Markets, whether in a bull market or a bear market, never move in one direction. As Dr. Burry noted on the bird app this week, in the 2000 episode there were seven bear market rallies of around 20% as the NASDAQ fell 78% to the 2002 low. We don’t know whether the current episode will end up being as catastrophic as the first Tech crash, but what we do know is that the rally in equities and credit from the June low has reduced a considerable amount of the risk premium built in the first half of the year. Moreover, the recent compression in risk perceptions appears counter to the Fed’s motivation to tighten financial conditions, slow inflation and the leading indicators of profits.
While many investors have been (quite rightly) focused on the rally in equities from the June low, credit spreads have also retraced around 60% of the widening in risk premia in the current episode. As we often note, credit spreads are inversely related to liquidity and volatility. Stated differently, a long position in credit is effectively short volatility (chart 1).
While the recovery in credit spreads is clearly consistent with the rally in equities from the trough in June, it appears inconsistent with the probability of higher short term interest rates, tighter dollar liquidity and a probable profit recession over the next few quarters. One of the key fundamental drivers of credit is the corporate cash flow and earnings cycle as debt is serviced out of cash flow.
A key leading indicator of the earnings cycle is the ISM manufacturing index (light blue line inverted in the second chart below). As we have noted over the past few months, the rapid tightening in financial conditions and the deterioration in ISM new orders to inventory, suggests that the odds of a 15-25% decline in earnings is relatively high. In turn that suggests default risk and credit risk is underpriced.
Of course, positioning, sentiment and beliefs are additional considerations and a key reason for counter-trend rallies in markets. At the low in financial assets in June, the prevailing bias was extremely pessimistic on risk. In that context, the counter trend rally was probably warranted even if it was inconsistent with the ongoing deterioration in fundamentals. As one of my good friends also noted, counter trend moves often extend to cause the maximum pain for consensus positions. In the near term that suggests the rally using the S&P500 as the risk proxy could extend toward 4500 (or so) as short or underweight investors are forced to cover and momentum based participants (CTA and vol targeting) move further long.
However, communication from a number of FOMC members following the CPI report was consistent with our observation yesterday that the Fed will likely continue to hike rates until there is a meaningful deceleration in consumer price inflation. From our perch, the more the Fed raises the policy rate, the greater the odds of a profit recession. That is probably not priced in the S&P500 and it is definitely not priced in the junk bond market with spreads trading at 408 basis points and below the long term average. Similarly, credit risk premia is also probably too narrow in the investment grade market as well (final chart). However, we are cognizant that the counter-trend rally in risk can squeeze further over the next few weeks.