What happens to the US equity market if macro volatility rises as a result of untethered inflation that forces monetary policy to be less predictable?
That seemingly straightforward question admits of more nuance than you may think.
The obvious answer is that if inflation remains elevated, causing expectations to become unmoored, the Fed will have to be proactive. A proactive Fed that hikes preemptively to manage inflation is not a “friendly” Fed, or at least not vis-à-vis markets. An unfriendly Fed means tighter financial conditions with knock-on effects for credit and equities.
But there’s more to it than that. Time and again over the past 12 months, I’ve mused about the ramifications for multi-asset portfolios in an environment of rising inflation. Returns seem destined to be lower, at best. If inflation persists and yields rise, bonds will suffer. After a four-decade bull market, bonds are surely a bubble, and various distortions brought about by trillions in central bank intervention raise the odds of disorderly price action — “tantrums,” as it were. The read-through: Not only could bonds be a source of risk, they may also increase portfolio volatility.
Even if yields don’t rise (either because inflation calms down or policymakers refuse to countenance a disorderly selloff), bonds’ capacity to cushion equity market drawdowns is limited by how far yields have fallen over the years.
Because most assets are priced off risk-free rates (i.e., benchmark US yields), the bond bubble is “embedded” in credit and equities. Credit and equities are vulnerable to tighter Fed policy aimed at curtailing inflation.
And so on, and so forth. I often describe self-referential dynamics as “moving Venn diagrams.” This is a good example of just such a dynamic.
Where the nuance comes in for US markets is the massive representation of bond proxies and secular growth shares, not to mention investors’ infatuation with hyper-growth “high-fliers,” some of which are unprofitable. When it comes to tech and growth in the US context, valuations are high pretty much across the board. In effect, US equities are a leveraged duration bet.
Underscoring the above in a recent note, SocGen’s Sandrine Ungari and Andrew Lapthorne wrote that “the future sensitivity of equity markets to a rise in bond yields is a function of how much they have benefitted from declining bond yields.” The S&P and the Nasdaq are more vulnerable than the Nikkei, for example.
If you slice the market into quintiles based on correlation with 10-year yields, you can see the “polarizing” (as SocGen put it) effect of the “slow-flation” macro environment and accompanying monetary policy accommodation (figure below).
The aggravating factor is the self-feeding loop between valuations and market cap.
“The problem comes when we measure the relative size and valuation of each of these quintiles, with the bond proxy market cap not only 1.6X that of the cyclical group, but also trading on 26X instead of 13X,” Ungari and Lapthorne went on to write.
The figure (below) drives home the point. The US equity market is highly (and disproportionately) exposed to a disorderly bond selloff.
Again, one key issue is the benchmark weight of growth shares, and particularly high-growth tech. A shift in the macro backdrop that sees developed markets transition from slow growth and subdued inflation to high nominal growth and persistently elevated CPI prints, would likely undermine market leadership, especially considering elevated valuations.
The problem isn’t just that cyclical value (in all its various manifestations) likely isn’t prepared to step into mega-tech’s enormous shoes. The situation is complicated by the likelihood of policy tightening to control inflation in an otherwise friendly macro environment for cyclicals.
Things are even more complicated for small-caps, something Bloomberg’s Heather Burke discussed in a short blog post over the weekend. “Tech stocks are sensitive to higher rates and have declined amid the Fed’s more hawkish stance, but the Omicron strain and resulting travel restrictions have brought COVID volatility back to markets and play into tech’s defensive status, leaving investors more willing to tolerate frothy valuations,” she wrote, adding that “small-caps face not only the headwind of a more hawkish Fed but of higher inflation and any resulting economic slowdown.”
The distinct possibility that the inflationary impact of additional COVID waves (i.e., prolonged supply chain disruptions and persistent labor shortages resulting in upward pressure on wages) could outweigh the deflationary drag from subdued demand (i.e., if consumers simply shift to buying goods as opposed to closing their wallets altogether), raises the specter of a Fed that’ll be in inflation-fighting mode for the foreseeable future, a rather stark reversal from the laser-focus on maximum employment that characterized official banter as recently as early October.
Ultimately, it may come down to which assets can perform in an environment of suppressed risk appetite and tighter policy. And that, SocGen’s Ungari and Lapthorne warned, is “an important blind spot of traditional portfolios.” In short: There are no such assets.
