January started the year strong in markets as the mean reversion trades we suggested likely in our year ahead piece all seem to have happened, with markets in January producing pretty much the inverse of 2022, in other words a month in which almost everything went up, except for the $, as shown in the following chart, courtesy of Redburn. Last year, the traders beat the asset allocators hands down. So far this year, it’s the other way around, with some extremely painful moves for some of the short term traders and some welcome relief for the 60:40 crowd. For example, Goldman’s Most Short basket is up 30% year to date, while by contrast, if we use the Vanguard 60:4) ETF as a proxy for the 60:40 world, after a shocking 2022, they have had a strong (+5%) start to 2023.
In part this was because the Macro Traders, after a blow-out 2020, returned to the proverbial table and, rather than repeating last year’s ‘everything on red’ strategy, instead spread their chips more widely and in many cases were calculating on a rebound from the over-sold positions that they themselves had created last year. This was then compounded by some rebalancing by medium term asset allocators moving closer to benchmark and what seemed like an end to long term investors selling the rallies. If we then throw in some extremely painful short squeezes – Tesla is up 75% year to date for example, albeit only back to where it was at the end of November – then we can see how much trickier things currently are for the traders. As far as Tesla is concerned, most likely, this is a symptom of the short dated options traders at work once again. Tesla dominated that market in 2021 when it had its remarkable spike to the upside and according to Zero Hedge it is leading the charge into ‘right tail’ hedging as an unprecedented amount of option trading is taking place in early February.
Broadly speaking, if the story for January was one of mean reversion, then February looks to be about Diversification, particularly away from $s and $ assets. Flows into Emerging Markets for example have been huge, as the market wakes up to a combination of higher activity from China and a lower $ and the technical indicators confirm a break through the long term resistance levels. With all of these moves, there will likely be a ‘two steps forward, one step back’ but we think a directional change has taken place. Similarly with US stocks with earnings outside of the US and of course European markets generally as the Euro shrugged off the hyperbolic ‘parity’ claims of last year.
Meanwhile, there is a value element at play too. The fact that the US is trading on around 18x forward PE is not a problem per se, (it’s within its long term median range) but the fact that everyone else is much cheaper is also helping drive the diversification we think; in particular, after almost 7 years of outflows, Europe, on 13x forward earnings, is now generating a lot of inflow. Moreover, some $4.8trn in money market funds on the sidelines which suggests that there is a lot more liquidity available – although crucially cash is now an asset class again, so it isn’t all moving!
In terms of Factors, Momentum has been stable, but Value has been strong, helped in particular by banks and financials as the realisation that ‘normal’ interest rates without a deliberately engineered credit crunch together with strong balance sheets and low valuations make for a very attractive combination. Also, global small cap, or Size, factor has been very strong year to date, with evidence that retail has increased its risk appetite. Overall the picture is of markets starting to focus on risk/return rather than hiding under the bed, of looking at opportunities to exploit the new conditions emerging – what we are calling the new ‘New Normal’ – rather than relying on dubious historical analogues of previous crashes. The challenge for 2023 is how to adopt our thinking to this new, unprecedented, environment
Short Term Uncertainties. – short squeezes and a shift in risk appetite.
The Dollar has been one of the key mean reversion trades and has now seen one of its worst ever 3 month performances, having lost over 11% on a trade weighted basis since the peak at the end of September, while Gold, which has moved inversely, is up over 20% (having given back a little at the beginning of the month.) Both moves look to be catching a breath right now. Interesting, in terms of ‘buy when there is blood on the streets’, Bitcoin is now up 43% year to date, which implies a bit more risk appetite we would suggest, while Natural Gas Futures – the big story of a year ago – have had their worst ever 100 day price move to the downside. At the equity level, while much of the year ahead commentary was about the Fed and whether it would pivot (in our view, a lot of wishful thinking from the bond markets), some of the hedge funds have focussed on the fact that higher rates and higher net interest margins will not be offset by higher bad debt provisions (something we discussed a few months ago (see Money in the Banks – the Top down case for European Banks – this time it really is different). As such, Morgan Stanley note that net exposure of Hedge Funds to Banks has jumped sharply in the last two weeks, suggesting that trade is becoming popular if not yet completely crowded.
