In January the markets were caught out by some short covering from oversold positions in 2022, while in February there was some further rebalancing that helped shift the dialogue away from the apparent certainties of recession. In the February market Thinking we suggested that we felt a two steps forward, one step back session was due, and so it proved, not least as heightened Geo-Political tensions around the anniversary of the Ukraine war focused some investors on taking out some tail risk protection heading into the important March futures expiry. Meanwhile, as medium term allocators, having adjusted correctly for higher discount rates, now wait for greater clarity on earnings, we suggest some longer term strategic thinking about how globalisation may re-invent itself as a NATO plus Japan '$ bloc' to allow 'the west' to compete with 'the rest'.
Markets have first bounced from year end oversold conditions and then withdrawn to their long term moving averages, such that traders are waiting for some indicator of direction, making the Mid-month options expiry important once again, as we see how asset allocators roll their tail risk positions (or not). More interesting we suspect, will be how they shift weightings, eg more towards emerging markets and Europe/Japan versus the US. Strategically, we continue to see this as the end of a bear phase, if not yet the start of a new bull, as asset allocators have adjusted discount rates and risk premia, but remain uncertain of the outlook for earnings, despite a good reporting season. Meanwhile, the long term investors appear to have stopped selling rallies (bear) but have not yet started buying dips (bull). We disagree with many of the Macro pundits who are mis-representing equities as either being too optimistic on growth or having ignored recent bond weakness. Currently, the Equity Risk Premium (the spread between bond yields and the observed discount rate that market is using to price forward earnings) is taking the strain of the latest sell off in bond markets. Assuming that bonds stabilise and that earnings remain relatively resilient, then the markets can move to a bull phase. However, we suspect that in the near term, it is more likely that we will see Bull phases within markets for certain sectors and in certain markets and not others. Meanwhile, with trillions in dry powder, a still strong $ and an emerging, sanctions driven, 'common tariff barrier', as well as huge fiscal incentives under the 'inflation reduction act', we suspect US corporations will be very active this year in consolidating their dominance of the new $ zone, ie Nato plus Japan.
Short Term uncertainties – it’s not all about the macro
The near term debate still remains around whether or not this was just another bear squeeze and thus will get support at the long term technical levels and whether or not we get a second leg of a bear market based around earnings downgrades. So far, the bottom up picture is encouraging as to the second leg being mild, if happening at all, but there is undoubtedly a lot of (negative) noise from the macro side on growth and inflation as macro traders try and equate these variables to equity market levels and, to be fair, after a great run last year, they are getting more air time than usual.
One set of macro pundits are saying equity markets were overly bullish on inflation and wrong to buy into a Fed 'pivot' and lower discount rates, while a different set claim they were overly bullish on economic growth and downgrades are inevitable. Truth is that the equity markets were simply oversold and it was never about the macro.
However, that isn’t to say they are necessarily correct. On the one hand, we have some macro pundits who were bearish on growth and predicted a huge cut in Fed funds to ‘stimulate growth’ who are having to rethink their thesis as the Fed remain hawkish. These pundits are suggesting that equity markets had bought into (their predictions of) a collapse in the discount rates and are thus now going to have to sell off. On the other hand, we have those who are saying that equity markets were too optimistic on growth and that because the latest data (eg ISM surveys) are proving them wrong, that means equity markets are now going to have to sell off. However, as we see it, neither case is true. The markets didn’t bounce at the end of last year on exaggerated confidence about growth or inflation, or indeed the notion of a Fed ‘pivot’, rather on simply correcting an oversold position and thus ‘proving them wrong’ about macro is no guide to future market movements.
As we show below, we believe that equity markets are pricing in a considerable slowdown already. Similarly, the Macro Trader obsession with the Fed and historical precedents from yield curves and ISM surveys misses some very key reasons why it really is different this time – if the, literally unprecedented, combination of zero carbon, zero Covid and zero interest rates wasn’t a big enough clue. This is the new New Normal, one where interest rates are heading back to normal levels, not one where they are deliberately engineering a credit crunch. An environment where normal companies make normal profits and good companies make good profits. Meanwhile, having dismissed the idea of China re-opening in their year ahead analysis, many commentators are now scrambling to catch up, albeit choosing to ignore indicators like positive Chinese ISM surveys, while simultaneously leaning heavily on weaker US ones.
