The Fragility of HOPIUM

Mon, 6 DEC 2021

The correction in non-profitable technology stocks – or what we like to call “hope at a ridiculous multiple” (HARM) was fairly brutal last week. Our index has corrected by 21% since mid-November or similar to the “famous” innovation ETF in the United States. One of the plausible contributors was hawkish language from Jay Powell, the re-calibration of QE withdrawal and short rate expectations. The re-calibration of consensus beliefs was probably exacerbated by (still) crowded positioning and leverage in the previously popular growth names.

As we noted last week, while there has been a re-pricing of growth names, our basket of the most levered stocks with negative free cash flow and excessive balance sheet leverage, still trades at 10 times sales! The big picture point is that if the Fed really is serious about inflation, the current correction is barely a “flesh-wound” in a Monty Python-Black Knight sense. A proper rise in the discount rate would likely cause a correction of biblical proportions in levered and expensive growth stocks. A key question for growth equity is; just how complacent is pricing in US short rate expectations?

From our perch, investors remain fairly sanguine about the current US monetary policy cycle. While a taper of the Fed’s balance sheet will likely be accelerated and the markets are now pricing earlier and higher short rates, intermediate and longer dated rate and inflation expectations remain fairly sanguine. The interest rate markets appear to be pricing a shorter cycle but still well anchored terminal inflation and rate expectations. Put another way, in spite of the fastest current inflation in at least 30 years, market-based short rate and inflation measures remain anchored below the FOMC’s own terminal or neutral levels. For example, the Fed’s preferred market based inflation expectations proxy remains below 2.5% (chart 1).

As we noted a few weeks ago, the 16th Eurodollar contract is a decent market based proxy for the Fed’s neutral long term rate. That remains well below 2% and the 2.5% median projection in the Fed’s infamous Dot Plot. It might be telling that the 16th contract fell in yield terms on Friday along with 10 and 30 year yields after the US employment report. Whereas near term short rate expectations remained firm which suggests that the markets are priced for a short and not terribly sharp monetary policy cycle without any shift in medium-to-longer term inflation and rate expectations (chart 2). It also suggests that the fixed income markets continue to have faith in the Federal Reserve’s inflation credibility.

In that context, the report on the other side of the Fed’s dual mandate was challenging for the markets to decipher on Friday. While headline job gains increased by only 210,000 (consensus +500,000) there was a decent lift in the participation rate. The unemployment rate also eased to 4.2% which is only modestly above previous cyclical trough levels. To be fair, both participation and total employment remain below pre-pandemic levels. However, that probably continues to reinforce the concern about labour shortages, sustained wage pressure and the question mark over real or perceived “slack” in the labour market.

Although the participation rate is well down on pre-pandemic and pre-2008 levels, the current unemployment rate has historically been consistent with policy rates near cyclical peak, rather than still at emergency levels (chart 3). Perhaps the trend growth rate of the US economy remains structurally anaemic, retarded by high public sector debt that warrant lower neutral rates. However, if persistent inflation requires higher short rates, levered entities are vulnerable to a material reset. Stated differently, the risk premium on the path of future short rates still appears awfully optimistic. For markets, the potential for a sharper and more sustained interest rate cycle would likely increase market volatility.