No muss, no fuss


The last 3 months have been a rollercoaster ride. Anyone who’d slept through this period would be forgiven for thinking “what was all the fuss about?” The US equity market in particular has celebrated in earnest, taking the S&P 500 back to its early August levels. While other equity markets have been less ebullient over the last few weeks, they have nonetheless enjoyed a modest resurgence – all must be good in the world again!

One factor driving the turnaround has been the Fed’s inaction, with markets having effectively bullied the Fed into blinking at the prospect of a September rate rise, particularly in the absence of an economic “smoking gun” in the form of clearly strong economic data or rising wages / core inflation. While the Fed’s job is clearly difficult, those shouting the loudest for ongoing monetary support are those that have benefitted the most from it so far and continue to benefit the most from the Fed underwriting their risk positions. However, if the Fed continues its apparent hypersensitivity to short run market volatility then capital will continue to be misallocated.

At some point though, the Fed’s hand may be forced. The market’s current focus on inflation seems more fixated on the headline numbers, which are of course heavily influenced by trends in energy prices. As this effect abates, and the effect of the stronger USD moderates, it is probable that inflation will start to drift higher. Forward indicators of wages are also rising against the backdrop of a tightening labour market. While there are clearly some soft patches in the US economy, much of this relates to the production side which constitutes only 10-15% of overall demand.

Our concerns around this are twofold.

The first is that investor capital has flowed to assets that are levered to the continuation of zero interest rates and the implicit central bank support for asset markets. The economics of many of these investments (like infrastructure & A-REITs) may make sense should this assumption be validated, but would likely unravel quickly should interest rates rise. We’re are not talking here about rates returning to historic norms, but even if US 10 year bond yields rise to 3% (from 2.1% currently), valuations of interest sensitive investment would look significantly different. Likewise, even the broader US equity market is tracking along extended structural valuations, in large part related to the ongoing low level of rates.

The second is about perception. In the current environment some inflation is the preferred outcome (it’s clearly one way to de-lever). If inflation were to start to rise and the Fed (and other central banks globally) are at zero and still stimulating (in the case of Europe and Japan via QE), then the possibility that the Fed is behind the curve would likely come into play. This would prompt the market (if not the Fed and other central banks) to reprice to reflect the mismatch between policy and the economic risks. In short, rates would rise and yield curves would steepen.

We are certainly not suggesting that this is the only way things could evolve. There are risks to the downside which could validate low yields and Fed intransigence. But this scenario is perhaps even more negative for risk assets, as even low rates would not be able to provide sufficient support given extended starting point valuations and collapsing earnings. Either way we think caution should still prevail.

Having been “cashed-up” in early August we were able to take advantage of this volatility adding to both equities and credit (high yield and investment grade) amid the market lows of late August and early September. Having seen markets rebound (US equities in particular) we have again cut our risk position, this time through buying protection against renewed volatility in US equities via a 4.5% S&P put option position. This reflects both the relative cheapness of volatility, and more fundamentally that prospective returns from US equities have again diminished given the concentrated gains in this market. The overwhelming driver though, is that we do not think a lot has changed.

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