Three in a Half
Three Market Regimes in The First Half of 2022
Image Credits: png all via Google Images
July 24th 2022
After a beak to finish my master thesis and one to lie on a beach, I am back with a new market note. In this post I look into the main market developments from the first half of 2022 (6 1/2 months, to be exact) and offer my take on how to position for the future (feel free to skip to the end if you are short on time). As the title suggests, I see a succession of three (perceived) market regimes in the first half of the year – reflation, stagflation, and recession. More precisely, I believe that for a few months the market has been predominantly pricing each of these scenarios. What is remarkable is how quickly the perception has shifted from one regime to the next, causing volatility in most assets and confusion among many market participants and commentators. To be clear, this post is about short-term market regimes and not about long-term economic regimes, which change much more rarely.
Before delving into these three regimes, let’s begin with a review of the evolution of the main economic indicators and a performance recap for the main asset classes. For each asset class, I chose examples that illustrate the main themes in risk sentiment.
Recap
US Economic Data:
Note: The picture is broadly similar in Europe and the UK. Some nuances apply to Canada and Australia, which are commodity exporters, as well as to Japan, which has had structurally low growth, inflation, and unemployment for the past two decades. The situation in EM countries is much more diverse and in many cases affected by idiosyncratic factors, and thus omitted here.
In the US, inflation kept surprising to the upside, culminating in a 9.1% YoY print in June (caveat: watch the base effects). In Europe, the inflation is even worse due to very high energy prices (and their higher CPI weights). High and rising energy prices contributed to and were compounded by the strong devaluation of the Euro and Pound against the US Dollar. The currency weakness raised the cost of dollar-denominated energy imports, thus shifting the terms of trades for energy-importing countries (in May, Germany recorded its first trade deficit since 1991). High consumer inflation followed from high producer inflation, and both consumer and business confidence fell to historic lows (albeit less for the latter). Importantly, the inflation seems to be increasingly a self-reinforcing phenomenon, whereby price rises are no longer confined to food and energy, but rather consumer anxiety and the rush of businesses to protect margins collectively lead to strong inflation in core goods and services as well. Spending remains unusually strong, despite a normalised savings rate – the reason are wage rises and the wealth effect, both of which should fade in the event of a recession. Finally, the unemployment remains very low and is likely to stay so until we are in a recession (a sharp uptick in unemployment has defined every recession since at least WW2). So, in a nutshell, we have high inflation that looks to be as much about demand as it is about supply and a tight labour market caused by the chaotic pandemic recovery. All the reasons to tighten monetary policy! Let’s explore the consequences of this reasoning on rates and asset prices:
Interest Rates:
The Fed has so far tightened 150bps this year, bringing the target Fed funds rate to 1.50-1.75% across three consecutive hikes of 25bps, 50bps, and 75bps. This accelerated pace of tightening and the speculation of a potential 100bps hike at the July meeting (mirroring the Bank of Canada) has been one of the drivers of strong dollar performance. Earlier in the year, it looked like the BoE would match the Fed, but the economic reality and the so-called ‘cost of living crisis’ in the UK held the central bank back. The ECB only raised its rate by 50bps last Thursday, its first hike since 2011, while the BoJ stubbornly holds on to its low rates and yield curve control policy. As a contrasting example to the BoE and ECB, the Bank of Canada has taken its job seriously and delivered sizeable hikes, despite Canada being an energy exporter and having lower inflation than the US, Eurozone, or the UK – all of this helped support the CAD.
Stocks (main Developed Market benchmarks):
Stocks sold off in a rather efficient manner, with more defensive and commodity-heavy benchmarks (such as the FTSE) holding better and indices skewed towards interest-rate sensitive stocks such as the Nasdaq (growth stocks) or the Russell (smaller, more cyclical, and more indebted companies) suffering more. Europe and the US performed similarly in local currency terms, the US having outperformed in euro terms, given the rally in the dollar. In particular, as I anticipated in my ‘Demand Dilemma’ post, consumer stocks led the decline, while staples, defence, and energy outperformed. I discuss in more detail my view on stocks in the trade ideas section at the end.
Bonds:
Broadly, government bonds declined in 2022, causing their yields to rise – the 10-year Treasury yield peaked at nearly 3.5% in mid June, a staggering rise from the level of just 1.5% at the end of 2021. Initially the move was about a bear flattening (short rates rising faster than long rates), but later shifted to being more about credit spreads (see the widening Italian BTP - German Bund spread).
I also think it is interesting to look at the comparative shift in focus from duration to credit risk. In April, as the Fed turned more hawkish, long-dated Treasuries (EDV ETF) sold off sharply, while high-yield corporate bonds (HYG ETF) held off better. However, as concerns about a recession grew in June, the safer Treasuries outperformed the riskier high-yield bonds.
