Mispriced Duration And The ‘Otherside’ Of Rising Rates

“Facebook and PayPal seem to have reached valuations attractive to GARP investors and even some Value players,” Wells Fargo’s Chris Harvey said late last week.

It was a remarkable assessment. It was also a semblance of accurate, with the caveat that I wouldn’t personally own Meta outside of an index fund.

Recall that the richest, most speculative corners of the market began to “de-froth” in Q1 of last year. The process was intermittent, but unmistakable — a rolling bear market that gradually subsumed any and all manifestations of mispriced duration.

It started with the Cathie Wood complex and mega-cap Chinese tech, eventually torpedoed the cryptoverse and culminated in last month’s 13% plunge for the Nasdaq 100, the worst monthly showing since Lehman. Wood’s flagship fund suffered its worst month ever, falling almost 30% (figure below).

As the subheading on the chart suggests, some critics no longer believe it’s possible to make excuses. Wood is, in the minds of detractors anyway, in denial.

The faithful haven’t abandoned her, so I suppose she has the luxury of doubling (and tripling) down, but the reality is simple enough. Wood’s strategies can be conceptualized as one giant long-duration bet — the quintessential “hyper-growth” play. The shifting macro regime, a hawkish Fed and the rapid rise in real rates, are kryptonite. It’s just that simple. ARKK’s performance reflects as much. It’s down 70% from the highs.

The Ark complex is an extreme example, but it’s not an outlier. As Harvey wrote, some of the largest, most respected names in Growth (as a style) are down just as much.

Amazon joined the rout on Friday with its largest single-session decline since 2006 after the company reported a second consecutive quarter of single-digit top line growth and guided for a third.

Broadly speaking, there were three key assumptions underpinning nosebleed multiples for US growth stocks: 1) the assumption of perpetual top line growth and/or robust growth on key metrics, 2) the likely persistence of a macro environment characterized by subpar economic growth and subdued inflation in advanced economies, and 3) the notion that mega-cap growth, and particularly the tech sector, morphed into utility-like defensives over the past decade.

All of those assumptions are now in serious doubt. Amazon’s Q2 guidance, Facebook’s Q4 debacle and Netflix’s projection for two million lost subscribers undercut the perpetual growth narrative. The macro environment has shifted, and so has monetary policy. And, as Harvey went on to say,

Like most PMs, underperforming Growth PMs tend to become more risk averse, but with few defensive havens within their growth universe, such a shift in risk appetite can significantly impact the broader market by paralyzing PMs. Keep in mind that the fund group’s long-standing underweights — Staples, Utilities, and REITs — have outperformed YTD, discrediting the pandemic-born belief that uber-caps are the new defensives and placing more stress upon these PMs. During the Growth Bear market, Growth PMs have become increasingly aware of the extent of their duration exposure. Previous tailwinds from lower rates ceased, and new headwinds from rising rates made financial footing difficult for their most-favored stocks.

So much for the third assumption enumerated above. Mega-cap tech isn’t a defensive category. Depending on how things evolve over the next several months, some names may end up looking more like cyclicals, a terrifying (and familiar) prospect for anyone old enough to remember the dot-com bust.

Although crypto suffered an egregious peak-to-trough drawdown, I worry now that the persistence of rate hikes from developed market central banks, and particularly the prospect of rising real rates, might undercut the space anew. As Harvey noted, veteran PMs underappreciated the extent to which their portfolios had become giant long-duration bets. While acknowledging that the Web3 crowd may be more savvy in many respects than a bunch of stodgy fiftysomethings, there’s no chance crypto investors and NFT holders conceptualize of their holdings as the end-all, be-all of long-duration assets.

Over the weekend, Yuga Labs, creator of the Bored Ape Yacht Club NFT series, made a third power move in as many months, raising more than $300 million in a sale of “deeds” to virtual land parcels located in a metaverse project (Otherside) that has no official launch date. Recall that the company acquired the copyright and IP to the CryptoPunks and Meebits NFT collections in March, before launching its own currency (ApeCoin) shortly thereafter. Holders of ApeCoin paid nearly $6,000 for the Otherside deeds, or $12,000 including the gas fee (demand for the make-believe “land” was so strong that it drove Ethereum network fees through the roof).

Leaving aside the myriad questions raised by Yuga’s decision to hand out free deeds to Bored Ape NFT holders, who also received millions in free ApeCoin at launch (along with Andreessen Horowitz), I’m inclined to ask whether it’s occurred to anyone participating in this frenzy that conceptually speaking, there isn’t an asset on the planet more vulnerable to rising rates in developed economies than a blockchain-based claim on a virtual land plot in a video game that has no release date.

I’m sure there will eventually be monetization opportunities beyond the mere flipping of these plots (which, as far as I’m aware, is all you can do between now and whenever Yuga’s Otherside project goes live), but remember that real rates are the opportunity cost of doing something with your money other than investing in risk-free bonds. When those rates are negative, you’re being punished for not taking risk. The more negative they are, the more punitive that cost and the more risk investors tend to take. That’s why negative real rates in the US bolstered equities in the aftermath of the pandemic.

Now, those rates are turning positive, and while the majority of NFT buyers probably have no conception of what that means, institutional investors and other “big money” that recently strayed into crypto do, and their de-risking process will weigh on Bitcoin and Ether, as will any additional pressure on stocks. At the very least, that’ll devalue wildly speculative assets like make-believe land parcels in an unreleased metaverse game — after all, they’re denominated in cryptocurrency, which will depreciate as rising real rates bolster the dollar.

“The great central bank pivot is now well underway, and will only accelerate from here,” TD’s James Rossiter and Gennadiy Goldberg wrote, in a recent note. Have a look at the figure on the left (below). Hikes outnumber cuts by a huge margin.

The figure on the right (above) shows expectations for policy rates across developed markets out to 2024. “While there are leaders and laggards, one thing is clear: All major G10 central banks’ policy rates, outside of possibly the BoJ, will end the year at a much higher level than where they started.”

Not only that, G10 rates will probably keep rising next year unless a recession forces central banks to take a pause. Of course, a recession isn’t likely to bode well for speculative assets either, because who wants a piece of prime real estate on the Otherside when you’ve lost your job and need to pay the mortgage on this side of reality?

Dark humor aside, it’s likely that, given the overnight wealth created by Yuga’s meteoric rise, some holders of Bored Ape NFTs and sundry spinoff projects (including the deeds distributed over the weekend), have borrowed against those digital assets, if not at real banks, then on DeFi protocols. I won’t pretend to know the specifics, but what I do know is margin call dynamics, and I’d be willing to bet they work the same way in DeFi as they do in traditional finance.

Coming full circle, Wells Fargo’s Harvey suggested the bottom for some high-profile US growth stocks may come “sometime between now and early summer as the sell-side begins to throw in the towel.”

That may be true, and although they don’t know it, NFT investors certainly need it to be true. Because a turnaround in big-cap US tech would help immensely when it comes to putting a floor under crypto.

The ultimate irony in all of this is that the Fed has itself to blame. “We feel the Fed already made a policy error last summer with their bond purchases,” Harvey wrote. “10-year real rates were -100bps, depressing the cost of capital [which] catalyzed a massive mispricing in duration assets,” he said. “But that’s history now.”