With the end to Mutual Fund tax-related selling in October and the closing out of the CTA hedge fund short positions ahead of Thanksgiving in November, the equity markets finally managed to put together two back to back positive months, reinforcing the seasonality trends of this time of year and taking negative returns from the 20’s to the teens for most investors. and giving a feeling of some relief for managers. Investors are nevertheless understandably wary of the thin markets in December and are grasping for analogues as to what happens next. The bear camp are focusing on the upcoming recession and likely poor earnings outlook for 2023 and pointing to indicators like the yield curve and the fact that the Fed aren’t yet ‘done’. On the other side, the bull camp are pointing to the market appearing to have bottomed almost exactly in line with the average length of a bear market and the fact that the financial markets not only lead the real economy but that (early) bull markets always have to ‘climb a wall of worry’.
On balance we are more toward the bull camp; after several false starts during the year, the latest bounce appears to have more stability than previously and, while not yet buying the dips, (our definition of a bull) long term investors appear to have stopped selling the rallies (our definition of a bear). We are also wary of historical analogues that look at interest rates not just as the discount rate for valuing securities, but also as proxies for changes in the money supply; QE broke that relationship and while rates are now normalizing (ultimately a good thing) they are still out of synch. The reduction in the money supply that will bring on the recession is already baked in, while the discount rate change that has deleveraged and de-rated markets has already taken place, so in that sense we feel the impact of the Fed is already ‘done’. The biggest impact the Fed will now have will be on the $ and as that rolls over, there is a lot of cash to be deployed, we suspect into non US assets, particularly in Asia.
Navigating the Narrative
The idea behind Market Thinking is not to make macro predictions, but rather, as the subtitle states, to try and ‘make sense of the narrative’; to assess where the markets think they are and to assess whether that is either consistent or credible. To that end, this time a year ago, we put out a series of posts – ‘four problems and a solution’ where we looked at the real problem with Bonds – that they offered negative real yields in a world where rates were having to rise sooner or later and that they suffered from an illusion of risk management with a bar bell of cash and junk. As we put it : “Looking forward and with the prospect of tighter monetary policy and the certainty of higher price levels, we now find ourselves, after a decade of government intervention and misplaced risk management, asking what now is the role, if any, for bonds in long term investment portfolios?“
In a second article The problem with Passive Equities, we highlighted that a passive investment in the S&P500 was in reality a highly skewed bet to a very small number of mega cap tech stocks. As we said last year; “A US passive index for example has an exposure to internet/software/computers and semi conductors of around 37%.By contrast a European equivalent passive benchmark has, literally, one tenth of that, at 3.7%, the dominant components being Pharmaceuticals, Oil and Gas and banking.” We suggested that we were due a return of Smart Beta and that equal weighted would beat market cap weighted as a simple strategy. This proved to be a winning strategy for 2022 and likely for 2023 and beyond.
Simple Alpha from Equal weighting
As part of this view, we also highlighted in a third piece, The Problem for Stock Picking, that “in the short to medium term, the ‘bots driving the new index ETFs are becoming the key driver of the price for many if not most of the component stocks and the more specialised and thematic the indices become, the more important subscriptions and redemptions become for mid-cap stocks.” At a time when the profit taking after a powerful year of memes and mid cap tech stocks was starting to take hold, this was a warning about the inherent risk in concentrated portfolios being less about the company fundamentals and more about the Smart Beta baskets they were included within. As the chart (repeated below) illustrated, the growth of Smart Beta has been such that there are more ETFs than stocks and the fact was that the winning stock picks for 2021 were a lot more to do with their ‘smart beta’ than the market was acknowledging at the time and as we put it “illiquidity means fragility”.
Another year of Smart(er) Beta
The fourth article brought these together and discussed The Problem for Balanced Funds suggesting that, unfortunately “one of the biggest (albeit largely unacknowledged) problems for the Wealth management Industry at the moment is that one of the central investment frameworks, the 60:40 balanced fund model, is essentially no longer fit for purpose.” Thus we were not surprised to see that the 60:40 fund world had their worst year for decades – while by contrast the CTA macro traders had one of their best.
The final article offered A proposed solution to the above set of problems, which, while they have evolved, still remain. In essence it was based on our Global Equity Model Portfolio approach of a 60:40 fund where the Bond component was replaced by a basket of Global Equity Factors and the Equity component by a basket of Global Equity Themes. Utilising this Smart(er) Beta approach avoids the obvious issues with country and sector based market cap weighted passive indexation, while a dynamic allocation between these themes and factors based on a conviction scoring system allows investors to ‘get active with passive’ and avoid ‘tracking indices all the way down’ in the name of lower risk. In addition, being unconstrained allows for periods of low conviction to be reflected in periods of high cash weightings in a form of automatic stabiliser, reducing both drawdown and volatility.
