I wrote some months ago about the importance for any investor in the market to sit down and to start answering questions about where we are in this 2022, what do the current state of financial markets resemble in an economic cycle, where we could be going from here. I know and I understand how this is very difficult, no doubt about it. Events and developments in financial markets, but I would say the world in general, are not preordained, little is certain, and what we do in the present affects how events unfold, often in relevant and unexpected ways (the war for example).
Central Banks have been asked to address the problem they partially created: inflation. They have this duty as their primary objective. The FED likes to repeat the “nimble” word in approaching the economy and the markets, the ECB is trying to understand better the inflation, where it failed and how to improve from here. I suggest reading the Q3 Economic Bulletin of 2022, paragraph five, prepared by the European Central Bank. The paragraph has been written ?to explain the recent errors in the inflation projections of the Euro system. It is interesting to see when and how the deterioration of projection accuracy materialized and how this mistake increased toward the last part of 2021 and Q1 2022. After a careful study of the Bulletin, it is evident that the old models do not fit the reality and the technical assumptions played an important role in recent inflation underestimations. This is one of the current problems: relying on previous models for reading a reality that has been shaken by the COVID pandemic (external, unprecedent and exceptional shock), fiscal and monetary packages of enormous size (human factor), shape of the recovery from the economic reopening and the different and unusual consumer behaviors during and after lockdowns (human factor). It should be clear, for example - and to highlight only one problem- how the” simple oil price assumption” which was the most regular and prominent contributor to inflation errors for medium and long horizons is insufficient today for anticipating the CPI headline trend.
From the above, everyone can understand the complexity we are dealing with and the uncharted territories we need to explore and cross on daily basis. Any error, when committed, is not broadly comparable with previous mistakes of the past.
If nobody knows what is going to happen next, how do we limit and control the risks? How do we put together and reconcile our preference for certainty and continuity (the market we experienced in the last 10 years after the Great Financial Crisis) with the current market dislocation which gives us an opaque representation of the outlook? ?Is the market-based information and are prices a reliable source for preparing correct assumptions which are the base of any projection and portfolio allocation? Last but not least: how do we generate profits and position ourselves for the next opportunities?
Everyone with his own vision and risk/return preference, should sit down and try to address the relevant questions which should be able to highlight how the manager wants to manage risk, to generate returns, to distinguish himself from his peers by trying new things or by exploiting expertise and experience (the qualitative factors above the quantitative numbers).
These are the points that I consider important:
- No one among the existing portfolio managers in Europe or the US has ever traded in markets where inflation is at 8,5%/9%, where sheer market adjustments are happening in few months driven by Central Banks rethinking their monetary policies, where quantitative tightening is a new experience never tested before (similarly to what happened for quantitative easing), where there are new and rigid regulatory constraints and rules, where there are new actors involved (for example the private debt market) and where is such a strong concentration of firepower in few hands. This is enough for a good thinking and to be worried to put it mildly.
- Current prices and asset valuations are distorted as much as they were during the deluge of money available provided by Central Banks. The concept of relative value has been forgotten. An example is the leverage loan market in Europe which remained for at least a couple of months this year at an artificially high level against HY bonds because the CLO market went in “frozen mode”. I am not saying here we have reached levels in financial markets which are cheap or expensive, I am simply arguing how some asset prices are distorted against fundamentals and not in line among themselves under a comparable analysis. For mentioning another example, I am sure that the subordinated debt of financials and insurers will reserve major surprises over the next 12-15 months for the noteholders or for the investors who decide to remain sidelined in those sectors. The CLO market is another corner of structured finance where there are opportunities (and risks) for all tastes across capital stack and among the different vintages and new primary deals currently in syndication. As I did previously, I advise buyers to perform a deep analysis on the manager’s style, portfolio allocation, track record and organization because there are strong signals of future manager tiering and the drivers of this differentiation are already at work since several months. This is something never seen since the 1.0 CLO world. At least here we have a reference point, for what it is worth (not very relevant in my opinion: 1.0 and 2.0 are different moments that are not really comparable).