Commodities (front month futures):
Commodities are the big story of 2022 and increasingly look like the typical boom-bust cycle. Supply has been tight since 2021, but the war in Ukraine and the subsequent sanctions on Russia were the catalyst for huge price gains across energy (oil breached $120/bb), metals (the LME had to suspend Nickel trading), and agricultural commodities (the spot wheat price jumped 60% intra-day on the day of the Russian invasion). However, since May, fears of a ‘global slowdown’ (read recession) and of the resulting demand destruction have caused a significant retrenchment of these gains, despite little to no improvement in the supply of these commodities.
Currencies (and Bitcoin):
Finally, the picture in currencies broadly mirrors that in rates and commodities. The currencies of commodity exporting countries (e.g. US, Canada, Brazil), who were also able to hike rates more and communicate further rate rises gained over those of energy importing countries with dovish central banks (EU, UK). The dollar had the added advantage of being the main international reserve currency and the ultimate and most liquid safe asset, so it benefited not only from the hawkish Fed pivot, but also from the more recent increase in global recession fears. I included Bitcoin in the currencies section more due to its name. As a proxy for all cryptocurrencies, Bitcoin’s decline was very similar to that of high-beta growth stocks, so there is not much to say here, other than when risk sentiment sours and liquidity reduces, Bitcoin goes down.
Three Market Regimes
Having refreshed our memory, let’s look at the three market regimes:
1. Reflation (January-February)
Catalyst: High CPI inflation, the Fed pivots hawkishly, but the expectation remains for measured rate hikes and for other central banks (e.g. BoE) to follow suit. Economic growth remains strong, and while most expect a normalisation of growth, fears of a recession remain subdued.
Market reaction: In stocks, cyclicals (banks, energy, and travel) strongly outperformed, defensives were flat, the best performing hype stocks of 2021 corrected upon a few key earnings misses or upon providing poor guidance (e.g. Netflix, Peloton), while big tech only declined mildly. Bonds sold off uniformly across the credit spectrum, treasury yields rose, but the yield curve did not flatten too much. Credit spreads also did not widen meaningfully. Commodities continued to rise at a solid but not disruptive rate. The dollar continued its appreciation at a mild pace.
2. Stagflation (March - mid June)
Catalyst: Russian invasion of Ukraine. The blockade of Ukrainian grain shipments and the fears of sanctions on Russian energy exports cause a commodity supply shock. However, consumer demand in rich economies shows no sign of slowing down, thus causing inflation to surprise to the upside and the Fed to react accordingly by promising larger rate hikes.
Market reaction: Commodities, especially energy, grains, and vegetable oils rose abruptly, and it was not long before this led to higher fuel prices, and hence higher producer costs, and then consumer prices. Commodity-related stocks and currencies, as well as defensive stocks (staples, healthcare, defence) strongly outperformed. Long-duration bonds and stocks sold off sharply and Developed Market sovereign yield curves flattened to the point of testing inversion on some segments as participants started expecting larger and faster rate hikes to curb the (by now) very high inflation. Credit spreads started to widen more meaningfully as fears of a global economic slowdown increased.
3. Recession (mid June - July, ongoing)
Catalyst: The Fed raises rates by 0.75% and inflation continues to surprise to the upside.
Market reaction: Cyclical stocks (especially the most leveraged industries) have been underperforming significantly, defensives have broadly flatlined, while technology and growth stocks show signs of outperformance. General stock risk sentiment seems to be improving, with a few sessions delivering gains of over +2%, but not enough to cause a sustainable rally. After performing similarly so far, US stocks start outperforming European stocks. The dollar’s rally has accelerated, especially against the Yen and Euro, the latter briefly falling below parity with the dollar (before rebounding a bit on the ECB hike). US Treasury yields have started to fall as the market is starting to price rate cuts following a steep but short hiking cycle in the US. Commodities have been correcting, especially the best performing and most economically-sensitive ones, such as copper. Notably, however, despite declines (including a -9% oil intra day session), oil remains fairly anchored around $100/bb as demand for transportation remains high and inventories and spare production capacity remain reduced.
Investment and trade ideas
Now for the fun and practical side, here are my ideas on how to position for the future, at least until the next catalyst comes and the regime changes again.
