Overview – Tide Going Out
The liquidity tide is going out. The relief rally from the middle of March has completely unwound, leaving April as one of the worst performing months in Equity markets for years -especially in the NASDAQ. This reflected a combination of factors, including profit taking by short term traders who never trusted the rally, significant deleveraging and outflows from both stocks and bonds as concern rose that the Fed was now metaphorically selling calls rather than puts and a widespread loss of confidence, both in the ability of Tech stocks to actually ever turn revenue into profits and, more alarmingly, in the longer term prospects for the US$ itself. For even though the Trade Weighted Dollar index rallied strongly in April, we see this as only partly due to Fed rates and more a case of a ‘least ugly contest’ against other G7 countries, as well as a form of short squeeze, as forced buyers of $s to deleverage positions. The full consequences of the arrival of the Petro-Ruble have yet to be made clear, but our suspicion is that they will be profound. Meanwhile, our model portfolios remain heavily skewed to cash.
Short Term Uncertainties
The initial ‘bounce’ after the start of the Ukraine hostilities was largely driven by a recovery from an over-sold position – traders had gone short expecting follow through from asset allocators who proved to already be hedged. Equally, there has been little follow on buying from the sharp rally that followed the options expiry in Mid March, leaving April to see a drift all the way back down. As we saw with Covid, there is a growing sense that not only will this not be resolved quickly, but also there is a real risk of more policy mistakes that could make things a lot worse. Our model portfolios, which started to put a little back into markets in late March, have reversed and are showing very little in the way of conviction and we suspect most investors are feeling the same. Meanwhile, increased volatility in bonds and commodities is leading to some widespread deleveraging, which is sucking further liquidity out of markets (in turn further spiking volatility) as well as driving some very sharp moves in exchange rates – the Yen in particular has moved by orders of magnitude greater than might normally be expected if this was just interest rate arbitrage based moves.
The steady tightening of Fed Policy also continues to play havoc with the Bond markets as they add to the general liquidity issues by administering Quantitative Tightening at a time when markets are already deleveraging due to higher dollar costs, higher volatility and continued uncertainty around not only the Ukraine, but also the apparent reversal of China’s easing of zero Covid policies threatening a renewed round of disruptions to the global supply chain. On an annualised basis, year to date Bonds have had their worst year since 1920 and the collapse of the carry trade has caused serious pain across the whole fixed income investment space. NASDAQ meanwhile had its worst month since 2008 as the post Thanksgiving meldown in the small and mid cap tech stocsk spread to the mega caps, with the two big ‘lockdown winners’ Netflix (-48%) and Amazon (-26%) down heavily on profit warnings. In a sense this is all part of a massive shortening of duration.
Given all this, perhaps not surprisingly, fear is at a multi-year high, with the AAII Index of bulls minus bears the lowest level since March 2009. As previously discussed, while this is more of a coincident than a genuinely contra-indicator, it does show quite strong mean reversion and also tends to correlate with sector rotations as well. Seasonality (Sell in May) is not going to help in the near term, while the short Gamma position (derivative positioning creating a destabilising force – sell on the dip, buy on the rally) is not going to help either.
Medium Term Risks
As the short term uncertainty, combined with the tightening of rates, continues to hit longer duration equities, now extending to the big NASDAQ names, the mid cap techs continue to be hammered, none more than the so called ‘AARK stocks’, the mid cap tech stocks that had been squeezed higher by the liquidity upcycle in 2020 as inflows into ARK and a number of other funds with tight cross-holdings amounted to something close to a ‘ market corner’. However, as previously discussed, when the profit taking started around Thanksgiving, the liquidity tide rushing out turned a virtuous cycle into a vicious one and as Warren Buffet famously put it, it’s when the tide goes out that you see who has been swimming naked. The outflow is clearly continuing, as the chart shows, AARK is now 58% off its November highs, while another bull market winner turned loser, SPACs, are down 23% over the same period. Another way of looking at it, SARK, a fund set to be the inverse of AARK, is up 93% since November.
Chart 1: Tide Going out reveals ARK and SPACs swimming naked
Chart 2 shows our calculation of the IRR for the S&P500, best thought of as the Discount Rate that would be required to equate a stream of consensus expected earnings to the current share price. Thus the higher it is, the ‘cheaper’ any particular stock or market is on current estimates and price. We show it with a trending moving average and Bollinger bands ( 2 standard deviations).
