By Goldman trader and managing director, Bobby Molavi
The start of last week saw a risk on beta chase across all equities, as the positioning underweight and pervasive bearishness triggered the latest of a long series of 2022 relief bounces. Last week alone a reflection of the challenges of carrying risk efficiently in 2022. Liquidity appeared and disappeared, we had two 3% plus moves at the headline index level and for all the intra week ‘drama’ we pretty much found ourselves at close of play on Friday near where we started on Monday. A painful “nothing done” as one client put it. This week we have CPI, start of Q3 earnings, both of which will be key in terms of setting the tone for the next few weeks. For the second quarter in a row, more than 10% of the S&P500 market cap has preannounced earnings. The last time this occurred was early 2020. The general narrative from my conversations are multiples are still too high, earnings have further to fall and equity ownership remains high.
Good news is now firmly bad news… Fridays NFP a reflection that any positive indicator is being read as a signal that the FED has more to do in terms of hikes and slowing down demand side of the equation. That being said, we have mixed signals. Employment may be strong, mortgage repayments high and rising and energy prices may remain elevated but elsewhere we are seeing multiple signs of deflation – job openings slowing (JOLTS data), second hand car prices (Manheim used car data), US/China freight rates (-76% from peak), inventory levels at retailers etc. Elsewhere we saw an OPEC cut, adding fuel to the inflationary fire and cost of living pressures the world is facing. Almost impossible to play the game in an environment where the worlds fulcrum risk free rate is moving more and faster than at any point in recent history.
A market of extremely large tails… If we just focus on the facts. We see:
a stock market down ~25% ytd,
a bond market experiencing one of it’s worst performance years in history,
a housing market that is seeing consistent price falls for first time in a decade,
a consumer dealings with cost of living crisis,
a global economy experiencing 2 consecutive quarters of negative GDP
a slew of central banks that ‘no longer have your back.’
There is also a worrying reality that an escalation in terms of methods of warfare in Ukraine is now more possibly more likely than the market estimated 3 months ago. Scott Rubner recent piece with some sobering stats on 2022 and how things have panned out. Since 1900, 122 years of data, through Q3, the US 60/40 “worlds and voting retirement” Portfolio is down -21%, for the 2nd worst year on record. From an equity view the S&P 500 is down -24%, for the 4th worst year on record (only were worse 1931 – great depression / 1974 – inflation / 2002 – internet bubble). If we look at Bonds….through Q3, 10 year USTs are down -17% for the worst year on record, 1987 was second worse, and bonds were down -10%. To say that 2022 will go down in historical context would be an understatement. As we approach Q3 Scott argues that retail has started to capitulate….they rotated $89bn into money markets last week and at the same time we saw material retail outflows in consensus mega caps like Apple and Tesla. But…… it’s not all doom and gloom. We’re seeing the highest proportion of insider buying in Stoxx600 for 10 years, cash levels for mutual funds are extremely high, positioning in Europe is extremely low, PE dry powder is at all time highs and employment remains (thus far) sticky and high. US equity futures position % open interest remains at lowest since GFC, vol control funds equity allocation at 5th 10y%ile. Worth noting that CTAs have recently sat on sidelines and are now flipping to buy, which could contribute to a large right tail asymmetry. Our models project CTAs to buy c. $190bn on 2std up tape over the next month. It may not be likely, but there is also the extreme right tail of a positive resolution to Ukraine. A trigger for an immediate relief in terms of inflationary pressures, geo-political risk premia normalization and a likely multi standard deviation rally for equity markets globally.
The speed of the move is as important as the move itself… There are definitely signals that the withdrawal of liquidity and the shift to a new neutral is having impacts in unexpected segments of the market. The ‘lower for longer’ era of the last decade is clearly over but at the same time the question of at what cost remains. The reality there is leverage and liability in more places than we care to admit. In the housing market sitting with the consumer as they grapple with higher repayments. In the energy market as companies seek to manage their contracts vs cost base and the materially higher volatility of the underlying commodities. Twenty years ago, non-banks held $51 trillion of financial assets, compared with banks’ $58 trillion; on the latest data, non-banks have grown to $227 trillion in scale, outstripping banks at $180 trillion. Among them are asset management firms, pension funds and insurance companies. Unlike 2008/09 leverage exists in different parts of the financial ecosystem. At the end of the day Liquidity in times like these is key. This has been a theme for a while but I think it is now moving to front and center. I’ve noticed stats all year…low top of order book liquidity in the US, bid offer spreads at wides in Europe, SX5E and Stoxx 600 daily volumes vs last year or last 5 years. All signals are pointing to a withdrawal of liquidity from the system and this needs to be monitored. I always ask myself who is the marginal buyer at the moment in size vs the short gamma style trading of CTA (bigger sellers lower, bigger buyers higher). The great hope has been private equity and potential strategic M&A…it has been around but not enough to offset.
