With the Fed ending its POMO operations yesterday (March 9th) following a nearly 5tr USD increase in assets since the beginning of Covid, investors have remained skeptical if the equity market will be able to reach new highs in the medium term. The deterioration in the Russia/Ukraine conflict has left risky assets vulnerable since the start of the year, and the surge in inflation combined with a expected significant deceleration in the economic activity have increased investors’ cautiousness for 2022.
The chart below shows the strong relationship between SP500 and the Fed assets since the beginning of Covid. With the Fed balance sheet pausing at 9tr USD, could we see new all-time highs in US equities in 2022?
In addition to the consumer sentiment indicators, which have remained at ‘depressed levels’ amid Covid uncertainty in 2021 and the surge in inflation, the market uncertainty coming from the Russia/Ukraine conflict has increased the odds of a recession in 2022, particularly in Europe.
As war in Ukraine will lead to another inflationary shock, central banks will be ‘forced’ to tighten aggressively to tame inflation, which is approaching 10% in many EM and DM economies. As a result, the aggressive tightening response from central banks is very likely to accelerate the economic slowdown in the coming months.
Periods of surging ST rates have historically been followed by a significant deceleration in the economic activity. The chart below shows that the 2-year change in the 2-year US yield has strongly led the business cycle by 2 years in the past four decades. In the EM world, the impact is even faster with sharp increase in ST rates leading to economic slowdown in the next 6 months.
As opposed to the previous recessions in the past 30 years, governments and central banks will have limited ‘power’ this time as further stimulus and aggressive liquidity injections will lead to even higher inflation going forward.
Are we going to finally experience the ‘big bear’ equity market that a lot of participants have been waiting for in the past cycle?
In the past few months, we have seen that despite the significant decrease in economic surprise indexes, US equities have constantly been reaching new all-time highs, with the SP500 index breaking above the 4,500 level this week. We previously saw that the US mega-cap growth stocks (i.e. FANGs) have been mainly driven by the dramatic surge in global liquidity, which we compute as the total assets of the major G10 central banks.
As the FANGs stocks represent a significant share of the SP500 index (over 25%), the strong momentum in tech stocks have pushed the whole index to new highs.
Interestingly, the chart below also shows the strong relationship between the Fed’s balance sheet assets and the SP500 in the past year. As a reminder, when the Fed halted its POMO operations in the end of October 2014 (following nearly a year of tapering), US equities remained flat for 18 months and experienced several drawdowns before starting to edge higher in H2 2016 with markets starting to price in further stimulus (Tax reform plan, higher spending). See the article entitled ‘Could we survive without QE?’ that we wrote in September 2014 for more details.
Even though this time is different, there is still a lot of uncertainty over the economic recovery, therefore normalizing policy too early could halt the momentum in US equities in 2022. This is a challenging time for US policymakers as inflationary pressures remain elevated in both DM and EM economies and the Fed needs to normalize its policy in order to leave more room for a potential new economic shock in the future.
In the past year, central banks have been constantly injecting liquidity into the market in order to avoid the global economy from falling into a deflationary depression, which has generated a strong rebound in risky assets, especially mega-cap growth stocks. However, we previously discussed that the more liquidity reaches the market today, the harder the ‘COVID-19 exit’ will be. Equity markets have been diverging significantly from their ‘fundamental’ value in recent months and therefore a reversal in the stance of the Fed monetary policy could eventually result in a sharp selloff in US equities, which could have a significant impact on the real economy. This chart shows the strong co-movement between the 3-year change in the equity market (SP500) and the annual change in the US unemployment rate in the past 50 years; periods of equity weakness have been historically associated with a higher unemployment rate.
It the real economy robust enough to swallow a sustain period of equity weakness in the medium term?
One striking observation we can notice in the past cycle has been the speed at which the equity market recovers each time it experiences a significant drawdown (> 10%). For instance, while it took it took 7 years and 3 months and 5 years and 6 months in the past two economic recessions for the S&P 500 to recover to its previous highs, US equities recovered to their February 2020 peak in just 6 months after crashing by over 35% during the Covid19 panic.
As we previously mentioned, the drastic rise in liquidity to finance the high cost of lockdowns has been one of the major forces behind that historic rebound, and that a repeat of the 1930s period with stocks having a period of hope followed by a drastic selloff will be very unlikely this time.