The bottom-left quadrant in the figure (above) corresponds to a market “bust” and tighter monetary policy. As you can see, it (the quadrant) is empty.
As Ungari wrote, “traditional assets lose in this scenario and that poses a significant risk to the traditional 60/40 portfolio.”
Indeed, it poses a “significant risk” to all portfolios. As we saw (again) last weekend, crypto doesn’t live up to the “uncorrelated hedge” promise that some proponents make on its behalf.
Your story is the reason many advisors are looking at the cash or near cash asset as a substitute for bonds and possibly even stocks. The FOMC may be in a position of tightening into a slowdown. If that is the case, then US Treasury bonds will look like bargains not bubbles!!!
Maybe we get back to some kind of normality. Equities retreat, bonds retreat, interest rates gradually increase, inflation slowly goes back to a an acceptable value and the USD dominates again!. Works for me.
Cash is a reasonable substitute for UST and IG bonds in the current environment. Give up a whopping 50-220 bp of yield. Assuming one is looking for a temporary substitute (for months not years), I think the 4-18 bp/month is pretty cheap for portfolio derisking.
Most institutional and wealth portfolios are required by rule or custom to stay “fully invested”, so carrying elevated cash levels is often maligned as “market-timing” or some similar character flaw.
In reality, the fact is that, as H shows, there are market environments in which nothing much works, so why burn up performance hunting for the best house in a bad neighborhood?
Before we even get to what the Fed’s actions might be re: reversal of QE, raising rates, the Fed’s balance sheet, inflation etc. – it seems that first and foremost, the Fed must fulfill its unwritten and unspoken primary purpose to assist in anyway possible supporting the USD as the global reserve currency, refinancing existing US government debt and helping to finance current US spending in excess of taxes collected. Once that primary purpose has been satisfied, then and only then can the Fed attempt to take other actions.
Up to now- everything is just talk. Reversing the trend over the (almost) past 4 decades is not a flip of the switch.
We’ll, hate be that guy, but… you can make money in the lower left quadrant with a portfolio of cash used as collateral to sell uncovered put and call options. Time value erosion becomes your best friend. If you can read pivots and head fakes (up or down) to any reasonable degree you can do pretty well. Most institutional funds require staying invested. They pay up to hedge.
Sorry emptynester. Didn’t mean to post that as a reply to your comment. It was intended as a general response to the article.
I guess I disagree with the view that a combination of low risk appetite and tighter policy is bad for treasuries, especially the ultra long end (20y+), as such a quadrant is arguably what we’re seeing right now and long bonds have been outperforming.
If tighter policy entails tighter financial conditions more broadly, then we should expect a flattening of the back end and if the tightening goes far enough, an inversion. What that means for the absolute levels of long bond yields is hard to say, but it could be higher or lower (depending on the speed of the tightening with respect to the market’s estimate of the “terminal rate”). Credit, TIPS and short/intermediate term treasuries will be more likely to suffer in such an environment than long term nominals in my view.
I guess a lot of this comes down to whether or not you believe that current fed policy alone can materially raise the pricing of the terminal rate, given secular disinflationary forces still remain.
I’ve long been in the secular disinflation camp. But whether Biden is reelected (or another Dem is elected in 2024) or the GOP manages to pull off a soft coup and installs its candidate in the WH, I think the U.S. and China are headed for a major economic cold war, which (if it develops) will be a major inflationary development going forward.
It’s not surprising to see people grabbing volatility in an environment where nothing is safe.
H-Man, makes for a rather interesting trading market for the next couple of months. Everyone seems to be confused about the winners and losers. I guess that is why God invented vol.
I have ridden the “bond bubble” for the full 40 years, using the carry trade for the first 20. I earned 50-60% in some years. I’m reaching my sell-by date so prices don’t really matter any more; only income does so rising rates just mean I can reinvest my coupon earnings for better income. I’ll get par for everything at maturity. My FI portfolio now earns 4%+, with a quarter of the income being tax exempt. I have bond funds, CEFs, CLOs, MBSs, TIPS, individual USTs (@7%), munis, preferred stocks and all the individual bonds are currently in the green, selling above my basis. The TIP fund is yielding 5%. What’s not to like?
That is absolutely fantastic- but what is your investment advice to your daughter?
Generally speaking our current situation has a “walls closing in” feel to it … precious metals could be a good cashing parking spot, as well as the Yen … imho …