FRI 21 JAN 2022
From our perch, today is not the day to turn bearish on equity despite the ugly close in the United States. The time to do that was in late December in US assets and specifically profitless hyper-expensive growth equity. As regular readers know, we had warned about this risk for some time. When the king tide of super-abundant liquidity rolls out the lesson is to follow the leverage in order to find the naked swimmers.
While it has been frustrating not to have participated more on the short side, what we have done in our portfolios is hold companies with; high free cash flow, low balance sheet leverage and sustainable growth at a reasonable margin of safety. We have also had a long position in bank equity as a positive carry inexpensive hedge on higher rates. Our basket of bank equity in Asia Pacific is still +6% year to date (at the time of writing) and represents one third of our exposure. The point here is not to take a victory lap, markets are always humbling and will expose hubris (or those that confuse skill with leverage).
Our sense is that the impulsive and emotional nature of the price action and the very large drawdown in profitless equity suggests that there is reasonable odds of a counter-trend rally over the coming days. That said, and as we noted this week, the nature of the price action has changed because there has been a genuine shift in the liquidity regime. Most investors under the age of 40 have been conditioned to a dovish Fed. However, throughout most of the recent cycles, the Fed was able to have a dovish bias given the absence of sustained inflation (in their PCE defined measure). That is the key contrast in this cycle. Headline inflation is 7% today compared to 1.9% in 2018 when the Fed last capitulated into a dovish pivot. As we also noted this week, headline inflation will probably moderate this year, but underlying inflation (wages and shelter) could remain persistent.
Another contrast with recent policy normalisation cycles is the (relative) strength of growth momentum. While our sense is that growth and profits are likely to decelerate this year, the ISM and macro surprise indices are still consistent with above trend growth. When the Fed implemented the first rate hike in the last cycle (December 2015) the ISM was already below 50 and in contraction. That was the first time that the Fed had hiked the funds rate with the ISM below 50 (since Volcker). At the time, 4 rate hikes were priced for the following year, but only 1 was delivered after the dovish pivot. In the current episode, the odds that the Fed delivers on rate hikes and balance sheet run off is higher, in our humble opinion.
The final point to note is the starting point for financial conditions and credit risk premia in this episode. The time series below show the normalised (z-score) of the VIX, US high yield spread and the Goldman Sachs Financial Conditions index. While there has been an impulsive spike in the VIX, it still remains below the 2018 episode. It is also prominent that US high yield spreads remain anchored under 300 basis points. Although there has been a modest tightening of financial conditions, on a normalised basis they remain extremely low relative to the last cycle (chart 1). The point here is that if the Fed needs to tighten financial conditions, they will be forced to deliver more than the 4 hikes currently priced in the money markets and faster run off of the balance sheet. Of course, there is a reflexive or self-reinforcing element here as financial conditions include asset prices.
In conclusion, the correlated episode in rates and profitless equity is now well appreciated and better priced. That likely sets up a counter-trend rally over the coming days. However, it is important to note that the speed and magnitude of the rate hikes and Fed balance sheet run off are likely to prove more challenging for some assets in this cycle. That suggests maintaining a bias for low balance sheet leverage, high cash flow assets. The good news in this region is that China has pivoted and is easing liquidity. That is a relative support for Asia Pacific.