Each year we release a set of “non-predictions.” As regular readers and clients know, we do not have typical forecast based approach. Rather, we seek to take on expanded risk premium when beliefs have shifted rapidly and become anchored on an implausible outcome. Stated differently, we assess where there is a large skew or asymmetry in valuation, risk compensation, positioning, and the prevailing bias. In addition to a large valuation anomaly, our definition of a behavioral episode is when price has been driven by emotional sources of volatility, rather than fundamentals. The final element is the focus on a single story (The Economist Cover signal).
The non-predictions for 2024 (published in November 2023) were:
The US equity risk premium will not end 2024 narrower compared to end 2023. - (Risk premium has continued to narrow modestly so far).
The US high yield bond index will not outperform high grade bonds in 2024. - (High yield bonds have continued to outperform IG modestly so far).
Fixed income volatility will not end 2024 higher than equity volatility. - (Fixed income volatility is still higher than equity volatility).
Private equity will not outperform public equity in 2024. - (Public equity is outperforming private equity so far).
MSCI India will not outperform MSCI China in 2024. - (MSCI China is outperforming India so far from the January low).
The US dollar will not underperform EM currencies in the first half of 2024. - (The US dollar is outperforming EM currencies so far).
The key theme above is the absence of risk compensation in US equity, credit, and implied volatility (chart 1). Narrow risk premia were evident at the end of 2023 and have compressed further in the first half of this year. From our perch, the further compression in risk compensation was supported by the Fed pivot in December. That contributed to a reflexive and premature easing in broad financial conditions. The second and widely appreciated factor has been the resilience in macro conditions likely buoyed by the fiscal impulse in the United States.
Chart 1
As we noted recently, the December Fed pivot has compounded a series of policy errors in this cycle. When inflation was staring them in the face in 2021, their informed view was not to think about hiking rates. When inflation set on its largest and potentially structural surge of the last half century, they labelled it transitory and carried on with unholy QE while driving real rates into deep negative territory. When inflation was about to get sticky and re-accelerate, they claimed victory in the December 2023 dovish pivot. The Federal Reserve seems to be hanging on the asymmetric directive that they are not going to hike rates further in this cycle. Rather, they still expect to cut rates, but are going to wait for the data.
Historically central banks have been willing to ease policy rates with inflation above target if growth indicators are falling. However, for now, inflation remains above target and growth conditions remain resilient. Indeed, equity prices and corporate earnings revisions are consistent with a reacceleration in growth momentum back toward expansion. Irresponsibly loose fiscal conditions might become even more accommodative following the US election in November. If that occurs the path of future short rates and long end yields is probably higher, not lower. In that context, equity, credit risk premiums and implied volatility is probably too narrow. Our other fear is that a higher path for interest rates will amplify pressure in commercial real estate and private assets where there have been visible signs of funding stress. As we have noted before, this episode is not a distressed credit cycle like 2008, but a mis valuation cycle in less liquid assets.
A pleasing aspect of the first half has been the performance of MSCI China, especially from the January low. There were three elements to our contrarian optimism. First, the market was trading at distressed outright and relative valuations. Second, following a three-year drawdown phase the bear case, although genuine, was widely appreciated. Third, the price action in January and early February when we scaled up our position was rapid and emotional which suggested investors had capitulated.
On the final point, the potential for a higher path of future short term interest rates has helped support the US dollar against major currencies and especially emerging markets. Eventually that might also tighten dollar liquidity again and contribute to higher cross asset volatility in the second half of this year. Despite more attractive valuations and risk compensation in emerging markets, it is a reason for caution.
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