Overview
April marks the start of the second quarter as well as the start of the new financial year for many and while the Ukraine crisis has thrown up new challenges – not least in eating as well as heating – most of the issues we now face were already underway and have just been accelerated by the events and the responses to them. Traders are deleveraging, not least as the cost of funding rises, leaving market direction more to the asset allocators, who continue to rotate towards cyclicals, quality and cashflow. Meanwhile, long term investors appear to be picking up perceived value in oversold mid-cap tech stocks. Bonds are now in a bear market and the biggest risk to equities is now that the Fed repeats its mistakes with the wealth effect and actively targets them.
While the responses to both Covid and the Invasion of Ukraine were quite literally unprecedented, there are lessons from the past in much of what is going on at the moment. Economically the spike in energy prices has echoes of the 1970s, while the sell off in bonds looks similar to the mid 1990s. Meanwhile, the Central Banks’ moves to hike short rates and in the case of the Fed to flip the yield curve, threaten to impact western economies, particularly those with heavily indebted consumer sectors with floating rate mortgages, in a similar fashion to the mid 2000s.
The biggest issue for markets therefore remains not so much the events that hit them, but the policy responses that follow in their wake. For example, the short term economic damage from lockdowns, and the longer term risks from the debts incurred by governments in the wake of Covid, are likely to be far more significant than the impact of the virus itself. Equally, the sanctions on Russia, and in particular the freezing of Russia’s foreign exchange reserves in response to the Ukraine invasion, looks likely to have a far greater long term impact on markets than the actual event. Finally, the response of central bankers in raising interest rates to supposedly control inflation, even though it was not caused by loose monetary policy in the first place, risks short term stagflation and longer term recession, particularly in Europe. Thus despite the unforced (policy) errors of Zero Covid and Zero Interest Rate policy now being largely behind us and with, finally, some sensible challenges and policy proposals (nuclear) to the Zero Carbon proponents, we now face more unforced errors on energy policy and interest rates.
Short Term Uncertainty
When we are looking at short term uncertainty it is important not to get confused by valuation measures, since being cheap or expensive is rarely a catalyst for short term price moves. More often than not it is the esoteric but vital ‘market mechanics’ that are the main driver and these are often linked to issues of leverage and liquidity, as well as the need to control the ‘Risk’ in portfolios. Running into the March options expiry we saw a shift in the gamma position of the options market makers which essentially meant that they returned to a role as a dampener rather than an accelerator of market moves, while leveraged positions began to be reduced more generally. The week of the March options expiry was thus the pivot point for equities, as we had anticipated, with the lack of roll over of protection leading to a sharp bounce, suggesting a short term floor in markets, very similar to the situation back in 2020. Stage 1, deleverage and increase risk premium, stage 2 try and work out the new paradigm, taking account in particular of the policies just enacted.
Meanwhile, if we measure risk as volatility (as many do) then we can say that March saw Equities become less risky while both bonds and commodities became more so. Indeed, the sharp spikes in volatility of both Oil and US Treasuries were arguably the major driver of the selling that hit both markets towards the end of the month; many institutional investors are simply not allowed to hold assets once they exceed a certain level of volatility, as such they hit ‘air-pockets’ where prices can drop sharply until a new buyer can emerge.
Asset Price Volatility driving asset Allocation
In terms of other market mechanics, the upcoming Easter holidays are likely to have an impact on liquidity, while the tax year end may also be having a distorting effect, but overall it looks like the narrative is shifting away from the short term traders and towards the medium term asset allocators. In this sense, markets spent March considering the second order impact of the Russian invasion of Ukraine, just as they did two years ago in reaction to Covid, the second order being the impact of the policies brought-in in response to the invasion/virus rather than the impact of the invasion/virus itself.
Medium Term risk
Asset allocators were already long put options going into the Ukraine conflict, which is why the VIX actually ended the month lower (21 versus 31 before the invasion) and , as discussed in Market Thinking for March, we saw a potential pivot point for markets as being around the mid-month quadruple-witching options and futures expiry, where the likely lack of institutional follow-on buying of protection/hedging, combined with high levels of retail investor pessimism (and thus nothing left to sell) was set to produce the equivalent of a short squeeze. This was noticeable at the headline index level, but also in sub sectors like mid cap tech, where the distressed selling we had discussed at the turn of the year eventually subsided. Towards the back end of March, our risk models started to put money back into some of our preferred thematics (having been largely in cash since Christmas) – Cyber security, Robotics and Automation and clean energy, just as they did in April 2020. Similarly, at the factor level, risks are dropping, notably in minimum volatility, quality and momentum, consistent with rotation out of bonds, which remain at maximum risk on our systems. We anticipate this pattern continuing for the rest of the quarter.
