Latest thoughts on markets

“Perception is strong and sight weak. In strategy it is important to see distant things as if they were close and to take a distanced view of close things.”

Miyamoto Musashi, 五輪書

The Near-View

Risk-assets are likely to perform well into end-November or even the end of the year. Slower economic growth and geopolitical uncertainties in Europe and Asia-Pacific have led to a wash-out in market sentiment in recent weeks, while higher interest rates are largely factored into financial market prices at this stage.

The near-term rally in risk-assets is mostly technical in nature, where a confluence of bond yields stabilising, favourable seasonals, short gamma reversion and light investor positioning has set the stage for it.

US equity market (gauged by the S&P 500 index) seasonality is currently positive heading into the Midterm elections during Year Two of an American Presidency (Biden administration):

Source: Seth Golden @SethCL

The latest BofA Fund Manager Survey (FMS) shows that professional investors are underweight risk as they increasingly anticipate recessionary conditions, and have been defensively positioned for most of 2022:

This adds potential fuel to any strong rally from currently-oversold conditions, as money managers may be forced to deploy capital on the side lines this quarter to make up for lagging their benchmarks after ten months of difficult market conditions.

As the ‘Generals’ of the equity market (Amazon, Google, Microsoft, etc) have finally cracked, many other market segments are also forming bottoming chart patterns on their higher time frame price charts. These include cyclically-sensitive or interest rate-sensitive areas:

S&P Biotech ETF (XBI):

Source: Bloomberg

S&P Homebuilders ETF (XHB):

Source: Bloomberg

Home Depot (HD):

Source: Bloomberg

General Motors (GM):

Source: Bloomberg

Lululemon Athletica (LULU):

Source: Bloomberg

While average daily volatility in cryptocurrencies have been consistently lower than equity and fixed income markets – symptomatic of an asset class that has massively deleveraged and somewhat abandoned. Look at how tight the BTC market is these days:

Source: Bloomberg
Source: Bloomberg

To play this into the year’s end, I’m employing tactical trading models to capture near-term momentum across equity sectors should conditions turn favourable.

The Distanced-View

Recessionary conditions ahead

Whether we get a soft landing or crash into a hard one, it’s almost impossible to normalise interest rates without causing an economic fallout.

More than 240 rate hikes have been done year-to-date, and this will slow economic activity in 2023. This can be seen in the chart below (blue line, which represents the net amount of central bank rate hikes, leading the light-orange line, which represents global economic activity):

Source: Prerequisite Capital, Quarterly Client Briefing (Oct 2022)

Higher risk-free rates lead to more expensive financing costs, which makes the credit cycle go into reverse, affecting business investment, hiring trends, lending and loan creation, etc. We can get a better idea of how financing costs have risen using a simplified macro model that acts as the weighted average cost of capital (WACC) for the economy. As shown below, the rise in the nominal weighted cost of capital has surpassed the surge during the 2008 Global Financial Crisis (GFC) – the rate of change matters more to businesses and consumers than the absolute level:

Source: Bloomberg. Macro model = BAA Corporate Yield + Russell 3000 Forward Earnings Yield + 30Y Mortgage Rate. Recessions marked in blue areas

The credit cycle going into reverse is essentially deflationary in nature, and will adversely impact consumer spending trends in 2023. This is why there’s a common adage that monetary policy works with a lag.

Also, it’s vital to note that the current business cycle is highly unique. It’s uniqueness makes comparisons with historical analogs as reference templates less useful.

An unique cycle with extraordinary measures means an ending vastly different than others

Having emerged out of the Covid-pandemic two and a half years ago, the current business cycle is marked by disruptions in supply-chain activity and where relatively few corporate defaults have taken place. Huge amounts of fiscal stimulus by governments in 2020/2021 have preserved household income on the aggregate, which is unusual given that incomes have historically declined during economic slowdowns.

With robust labour markets in most countries and post-pandemic economic reopening (excluding Greater China) leading to a boom in services spending and in the travel/hospitality industry, this trend is buffeting against the current slowdown in other cyclical segments such as manufacturing and real estate.

This uniqueness is why the current cycle is likely to proceed very differently than its predecessors.

In seeking to maintain credibility, central banks are unfortunately looking into the rear-window as they try to use interest rate hikes to rein on inflation. A great deal of this inflation pressures that we’re experiencing is probably due to the cyclical after-effects since the pandemic took place. Central banks are directly fighting the unique traits of this cycle.

And because interest rates are a blunt tool, this sets the stage for a potential fallout that could be quite devastating. The single-minded focus to bring down inflation prints by raising unemployment and bringing down spending is incrementally painful, and it also threatens financial stability by raising the odds of disruption in the financial plumbing.

