The Sigh of the Tiger

THU 03 FEB 2022

On Monday we suggested that there is an uncomfortable parallel with the market correction in the fourth quarter of 2018. That correction was also likely driven by a rate and liquidity withdrawal driven valuation adjustment. Over the past few days while most of Asia has been celebrating the new year of the Tiger, US stock markets have staged an impulsive rally. Although there has been some encouraging earnings news flow from some mega-cap leaders such as Alphabet (Google) the nature of the rally also appeared to have a short-covering character to it. Moreover, the major social-media platforms have disappointed after the US close, putting pressure on the futures and potentially reinforcing beliefs that the rebound from the January low was counter-trend in nature (time will tell – chart 1).

As we also noted on Monday, in chaos theory, the edge of chaos with maximum complexity occurs between paradigm shifts. The (now obvious?) paradigm shift is the move away from zero rates and super-abundant liquidity. Clearly markets have moved a long way to price a significant shift in short-term interest rate expectations and normalisation of central bank balance sheets. However, as is often the case at major inflection points, participants find it difficult to give up on the prior regime that was so profitable for many investors (a behavioural bias).

The additional complexity in this episode is that central banks have left the adjustment so late that the required pace of adjustment to close the gap between actual and warranted policy settings is potentially disruptive for markets. As we have often argued, the potential policy error was not acting too soon, but too late. Similar to the Fed, the European Central Bank is also materially behind the curve. While the ECB has an inflation-only mandate rather than a dual mandate like the Fed, the estimated Taylor rule for the ECB (the warranted policy rate based on the inflation and output gap) suggests that official policy rate ought to be around 6% (chart 2). This week, Europe has simultaneously recorded the lowest unemployment rate on record and the highest inflation rate in the history of the common currency. That sets up a rather interesting ECB policy meeting today. However, the big picture point is that potential policy error is much broader than just the US Federal Reserve.

Complexity also still exists in macro conditions and the news flow. There clearly has been a pause in momentum evident in the data. It is plausible that US employment growth stalled in January. However, that was likely a function of employees being forced to remain at home and a pause in economic reopening rather than something sinister with regard to growth. The job openings survey continues to suggest record demand for labour. That dichotomy ought to be resolved over the coming months, but the key point for markets is that it is probably too early to fear a “growth scare” or recession-like slowdown in growth and profits. In turn, it also suggests that normalisation in short-term interest rates and liquidity likely remain a challenge for beneficiaries of the prior regime. For markets, volatility is probably under-priced, particularly in developed market credit.

The final point to reinforce is the good news that if macro conditions remain firm (or the reason why rates are rising), then profits are also likely to remain supportive for equities. However, the shift in regime likely favours companies that have shorter duration cash flows and robust balance sheets, rather than high multiple stocks based on hopes and dreams of growth in the distant future. The good news is that the likely shift in rate and liquidity conditions is much better priced and appreciated, the bad news for high multiple equities is that it is likely to persist and broaden more globally with the ECB and other central banks.