“What If Market Consensus Is Wrong” – A Hedge Fund Ponders The Alternative
A week ago we posed a simple qustion:”is the market wrong” in bidding up risk assets in a time of rapidly tightening financial conditions. With the S&P likely set to rise above 2,200 today, a new all time high, the market at least for now, remains “right.” However, more doubt has emerged.
In a note from our friends at Fasanara Capital, CIO Francesco Filia repeats the question we posed last week, contemplating what may be a “delusion” emerging on the boundary between reflation/growth and a QE bubble unwind. As Filia puts it, “what if consensus is wrong: what if rates are rising due to the end of Quantitative Easing and not because of reflation/escape velocity on growth?” He continues:
Rates then rise without growth, perhaps even without much inflation. Indeed, rates started rising back in August, on momentous shifts in policy by BoJ (forced by capacity constraints and collateral damage). Such scenario is not good for equities, contrary to what currently believed by markets.”
Indeed, such a scenario would be the worst possible one: with potential stagflation on the horizon, the last thing markets can afford is a withdrawal in central bank support just as US deficit funding needs are set to spike, something we have been cautioning for the past two weeks.
In any event, if the market is wrong about this most fundamental signal, what else is it wrong about? Here are the key highlights of Fasanara’s thought:
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Delusions: Rates Rising on Reflation/Growth or QE Bubble Unwind?
What if consensus is wrong: what if rates are rising due to the end of Quantitative Easing and not because of reflation/escape velocity on growth? Rates then rise without growth, perhaps even without much inflation. Indeed, rates started rising back in August, on momentous shifts in policy by BoJ (forced by capacity constraints and collateral damage). Such scenario is not good for equities, contrary to what currently believed by markets.
With Trump rising to power against all the odds of bookies, pollsters, a militant press, a reflexive army of pundits and an all-guns-out establishment, it is all too clear who are the big losers of these elections. After the supposed shocks of Brexit and Amerexit, you may imagine less and less market participants to pay attention next to pollsters, bookies and analysts in informing investment decisions at the next check point.
But there is a bigger loser, and that is the Efficient Market Hypothesis itself, a cornerstone of modern financial theory, which states that all relevant information are embedded in prices, making them fair prices. Going into the event a win by Trump was widely perceived to be an outright disaster. Coming off the event, after an initial shock, equity markets staged one of the most impressive rebounds in history. Clearly, this is not an example of rationale investment behaviour. From Armageddon to Paradise on Earth in just few hours. The market had known full well what the aftermath of a Trump win looked like, had been given plenty time to strategize on that, and yet it all seemed really new news. Ex-post, narratives of cash on the sidelines, retail coming in, fiscal expansion /reflation reality sinking in, are all handy but unconvincing scapegoats.
We look at this as the thinking trap setting the stage for the next moment of market volatility, which may be more violent and damaging as it would have otherwise been – even in the absence of fundamentals further deteriorating to a point where the need for re-pricing would be self-evident. The market structure of large passive investors (index funds and ETFs / ETPs at ca. $4tn), mechanical trend-chasing algo strategies (the bulk of a $0.5tn industry) and volatility-driven investors base (Risk-Parity, structured notes, vol-levers at up to $3.75tn), making up close to 90% of daily equity flows, is such that this illusion of knowledge and anchoring behavioural bias happens at a point of great danger for markets. Needless to say, parallels can be drawn for moments in history where similar ex-post rationalizations, proclivity to dismiss risks and climb the wall of worry resulted in deep declines (years 1929, 1937, 1966, 1972, 1987, 2000 and 2007). We will not go in there, this time, not to always sound as bearish as we actually are. We shall look at it as an opportunity to position for an outcome we (and few others nowadays) are abandoned solo believing into, making its payoff as asymmetric as it could possibly be. The majority of most prominent bearish players recently capitulated, taking the gamble / excuse of a Trump-win (including smart-money big names like Dalio, Druckenmiller, Gundlach and Icahn). To us, the drumbeats of potential downside gap risk for bonds and equities remain loud. Recent events (Trump, Brexit, BoJ) come in confirmation of our contention of where we are headed (de-globalisation trends, geopolitical uncertainty, beginning of the end for QE, bond bubble busting); volatility/leptokurtosis is on the rise, market complacency is vulnerable to sudden wake-up calls, political tail-risks are on definite upward trend (especially in the EU).
Let’s go back to Trump and try to recap what the market currently thinks he stands for in terms of economic and financial environment: resurrection of inflation, escape velocity on GDP growth via defence and infrastructure spending, repatriation of trillions of US Corporates’ foreign profits, pro-growth de-regulation, aggressive corporate and income tax cuts, de-globalisation stance benefiting internal affairs over EMs and cross-border flows.
Inflation yes, but what GDP growth? A few comments:
- Ultra-loose monetary policy and full QE is more bullish equities than fiscal stimulus can ever be. This is the key element in our eyes, and we will expand on it below.
- Gavekal reminds us that higher government spending tends to lead to lower P/E ratios, on empirical evidence from the last decade, due to misallocation of resources past a certain point, at a time where low-hanging-fruit capital spending programs are not easy to see.
- What about inflation and equities? Gavekal research also reminds us that accelerating inflation leads to lower P/Es. Time wasted in re-modulating prices and wages, stockpiling of commodities and inventories, and the likes.
- Protectionism and trade wars typically lead to less global GDP, as main contributors to GDP growth by and large were EM in recent years, after all, despite weak commodities.
- De-regulation policies help but the debt pile is huge already, and one wonders if Capex re-lever is not yet priced in, given where P/E Shiller adjusted are.
