“Bonds promoted as offering risk-free returns are priced to deliver return-free risk””
Shelby Cullom Davis
The above quote serves as a stark reminder of the long-held belief that the bond market knows better. Warren Buffett, the Oracle of Omaha, echoed a similar sentiment in his 2012 letter about the prospects of so-called risk-free bonds. Lo and behold, how risk-free return has delivered return-free risk for investors (Chart 1).
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“Things are seldom what they seem, skim milk masquerades as cream.”
W. S. Gilbert
Seems like the adage “anything that can go wrong will go wrong” has been turned upside down by Mr. Market. Despite rising interest rates YTD, US equity market has continued to climb a wall of worry. Central banks’ data dependence, declining inflation, high nominal GDP growth, EPS recovery & AI frenzy – what more could go right!
Given this uncanny backdrop, in our latest market insights, we try to uncover what Mr. Market – “wisdom of crowds1” – might be up to as we cover the most pressing topics on investors’ minds & give a sense about portfolio positioning.
▪ What are the key takeaways from YTD price action.
▪ What is US equity market signaling.
▪ What is the driver of US economic surprises.
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“In the short run, the market is a voting machine but in the long run, it is a weighing machine”
Ben Graham
As the narrative of human subservience to artificial intelligence has gained traction, speculation is ripe that Tech sector will be the main beneficiary and earn abnormal profits.
However enough has been written already about the YTD market frenzy and its narrow breadth in the backdrop of FED pause and AI revolution, so in our latest monthly market insights, we will share our two cents by simply framing the facts against the narrative. After all, a picture (s) speaks a thousand (s) words!
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“If one tries too hard to be precise, one runs the risk of being so narrow as to be irrelevant”
R. J. Shiller
Conflicting signals from “equity vs bond” market and “actual vs survey” data has many investors confused. So elusive is the nature of this cycle that only time will tell what the market was precisely up to. Mindful of this uncanny backdrop, in our latest market insights, we first try to broadly cover the most pressing questions in investors’ minds and then give a sense of portfolio positioning:
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“You think you understand ‘one’, you must also understand ‘two’, because one and one makes two. But you must also understand ‘and'”
Rumi
This 12th century mystic poet may well have written the above quote on behalf of the uncanny Mr. Market, “the wisdom of crowds1”, because who could have conceived that amid a banking crisis, the aggregate value of financial assets will increase (Chart 1).
As two US large regional banks and an EU GSIB failed, the fear of contagion not only propelled Central Banks to take prompt action but also helped ease the perceived risk of policy overtightening. Heads I win, tails I win moment for financial markets?
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“Stand by me nobody knows the way it’s gonna be”
Failure of Tech friendly banks – Silicon Valley & Signature – and demise of private banking crown jewels – First Republic Bank & Credit Suisse – sent shockwaves through the global banking system instilling fears of a contagion.
Nobody knows how this film “Bank Run 2023” will play out, but our sense is that if it does it will be “short and extreme” because while bank run seldom happens, when it does, it’s no marathon, rather a sprint. Regardless, it accelerates or not, there are likely to be long term economic consequences from banking channel.
With that in mind, in our latest Market Insights, we first cover the US regional fallen angels, the importance of US regional banks, and what this regional banking crisis may portend for US economy. With the help of T-Accounts we then map the flow-of-funds that may have taken place among US regional banks, US big banks, and the FED, along with base and worst-case scenarios for banking sector.
Furthermore, we try to make sense of recent price action and signal from financial markets. Last but not the least, we try to preempt reaction function of policy makers given the situation at hand and the signposts that may help investors in navigating this uncertain environment.
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“Risk means more things can happen than will happen”
Elory Dimson
The above quote is a tell-tale sign for pessimists that history has sided more often with optimists. That said, reasonable risk compensation matters and in our latest market insights, we will try to do just that i.e. eke out the elusive equity risk premium. But first let’s try to make sense of yesterday’s price action and, since daily moves can just be noise, also the year-to-date trend.
While yesterday’s inflation data was a tad higher than consensus, the equity market was rather unfazed. Yes, the market promptly repriced the likelihood of higher-for-longer interest rates, yet cyclical and long duration equities ended the day higher whereas equity volatility lower. The same price action holds true this year – with cyclical and tech sectors outperforming defensives at the same time as rising nominal and real yield in the backdrop of an inverted yield curve (chart 1 & 2).
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“The future is already here; it’s just unevenly distributed”
William Gibson
Usually, we find this famous quote by a speculative fiction author and often used by “inventors” apt for “markets” too. However, at this juncture, it seems that the future is now looking rather evenly distributed in the market, especially equities. In the build-up to FOMC, we have been highlighting the “inflection point” in markets amid the “divergence” between signal from risk assets and yield curve. Now that Jerome Powell clearly stated in his press conference that the disinflationary process has begun and that FED is not concerned with improving financial conditions, markets have marched on to greener pastures of a soft landing.
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Gong Ci Fa Xai!
In our last market commentary, we highlighted that with improving global financial and growth conditions markets seem to be reaching an inflection point by transitioning from a recession to a global soft-landing scenario, but this same set up may also lead to higher-than-expected inflation, in turn causing the FED to hold rates higher-for-longer.
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Looking back, it was a very tough year for markets with almost every long duration financial asset down on average 20% in dollar terms.
Absent Santa rally, this year too was feared to be not so rosy but as we often forget, markets have an uncanny ability to price the expected and bring out the unexpected.
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