Friday 6th May, 2022
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There has been considerable turbulence in both bond and equity markets this week as investors grapple with how best to position their portfolios given the potent cocktail of near-term risks to the outlook. These include rising interest rates, slowing global growth, deteriorating market liquidity, (explosive) geopolitical tensions in Europe, and the spread of a stringent lockdown in China. Moreover, cross-asset correlations have risen sharply this year due to the ever-more hawkish pronouncements of our (noticeably flustered) central bankers; and, as a result, there are few places left for investors to hide out as the outlook darkens (beyond dollars, hedge funds, and commodities). This is a tough environment in which to invest – and an even tougher one in which to be a central bank official. But crisis breeds opportunity.
At the Federal Open Market Committee (‘FOMC’) meeting on Wednesday, US policymakers decided to hike the ‘Fed Funds’ rate by 50bps, as expected, and to begin Quantitative Tightening (‘QT’) – i.e., the process of reducing the central bank’s huge balance sheet by selling government bonds and mortgage-backed securities (‘MBS’) – as soon as June 1st. This was the first time that the Fed has hiked US policy rates at consecutive meetings since 2006; and it will surely not be the last consecutive hike in the current round. Indeed, markets attach a 70% probability to a further 50bps hike next month – and the implied Fed Funds Rate by year end is over 2.8%. This is a much less accommodative stance than anyone in late 2021 believed that the Fed would or should adopt to fight inflation this year. But market expectations have changed drastically since the start of 2022; and, particularly since the war in Ukraine began in late February. A decidedly hawkish market consensus explains why, initially at least, the most rate-sensitive risk assets rallied so strongly in response to the Fed’s decision to go ahead with the well-telegraphed hike on Wednesday. The S&P 500 Index was up +3.0%, for example. Nevertheless, the excitement did not last and there was an almighty drawdown the next day when the S&P 500 sank -3.6% and the tech-heavy NASDAQ Index cratered -5.0%!
The depth of the correction on Thursday was reminiscent of the early days of the pandemic in 2020 when the character of the downturn to come was unknown and there were serious doubts about whether central banks could keep markets functioning through the intermittent lockdowns deemed necessary to avoid catastrophic loss of life until a vaccine was found. This time is different, of course. But investors are waking up to the notion that they cannot rely on the Fed to backstop high multiples should stocks fall too far and/or too fast (i.e., the so-called ‘Fed Put’). In recent history, we all got used to central banks intervening heavily and frequently in equity and bond markets to maintain buoyant liquidity, bolster risk sentiment, and reduce the cost of capital for households and firms in what was anyway a deflationary world. This was an environment in which even the most clueless investors could get rich; and many did. Companies with huge PR operations but little hope of earning profits anytime soon survived (even flourished) largely on hot air and dilutive equity issuance thanks to the glut of unsophisticated investors who bought into the viability of their growth-at-any-cost business model. In many ways, what we saw was just a giant FOMO driven Ponzi scheme that supported lofty valuations for mediocre or at best unproven companies. But now, as sentiment deteriorates, policy is tightened, and discount rates rise, the perceived value of such companies’ (highly uncertain and far-distant) future profits has shrunk greatly. This spells disaster for their financing model; and many profitless growth stocks have fallen precipitously this year as a result. Indeed, so dependent on easy financing conditions are many of these companies that their shares have become little more than a leveraged duration play.
The above is not to say that ‘growth’ investing (i.e., buying innovative and fast-growing companies with huge potential that is poorly understood by the market) is fraudulent by any stretch. Skilled managers able to identify future market leaders at an early stage in their lifecycle should benefit hugely from this approach to stock picking. And some stocks are now reaching ludicrously oversold levels given the indiscriminate nature of the sell-off of anything ‘growth’. The turning point could come soon if the global slowdown (in part driven by the dramatic drop in China’s economic output due to the lockdown there) halts the rise in rates rather sooner than markets expect. However, we feel that many growth investors got lazy in the good times and this year has been a harsh reminder that valuation matters.
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