- The repatriation of foreign profits will make cash-rich companies cash richer. Yet, they are awash in cash already and did not find a business proposition motivating enough to exchange savings for investments thus far. More cash alone will not change their utility function.
- Indeed, excess cash on the sidelines is often times a blue-sky narrative hiding a reality of debt rising even faster, resulting in higher net debt. The case of US Corporates is pictured here below.
So we have inflation yes, but what growth? And what if we get not much growth and not much inflation either?
Indeed, there is a bigger question to ask: are we sure rates are spiking higher on the back of a credible re-rating of growth/inflation and not because we are in the final phase of Quantitative Easing globally (BoJ, ECB, BoE) and ultra-loose monetary policy (Fed)?
Indeed, it is back in August that rates started rising from rock-bottom levels globally, on the BoJ back-pedalling from unlimited permanent QE. Later on in September, the BoJ introduced the ‘yield curve control’ mechanism, which only equates to QE if rates are above a certain threshold, while it means tapering/tightening if rates are below. To us, that is a de facto acknowledgement of reached capacity. Consistently, the ECB refrained so far from enlarging its QE program in duration or size. Consistently, the UK government came out in open criticism to the policies of the BoE, arguing that QE is not the answer to all questions. Below we reiterate our reasons on why we believe QE is running out of road and will be phased out relatively soon.
If we are right and rates spike primarily because of policy shifts from major Central Banks, then we may see rates continue to rise while inflation remains subdued, resulting in higher real rates. Higher real rates are an impediment to growth picking up much from here, and a heavy damage to the excess debt accrued in recent years, thus being inherently bad for equities. Rates then rise, bonds fall as full QE moderates / unwinds, while equity comes down and GDP growth falters – i.e. unwind of the QE trade of being long bonds / long equities.
On balance, absent damaging trade wars, we think Brexit and Trump have the potential to be positive medium-term developments for real people in the real economy, given the well-overdue reach to people’s discontent and the scope for redistribution of income and more inclusive growth. It does not make them necessarily positive for financial markets, though. Fiscal stimulus (here our research) do help the real economy, but nothing can ever be as good as full-steam QE for both equities and bonds. And if you assume that such bonds and equities fully price in ‘full QE’, which we do, then it is legit to expect a re-pricing.
The QE bubble – being a bubble – had never anything to do with valuations. It was cheap credit, buybacks, lack of investment alternatives as bond yields imploded to minuscule levels in most advanced economies. It was deflationary boom markets, where the economy did very poorly and ammo-rich Central Banks forced equity and bonds artificially higher. It all happened while debt in the system was rising faster than GDPs and earnings, resulting in deteriorating debt/GDP and net debt/EBITDA ratios all across countries and businesses – no exception. Now exit that monetary tailwind.
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Transitioning from ‘Full QE’ to ‘Some Fiscal Stimulus’: Bumpy Road
2016 will likely be remembered for the paradigm shift brought by the interconnection of Trump / Brexit / populism / protectionism / end of Full QE. Critically, the transition from ‘Full QE mode’ into ‘Some Fiscal Expansion mode’ will be no smooth ride for markets. There is nothing as good as ‘Full QE’ for bonds and equities. Full QE mechanically boosts equities and bonds higher, although with diminishing efficacy over time. Fiscal expansion, instead, has (i) execution risks (longer time to delivery, uncertainties over resource (mis)-allocation across industries & population cohorts), (ii) headwinds as rates and wages rise (thus squeezing corporate margins from all-time highs). Safe to assume volatility will rise / may spike. Possible to see large potential downside gap risks on bonds and equity.
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Regime Changes Happening On A Dangerous Market Structure
Amid such policy shifts, the potential downside is exacerbated by the thin ice of a dangerous market structure, dominated by rule-based / passive-aggressive investment strategies. Close to 90% of equity flows (from 7% 15 years ago) can today be attributed to either passive index funds or ETFs, Risk-Parity funds or Volatility-driven strategies, trend-chasing algos. Altogether, they now represent close to $8 trillion of AUM in firepower (rate of acceleration in recent years is staggering).
No wonder buy-the-dip is the strategy-elect these days. No wonder anything short of ‘buy-and-hold, fully invested’ underperformed in recent years. There is no way to know when and if such powerful forces may set in reverse motion at once, following a market downturn – nor, though, could one ever be surprised if that happens. Whether it does or not, off any catalyst or off no catalyst at all, will define the difference between a crash and a flash crash, a mild correction or a violent enduring re-pricing, a January 2016-type wacky market or a Lehman-moment.
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Positioning for QE Bubble Unwind, Populism/EU Disorder
At Fasanara Capital, we think it pays to be positioned for disorder from here. The asymmetry of payout profiles and risk-adjusted returns, let alone our macro assessment of where things stand, calls to position for an unwind of the QE bubble trade, which means bonds and equity down together, the polar opposite of Risk Parity funds or, more generally, balance portfolios (long equities, long bonds).
In a nutshell, the black clouds of regime changes has filled the horizon (full QE in retreat, Trump / Brexit / EU populism and political un-predictability, Dollar strength). It started raining already (rates spiking) and the illusion of knowledge bias / buy-the-dip mind-frames work as a thinking trap setting the stage for the next downfall. A market structure dominated by rule-based passive-aggressive machines make such downfall potentially way larger than it could have otherwise been.
The worst downside is for the EU, where (i) populism has built up over the years, now reaching a tipping point after the boost of Trump/Brexit and (ii) the transition out of ‘full QE mode’ is a bridge to nowhere. Willingness / capacity to fiscal stimulate in the EU is underwhelming. To adequately fiscal expand and drop money from helicopters you must be in need of your own currency: exit EUR.
Much more in the full note below (pdf):