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The Ideas of March

There has been a growing perception that equities are now in a “melt up” or “crash up” phase. However, the big picture problem for optimists is that it is already priced into markets. From a fundamental standpoint, the S&P500 in year over year terms has already implied a recovery in the ISM to 60 (chart 1). Put another way, equities have already built in a soft/no landing scenario.

Chart 1

Realized and implied volatility is clearly very low and index call skew is rich. Volatility has been suppressed by excess supply. Moreover, gross leverage is high among speculative investors. Positioning and consensus beliefs are crowded on the long side. Of course, risk compensation (the outright and relative valuation) in equities is also extremely poor (chart 2). The S&P500 trades at 21 times forward earnings. That is an earnings yield of 4.6% and only modestly above the 10-year Treasury yield. The risk/reward for equities is unattractive based on history and given macro risks.

Chart 2

The key macro development over the past few weeks has been the shift in the prevailing bias on future short rates. The December 2024 SOFR implied yield has increased by 100bp from the recent trough to around 4.4% (chart 3). That has provided support for the US dollar, especially against funding currencies like the Japanese Yen. The shift in consensus beliefs on short rate expectations is a function of macro resilience, inflation pipeline pressure and (still) elevated core services inflation ex shelter.

That has contributed to a renewed tightening in broad financial conditions over the past few weeks and will likely prove challenging for equities again as the Fed will not be able to deliver the 100 basis points of rate cuts implied in the markets.

Chart 3

In conclusion, consensus beliefs in a range of positions correlated to lower rates are extremely one-sided (crowded short convexity). Risk compensation in equities and credit are extremely narrow. Realised and implied volatility are compressed. From our perch, the only way out of this for the Fed is to crush the labour market. Meaningful rate cuts are unlikely while the equity market melts up and financial conditions remain ultra loose.

The good news in Asia is that after a long and brutal bear market since February 2021, consensus beliefs and valuation are deeply negative (contrarian bullish). The world ex US (excluding mega cap tech) is also considerably less expensive and euphoric (Chart 4). The non-linear price action and the lack of risk compensation is not necessarily the end of the bull market. However, it is a warning sign for contrarian investors.

Chart 4

The Ideas of March
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