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Good morning. The minutes from last month’s meeting of the Federal Open Market Committee fell yesterday at 2pm and they turned an uneven market, amid an uneven shift in growth in value, into an ugly mess. It seems that the minutes were worse than expected. Ethan and I didn’t look that way. However, this section seems to have taken people by surprise, setting a vague time frame around quantitative tightening:
Some participants also noted that it would be appropriate to start reducing the size of the Federal Reserve’s balance sheet relatively soon after the start of raising the rate of federal funds
How important quantitative tightening will be for the market and the economy is debated, but regardless of your view of this, this formulation (and the use of phrases such as “measured approach” in the following sentences) is consistent with our view that the Fed has turned tactically , but not strategically. This Fed will move, but slowly, unless inflation gets worse.
In any case, the Fed’s perception of the hawk only adds fuel to the growth trend in value – but the increasingly relaxed consensus on the long-term path of the pandemic is the real driver. More on that below. Send us an email: firstname.lastname@example.org i email@example.com.
Reflation trading is an Omicron trade
The reflex trade – betting on faster growth and higher interest rates – returns. Maybe he’ll stay this time.
The narrative was somewhat clouded by wide sales after yesterday’s Fed strike, but remained intact. Since closing on Monday, the technology-focused Nasdaq has lost 4.6 percent, up from 2 percent for the S&P 500. Notably, sales pressures have not bothered the Nasdaq banking index, which is up 2.3 percent from Monday (banks are benefiting of both higher growth and higher short-term rates).
The ratio of Russell values and growth index has risen sharply in recent days:
There is logic here. As rates rise, we expect investors to favor stocks with current cash flows over those offering the future – the discount rate is rising. If stock markets are working as they should, any semi-decent recovery should have this effect.
One of the ways this change is taking place is that a wave of normalcy is sweeping markets that have become demented. Meme stocks and cryptocurrencies were shattered on Wednesday. James Solloway, Chief Market Strategist at SEI Investments, reminded us that in the last decade, normalcy has not been, uh, normal:
We think that rotation from the most expensive areas of the market, especially in the technology sector, has long been delayed. We have achieved growth that has surpassed value, indeed since 2010 or so, soon after the stock market began to recover from the global financial crisis.
We had a hint that rotations were in progress [in late 2020 as studies rolled out showing high vaccine efficacy], but that started to disappear after the Delta variant started to take off. And investors have mostly returned to the proven and true.
In other words, the weak recovery from the last crisis caused a rush of growth in the market that was lacking. Now a false dawn in late 2020 and early 2021 could only give way to bona fide recovery, based on new evidence that Omicron’s threat to the economy is less serious than Delta’s, and the increasingly popular view that this latest variant could give way to a virus-free world. , hopefully, a little more than a persistent nuisance.
Reacting to the technology sell-off, Qie Zhang, a fund manager at Abrdn that specializes in technology and media, argued that investors need to differentiate between FAANG and nonprofit technology. Where long tail technology consists of far-reaching bets on growth, shares of FAANG (and several others like them) are companies that generate huge cash flows here and now. They may have a small hit, but are less likely to lag behind the market.
However, all this depends on the medical facts of Omicron. If it turns out worse than we expect, we could go back to the old pattern. A more deadly variant of Omega or some other unforeseen medical relapse cannot be ruled out. Reflation trading is, more precisely, the Omicron trade. (Ethan Wu)
Procyclicality of private markets
The liquidity premium of private capital is important – how big it is, whether it exists at all.
Many investors believe that we are in a world with a low yield, which is why their return targets will be difficult to achieve (they are probably right). They are allocating more to private markets to solve this problem. They hope to tie their money in return for many years, reap a liquidity premium, or have chosen a really smart private equity manager to surpass, or that private equity investments will be optically stable returns (they are not marked on the market) will flatter their reported risk-adjusted performance. Most of them are probably hoping for a combination of all three.
The liquidity premium is closely related to the simple idea that private capital managers – private equity and private debt funds – are long-term players. They take advantage of cyclical market fluctuations, instead of bowing to them, buying high and selling at a low price. When times are tough, we are told, private equity funds put their dry powder to work and, perhaps more importantly, can support their portfolio companies, allowing them to invest through the cycle and avoid default.
Maybe there is truth in this. But the latest Bank for International Settlements quarterly review contains a report that undermines one particular aspect of this story. Sirio Aramonte and Fernando Avalos argue that risk-taking in private markets is as pro-cyclical as in public markets:
While private markets represent end-investors with long horizons, they appear to be as pro-cyclical as public markets. Allocation of capital in [private markets] is positively correlated with stock market returns, ie. more transactions end in bull times. . .
. . . the sensitivity of private market investment to stock market returns is almost identical to that of borrowing and public offerings
Part of the explanation for this is very simple. In bull times, discount rates are lower, increasing the present value of future profits. This is almost tautological. But there are some specific reasons for the pro-cyclicality of the private market:
. . . some of these transactions require bridging or issuing high-yield bonds, which are inherently pro-cyclical. . . In general, leverage can contribute to pro-cyclicality. Fund managers can support higher debt when their net asset value rises, thus expanding their balance sheets.
Here are charts showing the relationship between the volume of different types of transactions in the private market and stock market returns:
The relationships are very similar to those between leverage and the volume of IPOs and stock returns. These two markets are considered to be highly pro-cyclical:
Managers of private market funds buy when markets are high.
(The top of the hat for Policy Tensor to highlight the BIS report in a tweet).
One good read
On Adam Tooze’s good Chartbook blog, nice cool analysis of the fierce debate on price control in response to inflation.