Stocks:
In stocks, defensives, and in particular consumer staples, are now relatively expensive, while cyclicals offer about even odds of loss or gain. Although forward rates pricing has come down, refinancing in a recession is hard even with low policy rates, due to reduced liquidity and risk appetite. Moreover, revenue vulnerability due to cyclicality (e.g. travel, retail) or single-factor concentration (e.g. energy, mining) can easily prompt an operating leverage spiral for indebted companies. Hence, it is in technology and non-consumer growth stocks with low debt that I see the strongest positive asymmetry. I would especially overweight some beaten-down stocks with strong balance sheets and strong brands, such as Facebook (NASDAQ: META), Zoom (NASDAQ: ZM), and Spotify (NYSE: SPOT). Despite being cyclical, I would still buy large universal banks – Citi (NYSE: C) remains my favourite even after the large 13% rise on their earnings, followed by Bank of America (NYSE: BAC) and Wells Fargo (NYSE: WFC). I also still like defence stocks, particularly Northrop Grumman (NYSE: NOC), Huntington Ingalls (NYSE: HII), and Leonardo (BIT: LDO), as I think that the full long-term revenue appreciation potential for these stocks is still not priced into the modest multiples (admittedly, the debt is a reason for this, although all names are investment grade). I also like some Japanese equities, particularly if these can be bought unhedged in yen – among these I own Cannon (TYO: 7751) and Takeda (TYO: 4502), but I am sure other quality companies can be found. Finally, I would warn that shorting any stocks at this point (except for fraudulent companies, of course) is dangerous, as it exposes one to the risk of a broad market rebound.
Rates and credit:
In credit, I believe that the duration component of the bond selloff is over, and that now the focus is mainly on credit risk. Thus, I suggest buying the long-end in US Treasuries (10 years and beyond), as well as top quality corporate bonds (for instance, an Apple bond maturing in 2043 trades at a yield of over 4%). If one wants to do this trade in a relative value way so as to exploit both the credit component and a tightening by the ECB, one could simultaneously sell the short-end of Italian BTPs, so for instance one can go long 10-year Treasuries and short 2-year BTPs with the same notional (so not risk-weighted), making the trade self-financing.
Currencies:
The constant throughout all three regimes was the rising dollar. In the first phase, this was due to the anticipation of a hawkish Fed, which proved correct. In the second and third phase, it was due to a flight-to-safety reaction. Personally, I’ve been long USD (mainly versus EUR and GBP) for more than a year and a half, but I think it is time to turn neutral on the dollar (but not short, as I cannot view a meaningful catalyst for a weaker dollar). Yes, Europe is facing an energy crisis and the ECB a rates dilemma (i.e. hike to arrest the currency’s decline, risking a recession, or don’t to save indebted countries, risking a broader devaluation in the euro and higher inflation). However, selling the euro seems like a crowded trade which is getting very consensus. At the same time, I believe that it is also too early to buy the euro, and that a better opportunity is available in the yen, for which the depreciation and the policy stance of the BoJ have been so extreme, that the risk-reward asymmetry is in favour of this trade. However, the timing is tricky again, so I would do it via long-dated options, at least one year expiry. The trade could be made again relative value by also shorting the Brazilian Real. In Brazil, the inflation is likely to last beyond the strong commodities prices. Plus, elections should increase volatility nonetheless, so one would want to buy options in this case. Hence, a put on BRL coupled with a call on JPY is what I would do.
Hedge against reflation:
The above trades are very much betting on an imminent recession and on falling inflation. How to hedge if this does not happen? Clearly, one should buy the assets that did best in the first two regimes, namely commodities. While oil is very much dependent on the Russia-Ukraine dynamics, copper has sold off even more strongly. Moreover, copper supply remains historically tight and copper should appreciate long term due to the energy transition. However, one could still lose money from continued downward momentum in the short term. Thus, I would suggest buying a call on long-dated copper futures, at least one to two years out.
Hedge against a severe recession:
While the trades above do bet on a recession and a Fed which will be forced to ease, they only reflect the risk of a mild recession. In a severe recession, all stocks would perform badly. Thus, one can mitigate this risk by buying a gold position (e.g. via the GLD ETF). So far, due to the monetary tightening environment, the negative carry of this trade has kept the gold price subdued. However, a severe recession would cause the Fed to cut rates significantly, thus reducing the opportunity cost of holding gold.
Finally, always remember that markets do not wait for certainty and that certainty is expensive. Since I am not (at least not yet) a good momentum trader, I mainly focus on the trades where I see a coming reversion to the mean or to the historic trend. But I have learnt enough about momentum to be careful about suggesting contrarian trades too early and in the absence of a probable catalyst. Therefore, I only see one clear and high conviction trade, and that is to buy secular growth stocks and long-term Treasuries (essentially, US duration). I believe that this is the only trade which is at the same time compatible with the idea of a recession and a bet on the rebound in some of the most sold-off assets of this year. I hold even higher conviction in the stock trade, as it may be a bit early for the bond trade, since there is still room for the Fed to surprise on the upside at the July meeting (100bps hike instead of 75bps, an event which only has 20% probability, as implied by the Fed funds futures) and afterwards. Hawkish surprises could also cause further declines in rate-sensitive stocks, so I would suggest starting with about 50-70% of the desired allocation now and average down on declines.
Good luck and thank you again for making it to the end!