Overall, many of these issues remain. While Bonds are now better value, they are at best a short duration trade – cash is now an asset and while long dated bonds will do well on a so called Fed Pivot, so will equities that will also pay you more to wait, while the upcoming recession (in the west at least) represents heightened credit risk. The Smart Beta theme continues we think and diversification away from US$ assets is likely to be done through different thematic baskets of global equities rather than simple country or sector allocations.
Short Term Uncertainties – overhead resistance for Equities and Gold, support for the $
Back in June, in an article (Build a Bear) we discussed the various analogues that market participants appeared to be using and, more than slightly tongue in cheek, suggested that using this process we would conclude that the market would bottom on October 19th (coincidentally the 35th anniversary of the 1987 crash) at around 3000. Seemingly, we (or is it they?) were a week early and 20% too low (!),but as they say, the first rule of forecasting is to always give a target and a date – but never at the same time. Joking aside, the timing was more important than the level since it was essentially very close to the ‘average’ for a bear market decline of 289 days and plays to the psychology of investor behaviour. As discussed last month, the combination of two events – an end to tax loss selling and a profit-taking short-squeeze into Thanksgiving – had its desired effect and Equities continued their rally from the lows without a renewed bout of selling the rallies from long term investors, where the psychology is such that if they were going to sell (after 289 days) they already would have done so. As such equities finally managed to put together two back to back positive months of returns and the Model Portfolios we run were showing steady signs of increased confidence.
Thus, while in some senses the set-up looks similar to July/August, before the Fed spoiled the party at Jackson Hole, the lack of meaningful follow through selling of the rally by long term investors is encouraging. Meanwhile, the recent rally in bonds looks less like an early warning of further aggressive tightening than it did in August and more like a rebound from an oversold position as the CTAs closed their year with some (large) profit taking. Also, the fact that the $ is selling off sharply on the DXY rather than rallying aggressively as it did back then also suggests a recovery/stabilisation phase rather than a new bout of deleveraging and selling.
Having said all this, the S&P 500 failed to break through its long term moving averages and December is, understandably, a poor month for liquidity. Meanwhile, from a market mechanics point of view, the market is short gamma again, meaning that the options market makers are once again acting as accelerators rather than stabilisers in markets – ie they have to buy when markets go up and sell when they go down.
The technical analysts are watching the long term moving averages on Equities very closely, while the FX traders are focusing on the $, where the trade weighted is unwinding its post Jackson-Hole rally, encouraging further profit taking. Currently the long term moving averages for Equities are providing resistance and for FX they are providing support, leaving both variables at or pretty close to where they began H2. High yield and investment grade bonds, as well as commodities like Copper have reclaimed much of the early q3 weakness, albeit remain below their long term moving averages. Traders are also generally understandably nervous of thin and volatile December markets and with the VIX dipping below 20 may well be buying some protection against a spike in volatility.
Elsewhere, while the collapse in the Crypto-sphere during November dominated the headlines, it has not seemingly had much impact on the outside world so far, probably because the ‘real world’ money that came in from the left hand side appears to have largely gone out of the right hand side already, leaving a giant souffle of supposed ‘wealth’ that has just collapsed. There will of course be real world implications in terms of business, the expenditure on servers and other tech undoubtedly boosted a lot of the tech sector, just as it did in Y2K/Dot com era, but that particular bubble has been deflating all year. In fact, the main impact of implosion of FTX so far seems to have been some serious embarrassment to the due diligence operations of some of the world’s apparently most sophisticated investors. One other consequence of the troubles in Crypto has been a resurgence of interest in Gold, which rallied hard in November, albeit, like equities, hitting resistance at the long term moving averages. With the $ weakening, gold bugs will be adding this to their list of reasons to buy.
