Higher real yields…
Happy 2022 — hopefully the year Covid finally becomes endemic!
As the first journal entry for the New Year, instead of highlighting the obvious with my usual review of weekly charts, I will focus on what I consider to be the most obvious macro theme/trend for much of this year.
LAST WEEK’S ACTION
S&P500 and the Dow put in a record high weekly close to finish the year, USD mostly offered except against JPY and ZAR, EUR the best performer, and commodities joined in on the year-end risk-on party.
As I’m biased towards a pullback in risk, I still continue to monitor the best performing equity indices to see whether they reveal any weakness or, continue to build on the strong close to last year.
A LOOK AT TAPERING & QT TRENDS
Despite a very volatile 2013-18 (something we may come to expect in the year ahead), the pattern of higher real yields (in comparison to nominals) is clearly discernible where tighter monetary policy measures were announced and implemented.
Stocks have seen higher volatility as QT was being discussed through 2015/16 and finally implemented late-2017. FED also went on to hike 7 times within two years during 2017 and 18.
Excess returns and Growth stock valuations have high interest rate beta and are noticeably sensitive to policy tightening announcements.
USD has exhibited strong upside reactions to policy tightening announcements while Emerging market currencies have suffered.
CROSS-ASSET IMPACT
As central banks have already begun to take away the punch bowl of ‘easy money’ (i.e. gradually tapering bond purchases and shifting towards rate hikes and balance sheet normalization), bond yields will no longer be suppressed, inflation expectations will get reined in, and real yields are likely to go higher as a result.
Over the last year we have seen EMFX and EMB (Emerging market bonds) perform the worst, HYG has been mildly negative and outperformed by the mildly positive investment grade LQD and government bonds GOVT. Considering that the market expects at least 3 hikes this year, this all looks consistent with the current bull flattening trend, inflation breakevens rolling over, and the rotations from high-beta to defensive assets we have been seeing since November.
IRRATIONAL EXUBERANCE?
My next point reminds me of a phrase popularized by many but originally coined by Alan Greenspan during the dot-com bubble of the late 90’s, and while lying in his hot-tub apparently.
To put things into perspective — over the last 2 years, S&P500 is up +47.5% and Nasdaq100 is up a whopping +87%. Outside the US, MSCI World (ACWX) is up +33.5% while ex-US markets (ACWX) is up a paltry +13.2%.
Last week I posted what I thought was a good and very relevant piece by FT at a time where US indices have surged to a series of record highs and now looking like it needs a serious dose of reality.
A number of excellent points in that piece but to quote one paragraph —
“… we end the year with valuations high in the US at least. On a cyclically-adjusted price/earnings ratio, the US market is more overvalued than in 1929 1973 and 2007. Inflation is rising, central bank stimulation fading and Omicron is upsetting the already fragile apple cart. Not exactly the Goldilocks scenario is it?”
No, not at all…
On inflation — most of us probably think of central banks when it comes to inflation but it is a topic that has become a highly politicized. We’ve all heard various forms of this “inflation widens the wealth inequality gap” message but this is quite eloquently put:
Enter stage right Cem Karsan who offers interesting viewpoints on this topic:
Political leaders are resisting additional spending policies in fear of public backlash and appears likely there will be more resistance towards policies that could exacerbate inflation. We went through much of last year anticipating ample fiscal support for 2022 as a major tailwind for global recovery, but this has now changed with consensus starting to lean towards significantly lesser fiscal support than previously expected.
GS noted last week that they do not believe consensus GDP q/q growth expectations of 3.4%, nor the median FOMC expectations of 4% can be met in 2022. In fact their revised forecast is at 2.4% a whole percentage point below consensus, largely as they don’t expect the Senate to pass Biden’s BBB bill resulting in a sharp drop off in fiscal support.
On Omicron —I came across a research paper over the weekend with early findings that Covid infections can spread to other major organs of the body where it can survive for months. Though far less deadly, Omicron is proving to be an extremely challenging strain due to its extremely high transmissibility. It therefore seems likely that the usual pandemic induced mobility restrictions we’ve been seeing will continue to put a drag on supply chains and recovery of the services-based economy, both of which will do nothing to alleviate on-going price/costs pressures.
SUMMARY
- US equities in need of a reality check — irrational exuberance?
- We’ve enjoyed some extremely low levels of volatility and this is likely to change in the year ahead.
- Inflation breakevens to gradually pull back and real yields to bottom out, negatively impacting valuations of high beta assets.
- Increasing sociopolitical involvement on the inflation debate means it will get under control one way or another.
- Omicron challenges points to continued upward price/cost pressures.
I’m holding short-risk exposures on the books:
- Long USD and JPY vs short AUD GBP
- Short Nasdaq100
- Short Gold
For the long-term trade, I like going short TIPS ETF as an expression of higher real yields.
