When assessing what a prospective down-trade for US equities into year-end might look like, 2018 might be a useful analogue. (Sans autocrat.)
There are quite a few similarities. Stocks are near records and real yields are rising, for example. And the Fed could be one hawkish communications misstep away from pushing the envelope too far.
Back then, 10-year real yields were “all the way up” at 1% (figure below). That the threshold for destabilizing risk assets is now far lower (indeed, it’s probably somewhere in negative territory) speaks to the Fed’s accumulated addiction liability.
There were, of course, other things going on in 2018. In September of that year, Donald Trump effectively went all-in on the trade war with China. The Fed was hiking rates and emerging markets were trembling.
But there’s no shortage of macro headwinds in 2021 either. And it’s worth noting that the trade war never really ended. It just got lost in the pandemic. Both Xi and Joe Biden are noncommittal on how to recalibrate bilateral relations.
In a note dated Tuesday, BofA wrote that in Q4 2018, “Powell disregarded market signals of a weakening economy and pushed on with rate hikes.” That policy bent engendered an increasingly furious backlash from Trump, not to mention warnings from the likes of Stan Druckenmiller and Kevin Warsh that the Fed’s double-barreled tightening had gone too far.
Ultimately, the combination of Trumpian balderdash, a government shutdown and Powell’s recalcitrance brought about the worst December for US stocks since the Great Depression (figure below).
BofA sees a parallel. Again, sans autocrat.
“Today, fading momentum combines with retreating Fed support and economic fundamentals falling from their peak,” the bank said, adding that “the tapering announcement clearly signals a hawkish turn [and] this may lower confidence in the perceived low-risk, high-return profile of US equities and reduce the appetite to chase momentum at any price.”
If investors stop “chasing momentum at any price,” the Pavlovian response function responsible for the post-GFC buy-the-dip mentality could short-circuit, as detailed here.
You might have seen allusions to normalization in the vol complex over the past several days despite ongoing gyrations in spot. I talked at length about that in “Clean Up On Aisle Vol” and Bloomberg mentioned the same dynamic in a Tuesday article.
“Options traders appeared to be reluctant to pay up for downside protection, a sign that the worst of the rout may be over,” Lu Wang remarked, in the linked piece, which noted that even as big-cap US tech made new lows, the Nasdaq VIX “produced a lower high [a] bullish divergence.”
BofA’s equity derivatives team took a slightly different angle. “Despite all the negative price action, the front-month VIX future fell on the day the [long streak without a 5% pullback] was broken,” Nitin Saksena and Benjamin Bowler wrote, before suggesting that the reversal of trend (i.e., vol unable to outperform even when spot drops significantly) “raises the question of whether the risk ahead may be a prolonged grind lower, à la Q4 2018, rather than a sharp collapse like February 2018 or the COVID shock.”
The figures (above, from BofA) along with their lengthy subheadings and annotations help you understand the argument.
All of this comes as the Fed is under intense scrutiny for questionable trading activities and as Elizabeth Warren campaigns for Jerome Powell’s ouster.
On Tuesday, I suggested policymakers (of the monetary sort) may be reluctant to intervene (even verbally) should equities swoon, given heightened public awareness of the Fed’s role in moving markets and some officials’ ill-advised (albeit legal) decision to trade while doing so.
BofA’s Saksena and Bowler recalled Powell’s famous policy U-turn from January 2019. “Only after over two months of moderate weakness did the market accelerate lower and trigger a dovish policy U-turn,” they remarked. The figure (below) is always worth keeping for posterity.
Another difference this time is that the Fed is taking the first baby steps down the road to normalizing policy as opposed to forging boldly ahead with what, if you measure from the lows in the shadow rate anyway, was one of the most acute tightening cycles ever.
That said, I’d reiterate that the longer policy remains ultra-accommodative, the larger the addiction liability.
As Deutsche Bank’s Aleksandar Kocic put it way back in 2017, “the accommodation has been in place for a very long time, during which traditional transmission mechanisms have atrophied and investors’ mindset has changed in a way that has altered irreversibly their behavior, the market functioning and its dynamics.”