The other big turnaround appears to have been a rapid reassessment about the timing and impact of the re-opening of China, something which we noted had hardly featured in any of the year ahead analysis where, as we noted in our own year ahead piece, “Consensus is for slower growth and lower inflation, a pause by Central Banks and a weaker $. Bigger differences appear on China, European Energy crisis and how much bad news is already ‘in the price’.” Within the US, stocks with overseas exposure are at new highs versus domestics, while as western media reported huge numbers of travellers and activity over Chinese New Year, the traders started increasing commodity exposure, notably in the metals – copper up 15% at one point year to date, Oil up 13%, although both have since given some back. As with Banks, Hedge Funds are also buying China equities, while they are selling Treasuries. Chinese Internet stocks, after a very strong q4 are up a further 20% year to date and are thus pretty much up 100% from their lows in October. In our model portfolios, we like this theme, while conviction is otherwise highest in shorter duration/value plays like Energy, Mining and European Banks, followed by longer durations themes like Clean Energy and Healthcare innovation and Gold.
Medium Term Risks – a return to ‘Normal’.
The biggest challenge for asset allocators right now is to assess whether or not we have seen a regime change from the last 14 years of QE driven markets. If, as we believe, we have, then to navigate it we can’t rely on simple historic analogues. Thus, in terms of ‘how much was already in the price?’, our framework remains that bear markets have two phases, the first, a deleveraging driven by a rise in the discount rate – which is triggered by, but then leads, moves in official monetary policy (ie last year) – while the second, a shrinking in earnings, is a function of the tightening of the credit cycle. It remains our contention that while some companies, countries and sectors will certainly see slower earnings, it will be more a function of an end to the distortions of ultra cheap credit being removed, rather than ultra tight credit being imposed. Crucially, this is not a normal interest rate/credit cycle and thus we should we wary of imposing historical analogues upon it. As we like to put it, “when was the last time we kept interest rates below their natural rate for 14 years, then closed down the global economy to disrupt global supply chains while pumping huge amounts of cash direct to consumers, only to rapidly open the economy up again and then suck as much of that liquidity back out?” If we can find what happened the last time we did all that, then we might have a good analogue. Otherwise it really is different this time and we need to think differently. In fact, we believe that, in order to understand the transition from the ‘old New Normal’ to the ‘new New Normal’, we need to go back to some Old Models. Let’s start with the real basics. Supply and Demand.
The New, ‘New Normal’ requires some Old Models
In the most simple terms, the triple policy errors of Zero Interest Rates, Zero Carbon and Zero Covid have acted to produce a series of unintended consequences through their impacts on supply and demand. First, by fixing the price of money at below its natural rate, the Central Banks produced an increase in demand for money, not from consumers, but from financial markets and by extension producers. This had the effect of increasing supply (S2-S on the diagram) such that for a given level of demand prices fell from 2 to 1. Thus keeping rates low to cause inflation in fact caused deflation. This was supported by the real life experience of Japan, which also saw ultra low rates lead to a decrease in demand as well as an increase in supply as savers, targeting a return on their cash, were forced to save more, not less. Not that any central bankers appeared to learn anything from ‘Japan’s lost decade(s)’ of the 1990s and 2000s – a classic case of, “That’s all very well in practices, but does it work in Theory?” Or as George Orwell allegedly put it. “Some ideas are so stupid that only intellectuals believe them.“
On the same framework, the ongoing market interference of Zero Carbon has of course managed to both increase the price and reduce the supply of energy, but the real damage has come from Zero Covid policies. In the first instance, the unprecedent adoption of ‘lockdown’ policies produced a large shift in the supply curve to the left (S-S2 on the diagram), finally delivering the spike in prices that the central banks had been hoping for from the demand side. This was, rightly, described as transitory and, now that supply has been largely restored, this is unwinding. However, at the same time, the, frankly reckless, fiscal spending by politicians was monetised by the central banks with an enormous increase in Money Supply, which in our framework moved demand out to the right. In effect, Zero Covid moved supply to the left and demand to the right. Hardly surprising that we finally (and dramatically) got inflation.