Medium Term Risks - Equity Risk Premium taking the strain
While the pundits scramble to recalibrate their models and the traders wait for a directional trend to emerge, the asset allocators are looking for relative value and the need to track closer in to benchmark. Generally, they are less convinced than the Macro pundits about the equity markets being ‘dumb’ ( a favourite trope of Bond economists over the years) and understand the interplay between corporate earnings and discount rates and are not simply using historical analogues of ISM Surveys, Fed Funds and yield curves as their only indicators. They also have a notion that a lot of things are (perhaps) already in the price.
In the recent video we posted on the new New Normal, I put up a slide of a schematic linking corporate earnings and discount rates that looked like this, asking the essential two questions; what is it going to earn? And what am I prepared to pay for it?
This is what underpins our analysis of Bull and Bear markets. In effect, for a given set of earnings (E), the value (P) is a function of the discount rate (here referred to as r). Note that the discount rate isn’t simply the bond yield, it is the bond yield plus what we refer to as the Equity Risk Premium, of which more in a minute. The first phase of a bear market move is usually a move up in the discount rate that moves 1/r to the left (1/r1 to 1/r2), such that for a given set of earnings (E1), we drop in value from P1to P2. The second phase of a bear market would involve a shift down in Earnings to, say E3, leading to a second move from P2 to P6.
We know what happened in 2022, that r went up, so that, all else being equal, according to the schematic, the value of equities should have come down, which of course it did. The questions now are
1) whether or not 1/r went too far left ?(and thus will move partially to the right again)
2) whether or not E1 has already shifted towards E3 (and thus might reverse somewhat) or indeed, might not shift at all?
3) whether both r and E have further to go.
Fortunately, rather than simply making assumptions about what markets are thinking based on macro pundits speculations, we can observe both forecast earnings and the implied value of r by deriving the discount rate that would be required at any time to equate consensus earnings forecasts with prices. This can then be compared to its own history and see if equites are then cheap or expensive.
We calculate this Internal Rate of Return (sometimes known as Implied Rate of Return) for a wide variety of markets and sectors and it can be seen here for the S&P500.
Thus, we can see that the current IRR on the S&P500 is at under 9%, its lowest level since the sell off last March and down from the peak at 10.2% seen mid last year. It is also now at the bottom of its Bollinger band (a moving average two standard deviation measure that is helpful in identifying when anything is over-extended). This means it is relatively more expensive than it was, but not exceptionally so and obviously in absolute terms is at the higher (cheaper) end of its 5 year range. This, in our view, is why markets have paused - they have moved from 'relatively cheap' - outside the green line, to 'relatively expensive' - outside the red line. Generally speaking, all major western markets are currently in a similar - if not quite so extreme - position, i.e. all are in the lower half (more expensive) of their recent trend ranges. With the exception of Japan.
Bringing in Bonds. Of course, while this is much higher in absolute terms than in early 2021, when it went below 5%, it is important to remember that at that, as mentioned earlier, the IRR has two components, the risk free rate, or rfr (as represented by the 10 year US Treasury) and the Equity risk premium. Back in 2021, the rfr was only 50bp, suggesting the ERP (IRR minus rfr) was around 4%. As bond yields go up, obviously the total IRR goes higher, but not necessarily in lock-step. We observe that the ERP moves as well. Currently, even as bond yields head back to 4%, the ERP is actually higher than in 2021– in excess of 5% in fact. This is illustrated in the chart, where the IRR is in Gold, the rfr in blue and the spread, or ERP is in Green. It is however at the lower end of its historic range.
The Equity Risk premium is taking some of the strain as Bond yields sell off, but it is incorrect to say that the Equity Market is ignoring what is happening to bond yields
On corporate earnings, the E in the schematic, the assumption by some Macro Pundits that Equity managers had moved up to E2, on account of being 'too bullish on growth' looks highly questionable. At best it is a question of whether they have moved down to E3 - or indeed if they need to. To us the question is more nuanced; for some parts of the market they may well need to move down, but for others (for example our theme on European banks), they may indeed need to move up. Equity fund managers are very aware of the importance of margins to corporate profitability, not just margin expansion, but also the simple fact of operational gearing, whereby a business with a 10% margin that gets a 2% increase in Sales that doesn't lead to much or any increase in costs (either because they have a very high fixed cost or very low marginal cost) will see a 20% increase in profits. Over the years, we have seen Macro pundits, with a naïve GDP = Sales = Profits model make this mistake over and over again and constantly claim that equity markets are too bullish, only to be contradicted by the bottom up numbers, which is one of the reasons that Equity Markets are said to 'climb a wall of worry'. In fact, at the risk of sounding very old, back in 1994 I wrote an exhaustive piece of bottom up research called 'A Profits Pathology' making exactly this point and the conversations now seem very similar to back then on many levels.