Of course the dominant theme for markets this year remains Energy; even before the Russian invasion of Ukraine, the US energy sector was up 33% year to date. It is now up 44%. Clean energy by contrast was down almost 8% by mid Feb and is now up 11% as the Green Industrial Complex continue to push their stocks as a ‘solution’ to the Russia gas problem, even though in our view they clearly are not. Indeed, the dependence on imported gas is a function of the exclusion of nuclear and the insistence on intermittent renewables that require gas for back-up. Nevertheless, this may ease some of the pressure on the ESG complex, where over the last year ‘dirty’ energy had out-performed ‘clean’ energy at one point by over 90%. It is now ‘only’ around 70%.
In terms of risk/return, we are also noticing some signs of stabilisation in the Chinese ADR plays, which have had a tough time as US investors started to ‘delist’ from the stocks last autumn. While the US media stocks may now be facing a challenge to their global ambitions – banning any discussion of any non US viewpoint plays well only within the western sphere of influence – Asian stocks like Tencent and Alibaba were already priced for US sanctions and, like Asia generally, are sitting at very attractive relative valuations, with many stocks now at the sort of discounts to book value that attracts long term value investors, especially given the likely changes coming in markets and regulation, as well as the prospect of the resumption of fiscal stimulus.
Long Term Trends – deleveraging.
The biggest concerns in the longer term centre around inflation. In our view, while the jury is still out on whether this is temporary or permanent, what is clear is that the Central Banks are going to steadily raise interest rates and if that means that the yield curve inverts, then so be it. This is clearly bad for Bond markets, which look to be in a proper bear market, as we have discussed in previous monthly notes. Inverting the yield curve means the carry trade is now over for this cycle, meaning traders are deleveraging, while the jump in volatility means that the asset allocators and quant funds are also forced sellers. The final domino to fall, the long term investors, is still supported for regulatory and risk management reasons (nobody has been holding bonds for return) but they will have to become value buyers for the market to stabilise.
Overall, inflation is about pricing power and so are corporate margins. Profit surprises will thus come from a combination of both volume and margin – in both directions – as the impacts of both Covid and Ukraine mean that the physical practicalities of Globalisation and the Platform company model are being challenged. ‘Just in Time’ inventories are being replaced with ‘Just in Case’, which while good for warehousing and short term demand (buy two store one) is ultimately a mis-allocation of capital and bad for margins – especially as the cost of working capital is now rising. Similarly, re-shoring of manufacturing is going to be good for machine tools and particularly Robotics and automation, but less good for corporate margins. Both of these trends will likely deliver excess demand in the near term, fuelling the perception of embedded inflation, even if what is actually happening is a re-pricing.
However, for Equity markets, the real risk from inflation is that the Fed are actually going to explicitly target the Stock Markets to slow the economy down – just as they targeted the stock markets to support the economy. In other words, repeat the mistake of believing in the wealth effect and make the equal and opposite error to Zero Interest Rate Policy.
The biggest risk for equities is that the Fed repeats its obsession with the wealth effect and actively targets the equity market on the downside.
Meanwhile, using the yield curve to predict the economy based on historical correlations is something of a cottage industry among bond economists, but we have always had an issue with the implicit assumptions about ‘stationarity of variables’, i.e. the assumption that the sensitivity of the economy to interest rates doesn’t vary over time. Central to this in our view is the mix of fixed versus floating rate mortgage debt in an economy. In the US, this was traditionally around 10% floating, compared to the UK, for example, where it was nearer 90% floating. Running into the Financial Crisis, the US floating percentage went up to nearer 20%, but is now back to nearer 10%. This means that rising short rates will impact the US in a different way to 2007/8, but the impact on UK, Ireland, Spain, Greece, Australia and others with floating rate markets may be as bad, or even worse than ‘last time’. In addition, the UK consumer is going to be hit with not only the equivalent of a tax rise from higher mortgage payments, to compound the actual tax rises they are facing, but also the major hit to disposable income from the jump in energy prices, which, despite attempts to paint it as a Ukraine issue, is due to just one of a number of policy errors. We have described, Zero interest Rates, Zero Covid and Zero Carbon and as the deadly trinity of policy errors, but the risk is that, just as we close down the first two, we double down on the third and make an equal and opposite error on interest rates.
Zero Carbon meant a misplaced focus on green energy and renewables at the expense of nuclear, which has left Europe dependent on Russian gas for baseload power (nuclear can’t be spun up quickly when the wind stops blowing), while poor strategy on storage and a misguided attempt to buy cheap spot at the expense of stable contract had left UK and European consumers facing gas prices multiples of their peers in the US and Asia. The insistence now by the US that Europe cuts itself off from Russian gas in support of what is essentially US foreign policy is a further example of how policy makers are seriously damaging economies. On the positive side, the crisis has pushed a strategy for new nuclear, but this will be slow in coming,
In the meantime, we would expect the ‘cost of living crisis’ to not only impact on disposable income in the UK and Europe, but also to lead to some political tensions and the return of populism. The French Elections will be the first test of this, but it seems likely that there will be pressure on the political ‘certainties’ around globalisation just as there is already on the practical certainties. This risks further mis-allocation of resources. Sadly, having inserted themselves aggressively into economies over the last few years, policy makers now have a key role to play in markets, perhaps we should focus on countries with competent policy makers?
