Good morning. Friday was another bad day for both stocks and bonds, after the jobs report suggested the Fed had more work to do to bring inflation down. Overreaction to single data points will be the norm until all the little bits of information line up to send a single message — that the Fed has done enough. A few reflections on investing in such a world below. Email me: Robert.Armstrong@ft.com.
What to own while waiting for inflation to fall
I was struck by this quote, from a Wall Street Journal article on Sunday:
“Earnings are important,” said Alex Chaloff, co-head of investment strategies at Bernstein Private Wealth Management. “But as far as earnings being the beacon for the future of the market? No, it’s less important this quarter. Inflation is the number one, two and three most important data point.”
It is remarkable to hear a strategist — a person who is paid to have clever, differentiated thoughts about the market — say, basically, “Screw it, it’s all about the Fed, earnings don’t matter, nothing matters, life is absurd.” But Mr Chaloff’s Beckettian view of the market has the advantage of being true. It is not all that gross an exaggeration to say that there is only one trade right now. If you believe inflation is near a point where the Fed can slow and then stop its rate hikes, seek risk; if you believe inflation is not near this point, flee risk.
It is not totally crazy to think that a Fed pivot is not far off. Another 75 basis point rate increase does appear locked in for the Fed meeting three weeks from now. But depending how the data comes in, a downshift to fifty basis point moves, and the Fed saying “we think policy is starting to work,” followed by a risk rally, is not all that hard to imagine.
The Unhedged house view, stated last week, is that inflation has peaked and will fall by fits and starts from here, but it is going to be a slow grind down. But our degree of confidence in this is informed by the historical success rate of economic predictions made by people way smarter than us.
There is only one significant wrinkle to this one-trade world. The Fed might make a classic Fed mistake, sending the economy into a significant recession late next year, and sending inflation down hard (as Don Rissmiller of Strategas has pointed out, even in the 1970s, recessions were enough to bring down inflation quickly). Under those conditions, earnings and all the subtleties of risk selection will suddenly matter a lot. We’re not nearly there yet, though (that’s another weakly held Unhedged house view; we have lots of them).
All that said, though, can it possibly be true that the world is now so binary that all forms of risk are the same — that it matters not whether you own growth stocks, or defensives, or long Treasuries, or corporate bonds? Which asset class will be the best to own until the Fed shifts its stance? A few thoughts:
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Big tech. What is interesting about the big tech stocks is that they have been badly beaten up, apparently on the grounds that they are “long duration,” an argument that may not even make much sense. Google has lost a full third of its value since its late 2021 high. It trades at 18 times forward earnings. Probably its 2023 earrings estimate, which assumes 15 per cent growth, needs a trim. And if rate expectations take another leg up, the duration argument may strike again. But when the Fed’s path becomes clearer, the amazing economic characteristics and now-lower valuations of companies like Google (or, say, Microsoft) seem likely to get another look from the market (Apple is a slightly harder case).
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Cyclical stocks/Value stocks. Things that are out of favour should be bought, but timing matters. Cyclical stocks are way out of favour. A vivid example is semiconductor companies. The stock prices of AMD, Lam Research, Applied Materials and Nvidia have been cut in half. The problem is that there may be a recession between us and the first signs of a recovery, suggesting there can be plenty more pain ahead for the semis, especially given that valuations are still not all that cheap. For all but the most patient investors, the argument for waiting seems compelling.
The same argument applies to value stocks generally. Banks, for example, look as cheap as anything in the market right now. But consider a rather chilling chart from Ian Harnett of Absolute Strategy Research, showing the relative performance of banks and Sifis (big banks) versus non-financial companies, plotted against global manufacturing surveys. If a recession is coming (ASR thinks there is) banks are going to get whacked.
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Defensive stocks. These have outperformed. But many of them are, in relative and absolute terms, wickedly expensive. The market is scary right now, but not so scary that I want to own big box stores, liquor brands, or bleach companies at 30 times earnings.
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Long Treasuries. The biggest long-term macro call in markets right now is: do you like the US 30-year bond at 3.8 per cent yield? That yield has more than tripled in just a couple of years. However the current inflationary incident plays out over the next few years, if we return to anything like the pre-pandemic normal, a four-ish per cent risk free yield is going to look pretty good. The consensus view is we are entering a new inflationary era. Step up, contrarians, and buy long bonds.
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Corporate bonds. Are credit spreads on mid- or long-duration corporates adequate compensation for the risk of a recession? It is not absolutely clear to me, but the fact that we are not at the levels of the 2016 oil price collapse makes me uneasy. Here are BBB (lowest rung of investment grade) spreads:
That said, short duration corporates yielding 4 or 5 per cent remain appealing. I feel wimpy just typing it, but collecting 5 per cent and sticking my head above the parapet in 12 months time doesn’t sound so bad.
We are extremely interested to hear readers’ views on the right assets, and the right asset mix, to hold in this strange market. Please do email us.
One good read
Anusar Farooqui (aka Policy Tensor) argues that we are in a nuclear crisis and a negotiated settlement with Russia is the way out.
Source: Financial Times
