13 March 2025
As we noted last week, what the markets are experiencing is a “reverse feedback loop” – it is the unwind of forever and ever policy support that underpinned the economy under the previous administration. It is part of the plan. Treasury Secretary Scott Bessent articulated this clearly: “We’re seeing the hangover from the excess spending in the Biden years. In 6 to 12 months, it becomes Trump’s economy.”
Put another way it is addressing the hangover from years of excessive easy policy. Policy easing to offset the hangover with the “hair of the dog” (more easing) becomes a self-reinforcing or reflexive feedback loop. Bessent has recognised that the disease is the drinking (excess policy easing) not the hangover. To address the disease, the US Administration requires the reverse feedback loop. Of course, if the fiscal tightening is large enough the cycle might end in recession. Or as Dave Dredge would say, “the good outcome (for debt sustainability and Treasuries) is a recession.”
The additional element at play for markets has also been the extreme crowding in positions and consensus beliefs. As we have also often noted, there is an intimate link between liquidity, leverage, and volatility. Leverage in this episode is evident in leveraged exchange traded funds. As our Italian friend puts it, they create a negative gamma like downside accelerator. That has coincided with peak concentration at the index level in the United States and global indices which has distributed maximum pain to the greatest number of investors. For example, if you had purchased the 3x long ETF on NVIDIA, your return is -82% since the July 2024 peak.
The good news as we noted last week, is that sentiment has probably become too pessimistic on a range of indicators. Clearly the major indices have also corrected a lot further over the past week with the NADSAQ now down 13% from peak. The correction has been relatively orderly, so far, without a large rapid and emotional capitulation. However, our sense is that the correction is well advanced.
The additional good news is that the Donald has made dispersion great again. One of our “non-predictions” for 2025 (from November last year) was that NVDIA would not outperform TENCENT this year. Tencent (+23.1%) has outperformed NVDIA by 43.4% so far in 2025. The broader point here is that the price you pay matters for your future return. Technology stocks in this region remain inexpensive with material upside. Our basket of Tech trades at 12 times FY+1 earnings, has net cash on balance sheet and 28% FY+1 EPS growth. Episodes of weakness like today are an opportunity to accumulate quality companies in Asia.
Differences of opinion between market participants are often (not always) a matter of time horizon. From our perch, sentiment on a shorter time horizon, has become rather pessimistic on some key measures. For example, the AAII US investor survey increased to 60% bears last week. For perspective, that is comparable to the 2022, 2020 and 2008 episodes (chart 1). Of course, the drawdown from peak in the current episode is less than 5% from peak compared to -25%, -33% and -48% respectively in the other examples. Moreover, most other measures of sentiment and risk compensation remain extremely benign by historical standards.(chart 1).
We’ve included in the following pages the first part of the note from the 3rd of March.
13 March 2025 - The Reverse Feedback Loop Part I.
Differences of opinion between market participants are often (not always) a matter of time horizon. From our perch, sentiment on a shorter time horizon, has become rather pessimistic on some key measures. For example, the AAII US investor survey increased to 60% bears last week. For perspective, that is comparable to the 2022, 2020 and 2008 episodes (chart 1). Of course, the drawdown from peak in the current episode is less than 5% from peak compared to -25%, -33% and -48% respectively in the other examples. Moreover, most other measures of sentiment and risk compensation remain extremely benign by historical standards. (chart 1).
Chart 1
From a tactical perspective, our sense is that sentiment (as of Thursday last week) had become too pessimistic in the short term. As noted above, investor surveys such as the AAII, increase in demand for put options (protection) and CBOE Skew suggested that the S&P500 (the global risk proxy) might have completed most of the probable drawdown in the near term (chart 2). To be fair, the correction in key mega-cap technology stocks or the leaders of the bull market has been much larger. The drawdown in the NASDAQ and NVDIA was almost 10% and 20% respectively from peak. We would also note that US equities have been in a sideways (“consolidation”) range since November. Albeit there has been considerable rotation within the S&P500 and between US and international markets. The world’s most hated markets: Europe and China have materially outperformed US equities year to date. It has been the ultimate pain trade.
Chart 2
On a longer time horizon, most measures of US sentiment and risk remain extremely complacent. The price to earnings valuation of the S&P500 is well above long term average and the equity risk premium is extremely narrow relative to history. In the credit markets, the high yield bond spread is one standard deviation below history. Implied currency volatility is also around half a standard deviation below average or extremely complacent compared to 2022, 2020 or 2008 (chart 3).
Chart 3
As we often note, there is an intimate link between liquidity, leverage, and volatility. Put another way, long phases of low rates and policy support (forward guidance, QE, and fiscal easing post 2020) contributed to an increase in leverage. Treasury Secretary Scott Bessent articulated this clearly: “We’re seeing the hangover from the excess spending in the Biden years. In 6 to 12 months, it becomes Trump’s economy.”
The hangover analogy is a good one. Policy easing to offset the hangover forever and ever with the “hair of the dog” (more easing) becomes a self-reinforcing or reflexive feedback loop. Bessent has recognised that the disease is the drinking (excess policy easing) not the hangover. To address the disease, the US Administration requires the reverse feedback loop. Of course, if the fiscal tightening is large enough the cycle might end in recession. Or as Dave Dredge would say, “the good outcome (for debt sustainability and Treasuries) is a recession.”
The implication for investors is that major phases of volatility have followed long periods of stability. Business cycles tend to be non-linear, not gentle, or smooth. If the US Administration achieves a reduction in the fiscal deficit to 3% over the next few years, that would be a meaningful reduction in the fiscal impulse or government contribution to growth and liquidity. In that context, the cost of protection, especially in credit, remains inexpensive for the potential payoff. Tactically, markets have priced a lot of the market unfriendly policies (tariffs and the breakdown of geopolitical alliances) as we warned at the start of the year. In the near term, there might be some relief if Treasury yields and the US ease. In the medium term, implied volatility and risk compensation remain too low.
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