A New Act for the Economy and Market
Last week’s sharp market actions of raising rates and stock rotations sent a signal that we are in a “new act” for both the economy and market.
If you indulge a former bunhead for a moment, this is what I mean:
Most classical ballets start with a similar structure. The overture plays and the curtain rises to a happy scene. Whether it is a young couple in love dancing at the harvest (Giselle, Coppelia), a royal birthday (Sleeping Beauty, Swan Lake) or a court celebration (Le Corsaire, La Bayadere), Act I is usually a big party with bright lights, joyous music, and sumptuous surroundings.
But then something bad happens near the end of Act I (usually it is some form of betrayal… nothing like a woman, or forest creature, scorned).
This ushers in a much more dramatic Act II. The lighting darkens (often to an ethereal blue), the music grows more affected and strident, the scenery becomes stark and the overall mood turns heavy.
Act II is still beautiful, but it is clearly different from Act I’s frivolity and festivities.
(If you’re wondering where the ballets go from this point, it is about a 50/50 split between death and marriage… the drama)!
There is a similar change in acts happening in the economy and markets today.
Act I: Party Scene
Act I of this cycle, starting from the bottom of the pandemic-related market meltdown, was a party.
From a market perspective, liquidity was incredibly abundant. Money was more than cheap, meaning real yields plunged to deeply negative levels. This provided a substantial valuation boost for long duration stocks, like Growth, and all things speculative: non-profitable tech, “innovation”, Biotech, IPOs, crypto, SPACs and distressed deep value. Performance chasing (read: momentum) amplified the upside in these areas, while narratives emerged to explain the outperformance and elevated valuations (“this technology is going to change everything!” “we are the future!”).
From an economic perspective, substantial policy support for both the economy and market amplified activity. Consumer spending was boosted by an epic cocktail of stimulus checks, low interest rates that buoyed durables demand (like housing and autos), the wealth effect from roaring bull markets and a general eagerness to spend post lockdowns. Strong demand for goods stoked inflation and supported the manufacturing cycle.
But just like in a ballet, the bliss of Act I cannot last forever.
As we wrote about in December and last week, we think the transition from Act I to Act II actually began back in March of 2021 when M2 Money Supply Growth peaked (a rough proxy for the amount of liquidity growth in the economy), which coincided with the peak in relative performance of speculative assets vs. the S&P 500.
This is why we have been calling for a rotation to quality and out of speculation (here, here), and warning about Growth underperformance vs. Value given the prospect of higher real yields in 2022 pressuring valuations (here, here, and here).
Act II: The Land of Lower Liquidity
Last week’s market action and economic news showed us that we are clearly in a new act of this cycle. The two point summary:
- Yields across the curve rose, with 2 year yields higher on expectations of tighter Fed policy (a print of 3.9% on unemployment increased the likelihood of a March hike) and 10 year yields higher on Fed discussion of quantitative tightening (balance sheet run off), positioning, and maybe some growth/pandemic optimism
- Real yields popped higher, putting sharp downward pressure on Growth/speculative/long-duration valuations, while Value rallied relatively
- The chart at the very end of this piece illustrates this relationship
This price action made it clear that this new this market and economic cycle is going to be different.
We expect liquidity to become incrementally less abundant. Money supply growth should continue to slow, the Fed’s balance should stop expanding and may even begin contracting and financial conditions should move off all-time low, easy levels towards tightening.
We expect economic growth to slow materially in this new act. Given tough comparisons from 2021 and less fiscal support, we expect GDP, consumption, manufacturing and EPS growth to all moderate and normalize substantially. This should cause the pace of inflation to begin to moderate as well, driven by the elevated goods demand normalizing and corporate pricing power waning as growth slows.
This tighter liquidity environment should, in general, put downward pressure on equity and risk asset valuation multiples (compared to a backdrop where liquidity growth is expanding at an accelerating pace, which puts upward pressure on valuations, like we saw in 2020).
We expect real yields to rise as inflation moderates and liquidity tightens, weighing on speculative and long duration valuations in particular (don’t forget: there is also a lot of leverage piled on to these kind of assets specifically, so a correction in valuations could be sharp and rapid given leverage unwinds often cause selling to beget more selling).
Two important points:
First, these movements won’t happen in a straight lines. There will be days of giveback after oversold/overbought conditions emerge (as they may be forming now), providing opportunities for rebalancing.
Second, none of these movements in macro and asset prices mean the cycle is over or that positive equity market returns are not possible. However, we do think these movements mean that the cycle is aging into a more mature phase where returns are more difficult to come by (lower forward equity returns with greater dispersion) and volatility is heightened (a feature of a tighter liquidity environment).
Because the underlying economy is still strong (low unemployment, overall strong corporate and consumer balance sheets), this act of the cycle does not mean shifting to full defensive, risk-off. Instead, this act of the cycle favors moving away from speculation and towards quality, while also having a more balanced approach to risk (for example moving to a balanced allocation to Growth vs. Value so as not to be overexposed to the risk of rising real yields).
We think the 2020/2021 days of a dearth of equity corrections is behind us, meaning investors need to be prepared for, and not necessarily spooked by, volatility.
As is important in the early days of a recovery, at this point in the cycle it is important to remember that the equity market is not the economy. The economy can remain resilient, with low unemployment and signs that we remain in an expansion, but the market will be more sensitive to the incremental changes in the liquidity environment.
This is what happened in 2018, where the economy was seemingly robust but markets were weak under the strain of Fed tightening. This is why we talk so much about the yield curve as a sign for when the market believes the Fed is getting too tight, regardless of the current economic data.
As liquidity tightens and the yield curve flattens, the risk rises that the Fed makes a move that rattles markets. The potential key question for 2022 and 2023 will be: how much risk asset volatility will the Fed tolerate before it reverses course to easier policy (like it did in 2018/2019). To say this another way, how low is the Powell Put?
To bring this all together, we expect this act of the cycle to have:
- Less abundant liquidity
- Lower growth and valuations
- Lower returns
- More volatility
- Outperformance of quality over speculationOf course, Act II can last for some time, it largely depends on how quickly the liquidity environment tightens compared to the underlying economy.
Act III: Death or Marriage?
Like in the ballet, where there is a 50/50 split that the show will end in death or marriage, there are two possible paths for Act III.
This next act could be rather far off into the future (6 months, 1 year, 2 years? Again, it depends on how quickly liquidity contracts), but it is worth thinking about the possible paths.
The “death” outcome is where the Fed ignores the signal from the market, and liquidity tightens beyond what the future economy can bear (which is likely at a lower level of interest rates than in prior cycles due to high leverage levels). In this scenario, equity and risk assets correct meaningfully, denting the wealth effect that has boosted consumer confidence and spending in recent years. We note that the economy and consumers are more sensitive to equity valuations than ever due to record high equity allocations and leverage.
The “marriage” outcome is if the Fed quickly backs off of tightening like it did in 2018/2019. That reversal in Fed policy and subsequent collapse in real yields stoked the valuation expansion (even bubble?) in Growth assets (see chart below). If the Fed turns dovish soon, we think we are in for a repeat of bubble-like conditions, where valuations seemingly defy the odds of gravity. Not to stoke undue fear, but this comes with risk to investors because crashes typically follow bubbles.
Keep an eye out next week for our 2022 outlook and until then just remember, “everything is beautiful at the ballet”!
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