Chart 2. S&P as cheap as in 2020.
If we look at the overall market, we can see that the valuation is actually as attractive as it was back in March 2020, it’s just that the IRR for many of the individual stocks (the ‘naked swimmers’ ) has got decidedly worse as the hoped-for earnings fail to come through. And not just the mid caps, like TeleDoc (One of AARKs favourites), but also the likes of Netflix, whose selloff dominated the headlines at one point during the month and Amazon, which had a more stealthy drop of 25% over the month, mostly at month end after some weak results. To this extent it is similar to the DotCom bubble bursting and is a classic ‘duration shift’ as interest rates rise, combined with a likely slowdown in economic activity as discretionary spending is crowded out by inflation in essential goods prices like fuel and energy, while higher mortgage costs and higher taxes create further inroads into discretionary spending. As such the economic impact of the fighting in Ukraine has been the increased risk of temporary inflation becoming stagflation.
Biggest Risk is Fed flip to aggressive tightening
It is becoming clear that the biggest medium term risk to markets is that the Fed flips from its wrong-headed policy of Zero Interest Rate Policy (ZIRP) aimed at creating a wealth effect and by extension CPI inflation, to the equal and opposite (and equally wrongheaded) policy of deliberately tightening monetary conditions with a specific target of causing asset prices to fall and create a negative wealth effect. While this will, ultimately, have an impact on the CPI, the risk of serious collateral damage is rising. We are already seeing de-leveraging, which in our view is causing short squeezes in the $ and likely elsewhere, but once that is over, the fundamentals will reassert themselves as credit conditions tighten and previously hidden fragility suddenly appears. We suspect a series of margin calls is likely over the coming summer which could not only hit individual securities, but also unravel a number of linked strategies. Elon Musk’s pledging of Tesla stock to buy Twitter is just one example of new risks being inserted into markets, but there are doubtless many others.
In the meantime, while higher short rates are undoubtedly starting to attract flows otherwise absent in fixed income, the apparent strength of the $ in April looks only partially to do with the normal functions of a Fed tightening cycle. The Yen in particular has sold off dramatically, as have the Euro and Sterling, and even the, previously resolute, offshore Rmb has weakened, but the speed and size of the moves suggests distress somewhere. Partly we think this is deleveraging (a currency and a duration mismatch is a double disaster), but we should also not ignore the new currency on the block, the Oil and Gold backed Petro-Ruble, which is currently the ‘strongest’ currency in the world (over the last month).
Long Term Trends
From a long term perspective, we would suggest that the most significant event in March/April will be seen to have been the launch of the Petro-Ruble to compete with/replace the Petro-Dollar. Combined with a shift to bilateral trade amongst at least half the countries of the G20, this will alter the demand for, and liquidity in, the US$ generally, which will likely lead to a a sustained period of deleveraging of trading books. Understandable concern among many countries with current account surpluses about keeping their wealth in $ assets is likely to lead, at the very least, to increased diversification. Most obviously China holds a little over $1tn in US Treasuries and while they wouldn’t look to dump them all, they have a number of alternatives. For example, they could leverage against them and invest in non dollar assets – their US holdings then hedged. Perhaps that is how they will pay for the next phase of One Belt One Road? (If they haven’t already). In addition they are already increasingly asking their customers to pay in non $ currencies, and accept them in return for commodities such as Oil.
To Conclude; Overall, the message is that the Financial system as we know it is deleveraging itself from the position it had got to over the last 15 years under QE and ZIRP, as, unlike when Covid struck or indeed other crises, the Fed is now raising rates as opposed to cutting them. The carry trade is over, as are duration and currency mismatch trades, while volatility is triggering automated (but distressed) selling, which in turn is leading to more yet volatility until a feedback ‘doom-loop’ appears. Similar distressed selling is appearing as the fund inflow/subscription squeeze in (mainly tech) names was flipped into reverse and as yet, there is no sign of that particular negative impulse reaching a bottom. Valuation is comfortable, but fear is high and confidence is low, while seasonality is also a headwind. The dramatic moves reflecting the short squeeze on the $ suggests potential opportunities, especially in the Yen and at least the possibility of lifting some hedges, while the prospect of 2.7% returns at the short end of the curve means that the idea that There Is No Alternative (TINA) to equities is no longer valid.