Long Term – Bloc Politics returns
The move to the new New Normal is quietly gathering pace and as we noted last week (China challenges the Washington Consensus (again)) there are geo-political shifts happening too. Importantly there has recently been a shift in rhetoric from China to state more boldly the threat is sees from what it refers to as the Hegemon. We interpret this as the start of a process to establish an alternative bloc to that of ‘The West’, both politically and economically. We like the visualisation provided by the recent UN vote ‘Toward a new international Economic order’ – 123 votes in favour and 50 against – essentially the US plus another 49 ‘western’ countries. Perhaps just as important though might be the idea that the US, rather than fighting to retain Dollar hegemony, has actually decided to focus on dominating the rest of the west. To adapt our map from the other day, perhaps rather than thinking about de-dollarisation of 'The Rest', we should focus on re-dollarisation of the West?
The 99 States of America?
In this vision of the new New Normal, we have a number of 'happy coincidences' for the US. Firstly, thanks to a decade or more of ultra cheap money and Zero Interest rates, US private equity firms have an estimate $3.3 trillion in dry powder to buy up firms elsewhere in 'the blue zone'. So large scale M&A into the blue zone looks very likely. Secondly, thanks to Zero Covid, a lot of supply chains have been permanently disrupted, allowing for 're-shoring' or near shoring into the blue zone, enhanced by the US designed, but increasingly blue zone imposed external tarriffs/sanctions against cheaper inputs from Russia and of course China. Third, thanks to Zero Carbon policies, energy costs are much higher and the sanctions on Russian energy and commodities, mean that industrial competitiveness within the blue zone, especially Germany, has been compromised. The fact that Nordstream 2 was blown up and that Germany now has to spend billions to build LNG import terminals looks part of the overall establishment of a new 'Zone', while the fact that the (laughably titled) $300trn US Inflation reduction act is incentivising multi-national companies to relocate to the US is also no coincidence we feel. The 'home' 50 states will be superior to the external 49.
Fourth, and another way of looking things might be the blue zone is NATO plus S.Korea and Japan, which then raises some interesting questions about who will pay for defense spending. If the NATO countries, whose GDP is collectively about the same as the US, were to spend 2% of GDP on buying high tech weapons(mainly from the US) then that would add up to around 50% of the Pentagon’s current Budget. Shifting the cost would certainly appeal to US politicians and maintaining the expenditure would appeal to the Military Industrial Complex (and its ‘friends’ in Washington). Positive for US bond markets.
To extend this notion of Bloc politics, there is a risk that the blue zone becomes like a defacto EU ++, with industrial, financial and other policies set from the center (note spelling). A common external tariff barrier by default on account of tariffs being set by ‘sanction’, an industrial policy that moves heavy industry closer to cheap power sources and large scale industrial agriculture to the prairies of the US and, perhaps, Ukraine. Note Ukraine has a lot of Nuclear power plants that could be aimed at the blue Zone, along with a lot of Natural Gas in the western regions (albeit most is in the east). Pressure to trade in $, even to the extent of a $ peg for Euro and Sterling, would make the DXY the trade currency for the blue zone, while the setting of standards by supra-national bodies has already bypassed both the nation states and existing blocs like the EU.
A common tax policy is clearly already a plan (the new UK government was quick to reverse the planned tax cuts and return to a policy of matching the US), while there are also plans for a Global Tax policy like the US has on individuals – made simpler with the digital ID and Central Bank Digital Currency. Indeed if we were to reverse Hanlon’s razor and suggest that things were not incompetence but actually a clever plan or conspiracy, we might suggest that there are elements within the US that are already planning for a de-facto 99 United States of America, with the Federal Government in Washington treating the other 49 nation states in the blue zone the same way they do their existing 50 states. In effect, re-invent Globalisation by taking Global Institutions and imposing those rules onto the blue zone, making the 99 States now homogenous (albeit we suspect always favoring 'home team').
This is obviously a long term issue, but to start with investors should perhaps start thinking in blocs. Who is the best company in blue zone? They will likely get the capital flows as ESG can (and to some extent already is) allocate the bulk of savings capital to ‘approved areas’ – ie not sanctioned ones. Equally, investing outside of the blue zone will require using other stock exchanges and bond markets. Here we can clearly see a role for Hong Kong, as the market for offshore Rmb, rather as London was the centre of Eurobond markets in the 1970s.