Additionally, the US Federal Reserve isn’t just the American central bank, it’s also the central bank of the world. This is because the global financial and credit system is US Dollar-centric, with the greenback comprising of the lion’s share of global trade invoicing, payments, and eurodollar credit creation (via loans and international debt issuance) according to the Bank of International Settlements (BIS):

Source: Bank of International Settlements

A slowdown in global trade, tighter financial conditions and a stronger USD have historically led to countries at the ‘fringe’ / in the emerging world to blow up. A vicious cycle of a resilient US economy forcing the Fed’s hand to stay hawkish may lead to deteriorating conditions in countries highly reliant on USD financing.

The Fed is proceeding at a pace that will eventually ‘break’ something.

As seen in the UK and Australia, where policymakers have already ‘blinked’ and are wary of financial instability due to their tightening policies, the Fed has officially yet to do so (we’ll see in coming weeks).

Current implied volatility levels in fixed income markets (MOVE is > 140) is not what is deemed as ‘normal’, and one can easily see it from comparing current levels to where they have been over the past twelve years:

Source: Bloomberg, Bank of America. MOVE Index is a yield curve index of the normalised implied volatility on 1-month Treasury options (weighted average of 1m2y, 1m5y, 1m10y, 1m30y)

Taking a step back from the economic picture and putting on the market participant’s hat: I’m personally not as concerned about the risk of a recession as it’s widely anticipated by market participants. I also note that the consensus is somewhat expecting inflation data to decline in 2023, as indicated by the current forward implied CPI curve (green), which has fallen relative to where it was a quarter ago, particularly in the front-end:

Source: Bloomberg, USD inflation swap curve. 1y, 2y, 3y swaps have fallen quite substantially

But the risks (or opportunities) lie in the potential mispricings of the situation. Alfonso Peccatiello pointed this out well recently, where market participants are assigning about ~11% chance that the Fed either raises or cuts rates by 200bps by December 2023.

Source: The Macro Compass

With a better understanding of the uniqueness of the current cycle, an interesting macro bet here will be to bet that a higher premium on either the left or right tail of the probability distribution should be warranted.

Move slowly out the risk curve

Financial theory teaches that when interest rates are reduced, the rate at which future cash flows from assets are discounted back to the present (the discount rate) is lower. This works vice versa too.

This discount rate is the base reference that all investible assets are compared against because holding onto cash is an alternative to holding assets. The required yield on various assets either increases or decreases as risk changes. This creates what asset allocators call a risk curve.

A decade of low interest rates before 2022 have led to all kinds of investors moving out the risk curve in order to seek higher returns. With higher discount rates this year as compared to the years before, the risk curve has changed as risk premiums have risen across various asset classes from bonds to credits and public equities to private markets.

As shown in the graphic below, we’re currently in the stage of rising risk premiums as asset valuations fall, and because investors tend to flock to safety during uncertain macroeconomic climates.

Source: Bridgewater Associates, CIO October update

Higher yields on all assets, such as short-term government bonds, will attract existing and new capital first before riskier asset classes such as equities and private markets as a whole. As long as the yields in corporate credit markets are higher relative to equity yields, this will put a lid on how high equity valuation multiples can rise towards.

Investors can consider capturing those higher yields in fixed income markets first, before gradually moving out the risk curve and allocating to riskier asset classes when the cycle turns and economic conditions recover.

Concentrate on the new leaders for the next cycle

One thing that stands out in the current bear market in equities is the outperformance of the energy sector. The chart below shows the performance of the US S&P 500 sectors year-to-date, where the white line represents the S&P 500 energy companies:

Source: Bloomberg

This pattern is similar in other equity markets.

This is a clear sign of a change of leadership for the next cycle. Where we’ve seen big-tech outperformed their peers in the 2010s, the 2020s will be the decade of energy, materials and resources industries.

Using the Capital Cycle framework, we know that the cyclical industries with the highest expected forward returns are the ones that have experienced the least amount of capital expenditures and investment. The energy and resource industries, after years of oversupply and pressures from social constraints (from ESG initiatives) limiting new investment fall into this exact criteria.

Source: Saxo Group

This is an area where I’ll be concentrating my capital in, and the winners in this new cycle are those that can navigate shareholder priorities and geopolitical issues while also revamping their business models towards fulfilling sustainability aspirations.

Demand destruction and falling prices as a result of further weakening in economic backdrop could dent these sectors further, but that will be a wonderful opportunity for investors able to jump in.

In the next post, I’ll share how the new market regime is likely to look like after we’re done through this cycle.

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