Why is Everyone Still Going for it on 4th Down?

It’s as if the hard knocks of 2022 meant nothing. Two months into 2023, many investors still believe the playbook (relying on Hail Mary bailout economics) employed by investors over the past 12 years remains Holy Scripture. What’s unfortunate about this view is that it misses (or worse, ignores) the paradigm shift that will (and should) fundamentally alter which plays to call and when.?

Team Reckless

First, the inverse correlation between bond and stock prices no longer holds as persistent inflation holds for the first time in decades. Second, as Katie Martin and Harriet Agnew at the?Financial Times ?put it recently, “One big difference for investors now is that the safety net from central banks—their ability to roll out rate cuts and bond purchases that prop up markets whenever trouble hits—is simply not possible.” In my view, the obvious issue for these Hail Mary types is that their only hope is to catch the easy money thrown by central bankers. I would go so far as to say that a good number of these passive investors cannot survive without that easy money. Their play? They go for it and use their lobbying power to influence central bank decisions in their favor—a real pile-on to force central banks to continue easing. Hence, the pullback of easy money will be non-linear and messy. Why? Well, let’s look at how we got here.

In response to the economic impact of the pandemic, the U.S. increased the money supply by nearly 40%, which in turn triggered the following:

1. Explosion of tech/growth market capitalization
2. Explosion of debt levels across the world: U.S. HY market, private credit market, and leverage loan market each became a $1-1.5 trillion market
3. Zombification of credit markets where low-quality debt kept getting issued and default rates collapsed

I believe this then created a culture where the markets expect easy money to keep the bad debt and zombie companies on the field forever. But the reality is, that’s likely not happening.?

In my view, the Fed knows that if it is going to return the U.S. economy to a sound monetary system, it needs to call an audible. It must get the money supply back to the trend line, which means a negative growth rate of the money supply—reversing Quantitative Easing in all its forms and raising rates. The negative growth rate of the money supply will mean the tightening of liquidity.?Assuming zombification and the collapse of default rates were driven by a 40% increase in the money supply, a reverse will surely send things in the opposite direction.?

To be clear, we are early in this paradigm shift. The layoffs have started in earnest, and the squeezing of high and low earners is accelerating. The Fed has signaled it expects to keep raising rates—further depressing bonds and equities; every bank CEO is saying pain is coming. And yet still, markets (the Hail Mary types) refuse to admit defeat.

Yes, spreads in high yield and investment grade have widened, but put into historical context, they remain unchanged. These levels may seem ostensibly attractive for some investors, but are they wide enough? Whatever your opinion, spreads alone don’t tell the whole story.?We must also look at defaults.

We see a massive dislocation between the palpable, real risks affecting businesses and the market values at which their debt trades. Spreads may seem wide, but current levels do not compensate investors for defaults at any level close to the historical average (recent history devoid of inflation, by the way). The “default party” has not even started. However, several guests have arrived: free cash flow deterioration, higher costs of capital, a new world?order of energy ?(prices), and a global trend toward isolationism are already starting to uncork the champagne. What is making matters worse? If they play out, the biggest tail risks are cataclysmic for some, as volatility in credit markets has collapsed as several market players have stopped buying tail hedges.?

Team Thoughtful

Few market participants have experienced anything like the market we are heading into. However, these impending defaults and ensuing selloffs may present an attractive landscape for certain players.?

For the first time since 2009, bonds are taking up a larger share of portfolios as investors expect bonds to rebound. In other words, what was considered alternative investments over the last ten years are now becoming attractive, and value investments are popular once again.?I might not always agree with the Fed, but those who get emotional about challenging the Fed will likely lose. As I said, the game has changed, and those who take a thoughtful posture in the final minutes, on fourth down in an era of recklessness, will now win out.?

There will be a lot of pressure from the political class to force central banks to take the risk of de-anchoring inflation expectations and (I pray not) make the U.S. more like Brazil/Argentina.?If the Fed chooses to take that risk, we expect a much bigger tail risk down the line.

It’s fourth and impossible. The age of riding the wave of central banks is over. Admit defeat and walk off the field.?

P.S. The Kansas City Chiefs went for it on 4th?down the?second least ?number of times this season.