As we noted recently, human beings are not particularly good at non-linear thinking. From our perch, a key reason why there is resistance to consider extreme (or non-linear) outcomes like monetary policy reversals, inflation persistence, acknowledgement of higher neutral rates, depletion of inventories and wars is that most investors are short convexity. Stated differently, the real world is not linear and systemic risk can increase at an accelerating rate as correlation moves to one in a major episode. It also generally benefits most financial market participants when asset prices rise, not when they fall.
One of the best descriptions we have seen on convexity is the automotive analogy. In automotive terms, if the delta of an option is its speed, then gamma is the acceleration. This analogy can also be extended to the relationship between duration and convexity in fixed income or the non-linear relationship between the change in interest rates and bond prices. For investors, an increase in market interest rates (cost of capital or discount rates) is typically kryptonite assets that are naturally short convexity. As we have experienced since the start of 2022, phases where fixed income yields have increased sharply have tended to coincide with higher cross asset volatility, US dollar strength and tighter broad financial conditions. There is an intimate link between liquidity, volatility, and leverage.
A key quarrel we have with the current prevailing bias is the consensus belief in a soft landing. US Federal Reserve policy is driven by inflation and employment. The prevailing bias hopes for (linear) disinflation and full employment or a gentle rise in unemployment. Historically, that is highly unlikely. The market hopes that gentle disinflation will coincide with a moderation in market interest rates and potentially a lower Fed funds rate. At the same time, growth and earnings expectations are anticipated to recover again next year.
Historically, major phases of volatility have followed declines in short term interest rates, not the other way around (chart 1). While the equity market might enjoy the initial fall in rates, the reason the Fed and the fixed income markets price lower rates is that there is likely to be a cyclical deterioration in growth, profits, and employment. Business cycles tend to be non-linear, not gentle, or smooth. Of course, there are exceptions. However, the current cycle has experienced the largest and most rapid tightening cycle in history. Moreover, factors that contributed to resilience – excess savings, Fed emergency liquidity and the fiscal impulse – have all started to reverse over the past few months.
In addition to our quarrel with the prevailing bias on the benign outlook, our key concern is the compensation for risk. The earnings yield on US equities relative to the US Treasury yield is back to 2005 levels and risk compensation compared to short term interest rates is negative. Historically that has not provided a positive signal for forward looking returns, especially in sectors like REITs where the discount rate is even more critical to outright and relative valuation (final chart). While we are not surprised that equities have enjoyed the prospect of peak rates, the implication of lower rates for future growth, profits and returns is probably not bullish. In that context, volatility and the compensation for risk is also probably too low.