What do you know that the market doesn't already know?
- sebastienpautrot
- Apr 9
- 3 min read
09 April 2025
A mentor of mine used to say in these moments, “what do you think you know that the market doesn’t already know?” We know that the Donald has a maximalist hard-line stance on China. Price and valuation already reflect that. The drawdown from peak and the oversold condition is now close to pricing a recession. However, it is not fully priced, and equity prices can decline further in the very near term.
As we have noted, one of the key challenges in this episode is that the US stock market started from a poor risk-reward position. Even adjusting for the 20% drawdown, the S&P500 at 18 times forward earnings is still in the 81st percentile of all valuation observations (and that is before the probable downgrades to earnings estimates). The long-term average valuation (85 years) is 16.7. As have also noted, the poor risk-reward starting point was also reflected in crowded positioning, beliefs, and concentration in US mega-cap technology. The strong prevailing bias or belief in “American Exceptionalism.”
As we noted earlier this week, the price action is NOT an emotional overreaction. It is a fundamental shock to global growth, profits, and trade. It is warranted. That is an important distinction. However, there are also parallels to the 2020 episode. That caused a sudden stop in global final demand and dislocations in trade. In that sense, the current episode is also policy driven and will likely pivot once a deal is agreed. We don’t know when, but a deal will be arranged. Another parallel is the TARP package in 2008. From memory, it took Congress three votes, and considerable pressure from the markets, to approve that at the time.
What has also changed in the past few days is the correlated sell-off in US Treasuries (rise in bond yields), the widening in credit spreads, funding market spreads and correction in gold. From our vantage point, that suggests investors and corporates are starting to face funding and liquidity stress. Put another way, the policy driven episode has morphed into a liquidity crisis. If credit spreads widen materially further from here, the episode might develop into a solvency crisis. As we have noted, the risk-reward starting point in credit was also poor. Even today, US high yield spreads only trade at 453 basis points relative to the long-term average of 500 basis points. If equity volatility is sustained and a deal with China is delayed, the warranted high yield spread is probably well over 1000 basis points. In these moments you discover the hidden leverage.
Chart 1
As we argued earlier this week and is clear (known) Trump is likely to maintain a brutally hard line in the near term (on China). However, if liquidity and funding markets start to exhibit extreme stress due to counterparty and other solvency risks, the Administration and the US Federal Reserve will have no other choice but to inject liquidity and pivot. What we also know is that there was a genuine impact on global growth, trade, profits, and confidence last Thursday. We have stress tested our own equity holdings for a 50% decline in earnings. On an adjusted basis, the portfolio trades on around 14 times earnings. We also hold a very large proportion of the portfolio in cash (just under 40%). Clearly, we wish we had even more at the current moment. No one should be a seller of equities here.
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