Medium Term Risks – need to be more active
All this rebalancing of the Q3 sell-off is setting the scene for medium term investors to consider actions for 2023. From the Macro viewpoint, in our view, the inflation we currently have was fundamentally driven by the rapid expansion in the Money Supply in 2020 and 2021 as fiscal policy on Covid expanded dramatically and was monetized by the central banks. The reversal of that means we will almost certainly face a recession in the west in 2023/4, while the transitory nature of some inflation indicators due to supply chain disruptions (shipping, spot gas prices etc) means that the headline inflation rates will appear to drop quite sharply into 2023. Expectations about the Fed easing will increase, but will likely impact the $ more than other asset markets. With a lot of money ‘hiding’ in US$ cash, one of the big decisions for 2023 will be where to deploy that cash and we suspect it will lead to a reduced exposure to US assets. Moreover, with a steady shift away from the $ for trading purposes, we would expect to see strength not so much in the traditional DXY cross currencies – Yen, Sterling and Euro – but rather in in Asian currencies like the Chinese Yuan, Singapore $, Taiwanese $ and Korean Won.
At the very least we suspect a continued shift away from Market Cap weighted, to equal weighted exposure as discussed above. Meanwhile, the normalization of interest rates will continue to negatively affect those that have benefitted from the decade of abnormal rates and vice versa. This is likely to be regional and sector specific as well as challenging to a lot of the ‘Shadow Banking’ system that evolved in the wake of QE. Thus, as discount rates normalise and the financial markets stabilise, the question will shift to earnings and the biggest medium term risks for asset allocators appear to be shifting from what they own, to what they do not own. As we highlighted in the case for European Banks, (Money in the Banks), there are areas like European Banks and Global Mining that are unloved, under-owned, full of cash and paying out a lot of cash flow while you wait. In this, they are similar to Energy Stocks a year ago. One of the biggest motivators for asset allocators is getting ‘in line’ with benchmarks when things they don’t own are rallying.
Elsewhere, the opening up of China is, in our view, one of the biggest themes for 2023 and, as we noted in The Mountains are high in many ways those worried about inflation should actually be grateful that the Chinese did delay opening up. Full China demand into a compromised global supply chain post Covid would have almost certainly significantly increased the impact on global commodities. Instead, we see it creating a second wave of transitory inflation in the second half of 2023 similar to 2010/11 and a resumed focus on the equity beneficiaries.
Long Term Trends – history lessons.
The classic line on the lessons of history is from philosopher George Santayana
Those who refuse to learn from history are doomed to repeat it -- George Santayana
while a more modern sage, Warren Buffet, pointed out that
What we learn from history is that we don’t appear to learn from history -- Warren Buffet
Overall though we prefer Mark Twain,
History doesn’t repeat, but that it rhymes -- Mark Twain
This is important when commentators are trying to impose quite precise analogues for markets such as the current meme that markets never rise when the Fed is raising interest rates into a steeper yield curve. While this is objectively true from the statistics, we need to be wary of the idea that nothing is different this time. We have objectively, just been through a period (as noted at the top of the page) of the three zeros – Zero Interest Rates and QE – unprecedented, Zero Covid and lockdowns – unprecedented, and Zero Carbon, where we are increasing the cost of energy. Also unprecedented.
As Zero Interest Rates unwind, we need to recognise that markets lead the economy in that interest rates are the discount rate for securities as well as the cost of money for real economic activity. They are also usually coincident with the growth or shrinkage of the money supply, so are used as a short cut, meaning that when analysts talk about the Fed and the shape of the yield curve they are implicitly assuming changes in the Money Supply -like last time. But what really is different this time is that rates and the Money Supply got out of synch. Ultra low rates did not cause inflation over the last decade, but a dramatic expansion of the money supply in 2020/21 did and an equal contraction of the money supply is what will cause the recession that is coming in 2023/4. At the same time normalizing rates will damage the parts of the economy that benefitted from the ultra low rates (part of our thesis on Banks), but areas – and countries – that did not mis manage their interest rate policy will emerge stronger.
Meanwhile as Zero Covid unwinds the initial supply driven spike in inflation is dropping out (look at shipping rates, oil and gas prices etc), although the opening up of China is likely to provide a ‘second wind’ for commodities next year. The structural problems, especially in the west remain however, including seriously impaired government balance sheets. More importantly, the combination of Zero Covid and Zero Carbon has exposed the lack of coherent energy policy, again particularly in the west, which, together with US led sanctions on Russia threatens serious de-industrialisation of Europe. Economic growth has historically always been driven by technology delivering ever cheaper energy, deliberately reversing this has no historic precedent.
Finally and, almost unprecedented except perhaps when the $ came off gold in 1971, the ‘freezing’ of Russia’s foreign exchange reserves by the US has broken the concept of the Petro $, with ‘The Rest’ now breaking from ‘The West’ in terms of trading currencies (enhanced by Central Bank Digital Currencies) as well as an overall financial system. In that sense, it really IS different this time.