correlated to the direction of cyclical beliefs. Therefore, the recent impulsive rise over the past few weeks is might be an interesting barometer of the growth outlook as the global economy re-opens after the pandemic. The performance of cyclical equity versus defensive equity suggests a similar conclusion (chart 1). Of course, on the negative side, the yield curve is “bear flattening” and there has been a sharp and emotional rise in real yields (albeit from an extremely low level). The other, now widely appreciated correlated price action has been the evisceration of profitless technology stocks.

While the correlated episode in fixed income has become the prevailing bias, the key is how much has been priced relative to fundamentals? In the medium term, the “fair value” for a 10 year bond ought to be based on the future expected cash rate plus a term, liquidity and risk premium for inflation. That suggests the 10 year should be at least 2.5% based on where the terminal funds rate is priced and your view of inflation. Curiously, the 10 year has tended to remain anchored around the 10 year moving average of the policy rate, which in turn has tended to anchor beliefs (the behavioural bias that the future will continue to look like the recent past -chart 2).

As we have discussed recently, the sharp rise in consumer prices to the highest level since 1982 is a legitimate challenge to the prevailing bias that low trend growth, inflation and rates is a permanent state. The current episode could still be a cyclical one. However, if underlying consumer prices are more persistent, the correlated shock in fixed income, duration, volatility and correlated equity could be non-trivial. Tactically, BTFD is not as obvious in this episode.