Cathie Wood Keeps The Faith

Inflation is about to peak. Then, it’ll fall rapidly.

Said nobody, anywhere.

That macro narrative is passé. And it won’t be retro chic for years. “Transitory” is to macro what Gucci was to Kering’s Q1 results: A blight. “Entrenched” is en vogue now. “Broadening out” is Yves Saint Laurent (which posted a 43% YoY revenue gain for Kering versus Gucci’s comparatively lackluster 13.4%).

But Cathie Wood, whose flagship fund is on the brink of erasing the entirety of its pandemic gains (figure below), isn’t convinced. I said nobody, anywhere expects inflation to abate rapidly. But that isn’t true. Wood, speaking via video link to a “festival” in Singapore, said inflation will top out, then fall in “dramatic” fashion. That, she went on to say, could mean the Fed won’t hike as much as markets currently expect.

To be sure, market expectations for rate hikes look stretched. On Thursday and Friday, the situation in rates escalated dramatically. Traders explored uncharted territory and new downside expressions in sparsely populated strikes, raising the specter of fresh volatility tied to dealer hedging. The SOFR transition could exacerbate the situation to the extent it saps liquidity from eurodollar futures.

In short, the market is vulnerable to overshoots and false optics vis-à-vis what’s “expected” from the Fed. For Wood, a rapid decline in inflation could engender “a surprise” outcome, which she described as one in which rates don’t “go up as much as the market has priced in.”

Earlier this month, Wood suggested the Fed is “playing with fire.” She’s not what I’d call an impartial observer. Her strategies can be conceptualized as one giant long-duration bet — the quintessential “hyper-growth” play. Or, if you like, “playing with fire” during a burgeoning macro regime shift from a “slow-flation” environment conducive to low rates and infinity multiples for growth stocks to a backdrop defined by persistently elevated inflation and periods of red-hot nominal GDP growth.

Of course, there’s no guarantee the burgeoning regime shift will prove durable, and that’s precisely the point. Wood needs it to be… well, transitory. Because rising rates are kryptonite to a long-duration portfolio of concentrated bets on richly-valued growth shares.

One additional headache for Wood is growth stocks’ track record when the economy slows too much. “The recent underperformance of Growth versus Value has surprised many investors because slowing GDP growth is usually a tailwind for Growth stocks,” Goldman’s David Kostin said, in his latest, on the way to noting that growth shares need a tepid economy, not a recession.

“In our model, Growth stocks fare best when GDP growth is close to trend (currently 1.75%) but struggle when GDP growth is much stronger or weaker than that rate,” Kostin remarked, adding that “investors reduce length in recessions, including selling Growth stocks that often rank as popular top holdings.”

That’s a crucial point. When things take a real turn for the worse (or worst, with a “t”) you cut risk and tap winners as a source of funds/liquidity. Moreover, an economic slowdown predicated on a deliberate, policy-induced tightening of financial conditions can be a headwind, as the drag on long-duration portfolios from higher rates offsets the tailwind from slower GDP growth. That’s why Wood needs inflation to abate and the Fed to surprise on the dovish side.

Finally, due to the weight of US mega-cap tech at the index level, growth shares are now almost synonymous with benchmarks. That’s a problem. Have a look at the figure (below).

“The relative performance of Growth versus Value has recently been extremely correlated with the overall market, increasing the sensitivity of the trade to financial conditions,” Kostin went on to say.

In fact, Goldman wrote, “the correlation of Growth versus Value with the S&P 500 during the last three months has been the strongest in over 20 years outside of the 2001 Tech Bubble unwind.”

Wood does have one thing on her side, though. The Ark faithful are famous for their almost religious zeal. A Saturday headline from The Wall Street Journal read: “Cathie Wood’s Flagship Fund Is Down 45% This Year. Money Is Still Flowing In.”