Penrose Stairs

I talk quite a bit about self-referential market dynamics in these pages.

Some of those discussions likely come across as the stream-of-consciousness musings of someone who’s been doing this (whatever “this” is) too long.

Often, when you become intimately familiar with a subject, every aspect of it starts to look like a reflection of some other aspect, usually because it is. It’s only once you immerse yourself in something for years or, more aptly, decades, with no breaks, that you understand it holistically.

A long time ago (in a galaxy far, far away), I marveled at my boss’s capacity to effortlessly deconstruct a market narrative into its component parts, only to reassemble it, attach a witty punchline and present it as an improved version of all existing takes on the same narrative. All these years later, I’m able to do the same, only with a cadence that’s more distinctive but simultaneously more patient and measured.

Another, more important, difference between us is that he, like many of you, insisted on a “takeaway.” All the dot-connecting was useless if it led nowhere or, worse, led traders and investors around in circles. Unfortunately, that’s what this business is — a Penrose stairs.

I can’t personally remember a time when that’s been more readily apparent than it is in 2022. The “impossible staircase” nature of markets finds perhaps its purest expression in the interplay between policy, the constituent components of bond yields and commodities. But you can spot it in equities too.

Stocks, SocGen’s Andrew Lapthorne wrote, in a Monday note, “are stuck between a rock and a hard place.”

Over the past dozen years, the US equity market morphed into a giant long-duration trade thanks to the feedback loop between monetary accommodation enabled by subdued inflation, low bond yields, buoyant tech shares and a “perpetual motion” machine process (as Howard Marks described it in 2017), wherein passive flows and factor crowding served to perpetuate the swollen market caps of the FAAMG cohort.

When the unwind of pandemic dynamics collided with the war in Ukraine to usher in a new macro regime, the equity market’s sensitivity to bond yields was thrown into stark relief (it’s a turbocharged version of what happened early in 2021, when expectations about fiscal policy under unified Democratic governance triggered what, at the time, seemed like a “big” bond selloff). Now, every twist and turn is a reflection of that sensitivity. And every factor rotation seems somehow destined to run into itself walking in the other direction. Think, for example, about periodic rebalances associated with momentum strategies.

Lapthorne spoke to some of this in the same Monday note cited above. “The Growth/Quality cohort has seen their valuations de-bubble but are by no means cheap and remain overly driven by the fortunes of the bond market, while Value investors seem more concerned about a recession driving investors back toward Growth stocks — courtesy of declining bond yields — than the actual recession itself!” he exclaimed.

Regrettably, I’ve lost the capacity to feign anything like incredulous excitement at these Escher-like “impossible objects.” I could use exclamation points, but it’d convey a false sense of amusement.

Lapthorne went on to speak to the idea that in the context of an epochal macro regime shift, the post-GFC “duration infatuation” may be the wrong lens through which to view growth shares. “The anticipated decline in earnings is then impacting Value stocks and, perhaps bizarrely, Quality/Growth stocks are benefitting from softer bond yields,” Lapthorne said.

Why “bizarrely”? Well, because stocks which benefit the most from lower yields have actually seen the most downgrades over the past month (figure on the right below).

“[The] perceived resilience of Quality/Growth proved correct during the era of QE, with share prices largely ignoring the cyclical slowdowns of the last decade,” Lapthorne wrote, before cautioning that “without QE to support the market” and considering tech shares could be particularly vulnerable to more downgrades given high margins relative to history at a time when rosy margin forecasts are likely to be trimmed, “Quality and Growth investors have more to worry about than the discount rate.”

This recalls a discussion from last month, when I detailed how the unwind in growth stocks severed the intuitive link between strong balance sheets and “quality.”

But if the QE era’s perennial winners are no longer reliable as buffers in cyclical downturns (e.g., if some purported growth stocks turn out to be cyclicals in disguise, or if yields remain elevated and policy hawkish due to stubborn inflation), then were does one turn in a recession? To actual cyclicals? Surely not. Or maybe so. It’s hard to say. Would you recognize yourself on a never-ending staircase?