A repeat of 2018’s late-year swoon would almost surely force the Fed to rethink the pace of the taper, essentially before it gets started. BofA alluded to the same. “Powell may be quicker to turn policy around in a similar set-up today,” the bank remarked.
Hopefully, officials would be smart enough not to “rebalance” their portfolios the day before Powell executed another dovish pivot.
2018 redux seems like a worst-case scenario to me. Fed is way too accommodative and, for the good of the overall economy (velocity of money, business formation, retirees) rather than Wall St., needs to do something about its balance sheet. But I mean, it hasn’t even announced a taper and when and if it does, it’s likely to be a modest $10B/month in MBS, starting, maybe in 1Q22. Not exactly the end of the world. I mean, if the market gives up 20% (or more) in response, well, then…I dunno, maybe we should mint a couple of those trillion-dollar coins and stop pretending we live in a capitalist system.
I would think a recession would be the natural response to a pandemic. To NOT have capital losses in a pandemic (or other natural disaster) would be an aberration. That’s the reason that capital is rewarded — because it takes the risk in the first place.
Apparently, however, for the Fed, capital losses were unacceptable and printing money was the answer.
Seems to me that we have been well outside the capitalistic playbook for quite some time.
The Fed would be smart to announce a dovish taper in December after seeing 2 more at least decent employment reports. Then pledge to reduce buying a small amount each month. Like 5-10 billion per month, with the caveat that they could taper faster if things improved or stop tapering if they got worse. That would get the taper off their back. If they can make the taper really boring and market friendly, that would really help, and would get the issue behind them. The market would be unlikely to have a tantrum- but at least the Fed could say they began the process.
And it would give them some flexibility
Good point. Not a bad idea, imo, to keep the options desks and the Robinhood crowd guessing, at least a little bit.
It is only October 6. Delta is ticking lower, but it seems prudent, as Powell has stated on multiple occasions, not to be too early with tightening- which means we need to make sure we don’t have another variant surface this fall or winter, the vaccination rate increases and people actually get their booster shots (I have my doubts). This will take time.
Who knows where this inflation scale settles- somewhere between rampant inflation and returning to the pre-covid curve is the range of reasonable possibilities.
Not all facts are leaning “inflationary”. By some estimates, 20% of the workforce will remain remote and that 20% gap (to 2019) in people passing thru TSA checkpoints, will not be quickly, if ever, refilled by business boondoggles. This is all good news for corporate profits. Also, let’s not forget the $2.4T in excess savings (over pre-covid trend), sitting on the sidelines- not chasing used cars/TVs, cruises or stuff. Will this stay in savings? Finally, when covid is truly in the rear view mirror, I am guessing that some of the 3M who left the workforce during covid, especially women and the 55+ crowd, will reenter (downward pressure on wages). As far as oil/gas prices, Biden will blink- is my base case because I think the desire to get Democrats re-elected will overrule a Green agenda.
I will wait (in equities) until I have a clearer picture of the future. In the meantime, I just purchased some unbelievably cheap airline tickets for my kids for our “year end gathering”.
Marko Kalanovic has the right idea. Dump high multiple tech and buy everything else.
It is high time for TSLA stock to come in. High oil prices are good for Tesla, but not good enough to overcome a 412 PE ratio. TSLA has barely budged these last three weeks, and sits at a 6-month high.
Earnings aren’t the issue. Look at AMZN history. The thing to question is – will Sales grow fast enough to get their P/S to a reasonable number within a reasonable timeframe, while their margins improve…
And it’s a truly difficult question as adoption of electric vehicle in the next 10 years would be a arduous enough question if you didn’t have to contend with things like battery technology and its applications plus self driving AI and therefore the ultimate potential of fleets of leased automated Tesla taxis… At which point, good luck determining the ‘right’ TAM…
Basically, TSLA right now is either wildly overpriced or severely cheap – depending on which future plays out. And fine, it’s like that for everything except I’d argue trying to guess at the ‘correct’ probability weighting of these outcomes is particularly difficult.
H-Man the 800 pound gorilla in the room is inflation. This will drive the bus more than any other factor. Subdued or transitory, good for equities. Out of the bottle, look out and run from equities.
H-Man, by the way thanks for the editoral help on the Warren post. I went over the top and glad you caught it. Anger never generates anything of value.