The truth is, to borrow from Milton Friedman, inflation is always and everywhere a monetary phenomenon and the boom/bust inflation cycle we are experiencing is down to that recent dramatic expansion of the Money Supply by the Fed in 2020/21. The behaviour of markets meanwhile is more heavily influenced by the longer QE cycle. Looking at the graph below, we can see that, after the dramatic intervention in March 2020, month on month M2 money supply growth remained elevated in the 15-20% range during 2021, before falling negative during 2022 as the Fed reversed its stance, in effect shifting the demand curve back to the left, just as the supply curve is moving back out to the right, baking in the slowdown in growth and inflation as effectively as the money supply expansion baked in the surge in inflation back in 2020. Note that Japan and Europe showed similar, if less dramatic, profiles in M2 growth, while China actually saw an increase during 2022 and, more importantly is seeing Money Supply growing faster than nominal GDP at the moment – a further reason why China is important for global markets.
US Money Supply growth exploded, pushing demand curve to the right….then collapsed, bringing it back again
The net result of all this is that, by slowing the growth of the Money supply and allowing interest rates to return to ‘normal’, the Fed (followed by almost all other Central Banks) have not only removed the cause of the inflation spike, but have now taken away the distortion caused by 14 years of Zero Interest Rate Policy (ZIRP). Thus, while the unwind of the lockdown restrictions to supply and the Fiscal stimulus to demand has largely dealt with the inflation issue, the bigger issue for asset prices is going to be the end of artificially low interest rates. Note, saying the inflation threat is over is not to say that it returns to the 0-2% level. That was the old ‘New Normal’, more likely is a range of 2-4% for the new ‘New Normal’.
As to markets, the main impact of all this on markets during 2021/22 was via liquidity and valuation/discount rates, first a surge in the everything bubble, then a bursting; the last leg of a bull market followed by the first leg of a bear market. Here the chart shows the money supply expansion and then contraction along with the S&P500. (Similar charts are around showing expansion and contraction in reserve balance at the Fed.)The divergence over the last month is worrying some (although the January number isn’t out yet), but we would caution that as the rate of change approaches single digit, other factors come more into play (global money supply growth and the technicalities of the US Treasury Reserve account being just two of them).
More important and as previously noted, for a second leg of the ‘normal’ bear market, we would need to see lower earnings due to tighter credit conditions and falling demand due to a deliberately engineered ‘shock’. While the Bank of England, and indeed the ECB, may be talking tough on the need for this, we suspect that, like 95% of the rest of the time, they will follow the Fed, who, while not wishing markets to get carried away, are looking more sanguine. This is not to say that there will not be casualties, indeed divergence between winners and losers under this New New Normal will likely be wide – with the biggest losers being those who benefitted the most from the old New Normal. In this sense, Cash flow and earnings momentum – two other ‘old models’ – are re-asserting themselves.
Longer Term Trends
As well as medium term asset allocators starting to diversify, (see chart below from the FT) there is a growing realisation that the investment world in general is needing to get more exposure to ‘The Rest’ rather than just ‘The West’. At its most basic this starts with the $ and as we highlighted in January, probably the most important statement to come out of Davos was nothing from Klaus Schwab and the WEF , who are probably beginning to realise that their ‘vision’ of the Great Reset isn’t quite as popular as they thought. Rather, it was from the Saudi Finance Minister who said that Suadi was prepared to consider accepting payment for oil in currencies other than the $. Although we have been talking about this for quite some time (and certainly since the ‘freezing’ of Russian FX reserves a year ago) this is hugely significant in that it marks the end of the Petro$ system. This is not the same as the end of the $ as a Reserve currency, rather that the netting out of inter-country trade by countries outside of the US will likely no longer be done in US$, which given that currently 80-90% of all trade is done in $ will lead to a radical system change.
In summary, January looks to have reset some of the overbought/oversold conditions left over from the bear market of 2022, with a combination of asset allocation rebalancing, short squeezes and some long term buying of ‘value’. After the year ahead introspection about the fine detail of Fed interest rate movements, markets have broadened their horizons and started to embrace diversification, recognising value in Europe and growth in Emerging Markets as presenting good risk reward opportunities. Much of this has come from a rapid (if slightly belated) reassessment of the impact of the end of Zero Covid policies in China, further prompted by the realisation that the final, liquidity fuelled, leg of the bull market of 2020/21 and its subsequent bear market of last year had left them with portfolios too heavily skewed to the US$. Because we see the combination of the triple policy errors of Zero Interest Rates, Zero Carbon and Zero Covid as unprecedented, we can find little historical parallel for what happens next, as we move away from them, so instead we recommend a return to basic models of supply and demand and discounted cash flow as our guide to navigating this new ‘New Normal’