Speaking of M&A… There remains no bid for value with US value trading at 11th %’ile vs history and Europe at the 4th %’ile vs history. It is true that some companies are cheap for a reason…but at some point you’d have to assume that the spread between spot and unrecognised potential value unlock in some of these names triggers activity. We find ourselves in a market with $3.4tr of dry-powder globally across growth, infra, buyout, real estate and buyout. When looking at previous uncertain moments the dry powder stats were ~$800bn in 2016, ~$700bn in 2008, and ~$300bn in 2001.
The evolution of product segmentation… Years ago…I remember a sales person arguing that Bskyb was not a discretionary product…that it was in fact a staple. Once a consumer was hooked into that entertainment infrastructure there were many many things they would cut first before cutting this. I reflected on that again last week as I read about Pelotons latest round of job cuts and restructuring. I find it interesting (worrying) that we are on the verge (or already in the midst) of regime change and cycle shift. What was normal in 20/21 will cease to be so in 23/24 is my view. The marginal discretionary $ will move to different places and consumers behavior will change and as a result all recent modelling from a time of abundant leverage and a focus on ‘experiences’ may change. I read that in the second hand car data last week there was a clear signal that cars (especially luxury) were becoming an increasingly discretionary item, in the client (and friend) conversations around holidays and travel a shift towards less is more and closer to home as a preference. It will be interesting to see what consumers look to now for sources of entertainment – will terrestrial tv or vanilla sky suffice over 5 additional streaming channels…. will going out and having a few pints in the local replace the £23 smoked bay leaf martini at the trendy cocktail joint… are staycations the new vacation…. and will all things energy consumptive (especially where prices are pushed through the consumer) needing a discount factor we’ve not seen historically.
Climate….the state of things feels rather precarious at the moment. We seem to be juggling national, political, social and economic dangers and pressures simultaneously. We have discussed the food crisis as a result of Ukraine conflict and the supply shortages of many key staples they produced, but this is only one angle. Climate changes are impacting our eco system…whether it be floods, droughts, fires or more simply the environments where we grow our food. We are seeing harvests across food types being impacted globally as a result of these shifts….Rice shortages in California, corn in Iowa, grains across Europe, fruit in the UK, soy in china. In the short term, just another inflationary pressure but in the long term something even more worrisome. I think there are two vectors by which this will be interesting….firstly the yet to be felt consequence of this inflation and climate impact on our food supply. European farmers in the midst of a fertilizer shortage as access to ammonia and nitrogen fertilizer now scarce or too expensive. Secondly, what innovations will come out of this experience. Electrification and renewable energy might in part help reduce our dependence on fossil fuels but also will we see innovation to optimize will use of sensors, software and alternative feeds to optimize crops.
From a European perspective…in a very tricky spot if you ask me. Central banks having to deal with inflation having arguably fallen drastically behind the curve. Having to deal with inflation with a heavily bifurcated starting point between the north and the south and the haves and the have nots. A region that is sorely lacking in growth but equally lacking the room to takes risks to encourage it (see uk). On top of all this we are heading into winter with power outages increasingly likely, corporates having to rationalise, move or shut down production. Hard to see this all adding up to incremental investment in the region. (seeing signs of this in corporate narratives at the micro level). We’ve already touched on the material spike in cost of servicing mortgage debt as a % of weekly earnings for most UK households. Worth examining the impact of the materially higher base rate for the broader ‘unfixed’ European community. With variable rates common across Europe (especially in the periphery) the recent 75bps hike passing through to the end consumer who have become accustomed to the ultra low levels of funding available. There are potential political ramifications here. If you look at the eastern EU bloc of Estonia, Latvia and Lithuania you see regions with ultra high inflation (close to 25% in Estonia), low savings rates and the need to now absorb the ECB wide rate hike on top. If the emerging parts of the EU are the drivers of growth for the EU this dynamic can’t be helpful.