The Evisceration Phase
TUE 14 JUN 2022
A key element of our process is to assess whether a price episode is an emotional overreaction or a genuine response to a shift in fundamentals. From our perch, the recent correction has been warranted response to persistent inflation and the lagged policy response from central banks and not an emotional overreaction. As we have often noted, the policy error was committed last year when the Fed kept policy too loose for too long and allowed the current misallocation of capital and rise in leverage. Put another way, the inflation episode was primarily caused by excess demand and amplified by supply-shocks, rather than the other way around.
As a result, the Fed will now be forced to increase the policy rate much faster and take the terminal rate much higher. The short term interest rate markets now have the terminal rate at around 4% in this cycle. It remains to be seen whether that will be achieved, but what we do know is that the Fed will keep hiking until inflation moderates in a convincing way. In the 2018 episode, the Fed was able to pivot because headline inflation was below 2%. In the current cycle the Fed is constrained by 8.6% headline inflation. For markets, this suggests cross asset volatility is likely to remain elevated for at least another quarter or until after the northern hemisphere summer. Recall that volatility is inversely correlated to liquidity and leverage. That is a key reason why liquidity beneficiaries (long duration growth equity with no profits and crypto) have been at the epicentre of the evisceration phase.
The good news as we noted yesterday, is that although the Fed is behind the curve, the actions and promises so far have already achieved a material tightening in financial conditions. While inflation remains a significant problem, the tightening in financial conditions (shown in the light blue line moving down in the chart below updated from Monday) tends to lead the annual change in the consumer price index (dark blue line in the chart below). That is consistent with a slowing in other leading indicators such as new orders relative to inventory and some elements of the commodity markets.
The change in financial conditions is now the most rapid since the 2008 crisis. Clearly the other troublesome element of the current episode has been the correlated sell off in fixed income and the failure of bonds to diversify equities. Indeed, the drawdown in US investment grade credit (at -17.7% year to date) is almost as severe as the correction in equities. Correlations have increased more broadly which suggests that the correction has become indiscriminate and therefore more advanced.
The big picture forward looking question is when the correction is deep enough to warrant a sustainable rally rather than just a counter trend short covering squeeze? Our sense is that the path of least resistance is still lower on the global risk proxy (the S&P500). The good news is that the valuation multiple is now below long term equilibrium or neutrality. The bad news is that the tightening in financial conditions suggests that earnings are likely to be materially downgraded and that tends to be reflexive with risk perceptions or the valuation multiple. The positive in this region is that the de-rating started much earlier and is much closer to trough multiple. Moreover, China is already easing credit and liquidity.