Human beings are not particularly good at non-linear thinking - an observation we have made in the past. 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.
As we noted last week, the recent macro news flow on employment, retail spending (overnight) and inflation in the United States has reinforced the material shift in consensus beliefs on the path of short-term interest rates. That has been our fear since the start of this year and why we have positioned more defensively again over the past two weeks. We have very little fixed rate exposure in our portfolios. We reduced our equity exposure further today.
There has been a material rise in Treasury yields across the yield curve. The December 2024 SOFR Implied yield has increased by 140bp from the December low back to 5%. That has reinforced US dollar strength, especially against lower yield G10 currencies (JPY) and a tightening in broad financial conditions (chart 1). That is a meaningful shift in the prevailing bias from seven rate cuts at the end of 2023 for 2024. From our perch, there were two troublesome elements in the inflation data. First, this was the third consecutive upside surprise. Three months is arguably a trend, not an aberration. Second, core services ex shelter rose 0.7% and accelerated to 4.8% year on year. That is both a shift in trend and from a structurally higher level. This has been reinforced by resilience in final demand (retail sales control group that is calculated for GDP rose by 1.1% in March).
Chart 1
The probable re-acceleration or potential second wave of inflation pressure is a consequence of the US Administration running irresponsibly loose fiscal policy. The related consequence is on the path of future short term interest rates. It suggests that current policy rates are not restrictive. As we noted last week, rates remain below nominal GDP. The implication is that the Fed is unlikely to cut rates and might even need to hike the funds rate again in this cycle.
In this context, US equity valuations are expensive in outright terms and relative to Treasuries. The equity and credit risk premium are non-existent and equity volatility is too low. While there has clearly been a potential momentum/trend shift in equities over the past week, it is notable that the US high yield credit premium is still only 314bp and 200 basis points below the long run average. Implied equity volatility at 19, is not high by historical standards.
Chart 2
Another important development over the past few trading sessions has been “correlation.” For multi-asset portfolios sovereign bonds have again failed to provide diversification for equities. This is a related challenge for other popular strategies like “vol targeting and risk parity” strategies. It is also plausible that CTA or trend following strategies have or are about to flip. The big picture p oint is that there is likely to be self-reinforcing or reflexive gamma from investors who are short convexity.
Note that we have not made any observation here on the Middle East. We have always been reluctant to be “armchair generals” and pretend that we have an edge in geopolitics. That said, it has clearly been an additional element contributing to the deterioration in risk perceptions. However, our sense is that the more important development for markets has been trends in macro conditions, inflation expectations and the path of future short rates. In that context, risk compensation is poor, and the cost of protection is inexpensive.