WED 26 JAN 2022
The price action on Monday in the US session was rapid and emotional. It appeared cathartic to a degree given the very large volume and the stunning intra-day reversal. As we noted earlier this week, a range of tactical and sentiment indicators such as the AAII Investor Survey, the demand for put options versus calls and vol-of-vol are also consistent with a capitulation in consensus beliefs. That should set-up a short term trough in equities.
However, as we have also noted since the third quarter last year, the rationale for the correction; the withdrawal of super-abundant liquidity is genuine. Moreover, in contrast to previous buy-the-dip moments through the bull market, the capacity of the Fed to dovish pivot is constrained by unacceptably high inflation (from a political perspective). Put another way, inflation has lowered the strike price of the Fed put. For markets, similar episodes have ultimately provided buying opportunities. However, given the inflation constraint, it is plausible that a deeper correction in equities (around 20% from peak) is warranted before liquidity withdrawal and policy normalisation is fully priced.
On the positive side, we would push back on the prevailing bias that the episode will develop into a growth scare. Afterall, the Fed has not even commenced actual “tightening” – that only occurs once the policy rate is close to neutrality which is around 2-2.5%. To be fair, as we have noted previously, policy and broader financial conditions are more complex due to the influence of the balance sheet. While the level of financial conditions is still around two standard deviations below average, the rate of change is consistent with a slow down in growth and profits over the coming months (chart 1). However, it is probably too pessimistic to consider a growth shock or recession as a result of the Fed’s actions.
Today’s January FOMC meeting obviously provides a potential catalyst to drive the market in either direction, depending on what Jay Powell guides on inflation, policy and financial market conditions. However, our sense is that it is myopic or optimistic to expect the Fed to prevent a drawdown in equities with a dovish pivot. On the positive side, we would also have a quarrel with the view that Fed normalisation will lead to an imminent growth shock. That is probably an emotional overreaction to the recent correction in financial markets.
The additional positive for Asia is that China’s policymakers have pivoted which is likely positive for growth and relative asset performance in this region. Moreover, Asian assets have a much greater margin of safety in valuation terms. On the negative side, while the extreme in sentiment and the high volume capitulation in price would typically provide a buy-signal for equities, it is plausible that the inflation constraint has lowered the strike on the Fed put and a deeper correction in the global risk proxy (the S&P500) is warranted. We would also remain cautious on hyper-expensive profitless tech. In contrast, the recent drawdown is an opportunity to scale into profitable companies that can manage a rise in the discount rate. While implied equity volatility and broader risk perceptions have clearly increased, our sense is that cost of protection is still inexpensive in developed market investment grade and high yield CDS.