- Industrial corporates and financials did an excellent job in managing their liabilities and ratios during the previous bullish credit markets. They came out from the COVID period (which obliterated every economic cycle) without any apparent damage and with enough liquidity either provided by the markets or by the Government support schemes. I skip the debate on the leverage remaining in the balance sheets as I would like to introduce a different point. 2022 could be described a transitional year, but some maturities are arriving in 2023 and some financing solutions should be already in preparation. Investors have been served a new risk not seen since the Great Financial Crisis: the liquidity component. Everyone should start incorporating this risk and assigning it the right importance in any investment decision for the portfolio. I find the definitions of “mid-late cycle price behaviors” completely inappropriate and inaccurate for the reasons just written above. Take for example the Q2 earnings which are being released in these days and try to explain them without the big shocks we have seen in the commodity and energy markets. Which part of an economic cycle are we in at this moment?
- I do not believe staring into the rearview mirror will help us to connect the dots that are available at this moment and to provide us a reliable road map for the future. The past is not a reliable indicator of the future; it does not matter how far one looks back. The behavior of the US yield curve this year as I have written in previous posts, is another clear example of market dynamics at play that never happened before. The FED has started trimming its balance sheet and the pace of the unwind will accelerate in September to 60 billion per month of Treasuries and 35 billion per month of MBS. How much of this effect is already in the US curve? Is the curve inverted enough in the 5-30Y segment or not yet? Similar patterns and events are unprecedented and the past is not helping. Passing to Europe, the rate curve is too steep, another anomaly which looks unsustainable to my eyes as I wrote before. I have the view the credit curves will flatten but it is impossible to call exactly the inflection point: ?this week in the Euro area we have the first rate hike and we do not know the front-end reaction over the next 6 months. These are moments of exponential uncertainty and volatility where the” linear thinkers” struggle to find support from past experiences. If history does not repeat itself but sometimes it rhymes, the savvy investor should look at the past to find those rhymes and not the identical events which are currently present in the markets. In the last case the search will be useless and misleading. At the same time, it should be worth to look for and don’t ignore indicators and signals that don’t fit into familiar and comfortable boxes.
- It is important not to twist the numbers and stress tests to reinforce a strong conclusion and an investment decision that has been at priori already reached. I recommend being nimble, listen for any evidence that contradicts a guaranteed conclusion and a market consensus even if it starts to be accepted as general wisdom. Big conceptual mistakes taken on the US yield curve last year (the steepening trades) are the clearest evidence of a consensus which melted like an ice cream under the sun in this hot summer. Not having strong opinions but very good risk management allows to possibly prove any decision wrong and to shape the investment portfolio in a better way by discarding the positions which don’t make sense while accumulating exposure to others which do not encounter conflicting signals but strong confirmations over time. It is of course a combination of art, experience and risk practice.?It is not definitely the work of a mythical seer. The learning curve is very long; a strong risk management policy can facilitate the journey along this twisted curve by mitigating the subjective judgement.
PS: On the same day I posted my note on the ECB anti fragmentation tool (or call it as you like) another piece of research from a big bank came out supporting an opposite view and flagging exactly different points from what I have highlighted. I disagree with their conclusions: 1) the research does not take in consideration and ignores 10 years of vocal opposition from the Bundesbank. Axel Weber and Jens Weidmann for a long time were very clear in their counterarguments against the ECB quantitative easing and government purchases. They are not there anymore, but their legacy remains.2) the research does not explain why the spread of peripherical countries should tighten against core in an environment where rates go up: fundamental and historical reasons explain very well why a tightening cannot happen.3) the research does not say what is the target of this tightening vision announced in their pages: they do not say it because it is simply impossible to do it. They know this matter together with the ECB which indeed will never announce a target level for their protection tool. But meantime, they like publishing research...
Author: Sergio Grasso
, director at iason
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