This year has started with a complete reversal of the previous year’s trends. That has offered a welcome respite to owners of financial assets following the steep losses sustained over the previous 12 months. Indeed, for the traditional multi-asset (60/40) portfolio it has been the best start to the year in over 3 decades. Of course, it is not how you start, but ultimately how you finish the year that counts.
The positive catalysts since the October 2022 trough, which have helped to drive risk assets were: 1) the peak in bond yields; 2) depreciation in the USD; and 3) China re-opening. As we noted early in the new year, China’s re-opening has been faster-than-anticipated and has already contributed to a 60%+ rally in many related assets already from the trough. Put another way, that development is now well appreciated even if it is likely to be durable over the next two quarters. It is also reflexive with points one and two above, especially the correction in the US dollar.
On the negative side, our fear is that the dramatic rise in policy rates last year and corresponding tightening in financial conditions is still likely to contribute to a “hard(er)” landing in growth and profits. However, clearly the prevailing bias is leaning more towards a soft landing or benign outcome for risk assets. From our perch, the odds of a hard landing are still high, but clearly the economy (labour market and hard data) has been resilient which might delay when the deterioration in growth and profits commences.
An interesting feature of the episode (bear market) last year was that buying out of the money put options on equity was not an effective hedge. A proxy for that below is the “tail hedge” ETF listed in the United States (chart 1). The correction in equities was a steady down trend, rather than a violent, emotional liquidation (or capitulation). That was unusual compared to recent episodes.
From our perch, this suggests that a proper, emotional capitulation or spike in volatility is still likely before the bear market is over. In that context, the cost of protection in credit and equities is inexpensive relative to the potential pay-off if there is a hard(er) landing in macro conditions.
The table below highlights that the cost of protection (as a z-score with a look back period since 2005) is well below average in credit, neutral in equities, but above average in FX and fixed income. We would also note that (still) elevated volatility in fixed income is probably a reason to be cautious on other asset classes as the return on risk free dollar cash is a high hurdle rate for competing assets. Put simply, the cost of protection for the potential payoff is like a budgie: “cheap.” However, if the Fed manages to achieve a soft-landing, our long exposure in Asia Pacific ought to perform well. From a security selection point of view, the higher cost of capital environment is still likely to favour companies with high cash flow returns on investment and low balance sheet leverage.