Hence, market participants have constantly tried to buy the dip each time the market was experiencing a selloff. Figure 2 (left frame) shows that people were looking to buy stocks at the heart of the panic regardless of how dramatic the impact of Covid19 will be on the economic activity, especially on the service sector. Even though it has not always been a successful strategy in the past 100 years, ‘buy the dip’ has been a winning trade in the past 25 years (to the exception of 2002, 2008 and 2018); figure 2 (right frame) shows the average weekly performance of the S&P 500 following a negative week. If investors bought the dip in 2019 and 2020, they would have generated a positive average performance of 0.6% and 0.7%, respectively.
With another 3 trillion USD expected to reach markets this year (at least), we think that the ‘buy the dip’ strategy will prevail in the near to medium term.
Despite the 13% fall since March, investors’ sentiment on the USD is still extremely negative for 2021. We previously argued that central banks (ex-Fed) will not let the greenback depreciate indefinitely as it will dramatically impact the economic ‘recovery’ (i.e. Euro area is very sensitive to a strong exchange rate) and weigh on long-term inflation expectations. In addition, figure 1 shows that a weaker US Dollar has coincided with a positive momentum in equities in recent years, especially since the February/March panic; therefore, being long US Dollar at current levels could offer investors a hedge against a sudden reversal in risky assets in the short term.
Another interesting observation comes out when we look at the seasonality of the USD in the past 50 years; while December tends to be the worst month on average for the greenback, January has historically been the best performing month with the Dollar averaging nearly 1% in monthly returns since January 1971.
Is it time for a ST bull retracement on the US Dollar?
As we previously saw, the massive liquidity injection from major central banks to prevent the economies from falling into a global deflationary depression has generated a significant rebound in equities prices, especially for the mega-cap growth stocks. Figure 1 shows that the FANG+ index is trading over 50% higher than its February high, which was mainly driven by the surge in global liquidity.
In addition, the major 5 central banks (Fed, ECB, BoJ, PBoC and BoE) are expected to increase their balance sheet by another 5 trillion USD in the coming 2 years, to a total of 33 trillion USD, to cover the high costs of national lockdowns. As a result, ‘Wall Street’ strategists have constantly reviewed their SP500 forecasts for 2021 to the upside in recent months, with the average forecast rising to 4,035 in December according to Bloomberg.
With central banks ‘ready to act’ as soon as we see a sudden tightening in financial conditions (due to a drop in equities), the risk reward in the SP500 is currently skewed to the upside with all the liquidity injections expected to reach markets in the coming months.
Since the start of the year, we saw that the dramatic liquidity injections from central banks to prevent the economies from falling into a global deflationary depression has led to a sharp depreciation of most of the currencies, especially against assets with limited supply such as Gold, Silver and Bitcoin. The liquidity also generated a strong rebound in risky assets such as equities, reinforcing the trend on the mega-cap growth stocks (FAAMN companies). The NYSE FANG+ index, which provides exposure to 10 of today’s highly-traded tech giants, is now trading nearly 50% higher than its February peak, which has massively contributed to the recovery in the SP500.
In the past few months, we have noticed an interesting observation: it seems that the Fed (and other central banks) interventions have led to one ‘global trade’ as a significant amount of assets have strongly co-moved together in 2020. This chart shows the strong relationship between Bitcoin prices and the FANG+ index; a few weeks ago, cheaper equities due to the rise in uncertainty over US elections and the lack of stimulus has led to also lower Bitcoin prices. Are ‘Bitcoin bulls’ really hedged against a sudden reversal in equities?
Even though price volatility has eased significantly across all asset classes amid the massive liquidity injections from central banks, the market could experience another little selloff in the near term due to the rising uncertainty coming forward. In addition, we know that most of the risky assets tend to perform poorly in the ‘summer’ period that runs from May to October.
Although some investors may define silver as a risk off asset, we recently saw that the precious metal has performed very poorly during periods of market stress. We think that silver could experience some weakness in the short run, especially now that we are approaching the month of June. In figure 1, we compute the average performance of silver for every month of the year since 1982; interestingly, June has historically been the worst month with silver falling by nearly 2% on average. Time to sell and go away?
Source: Eikon Reuters, RR calculations
One particularity of a safe-haven asset is that it is negatively correlated with the performance of equities during periods of panic and selloffs. For instance, we saw that gold performed strongly in the past two equity selloffs, up 7% in Q4 2018 and 3.5% in Q1 2020 while equities were down by 14% and 20%, respectively. Figure 2 shows that silver did not act as a zero-beta asset and co-moved strongly with equities during the February / March panic. We strongly believe that investors have this chart in mind for the coming months and that a little 10%-15% drawdown in stocks in the near term will certainly lead to a little (bear) consolidation in silver.
Source: Eikon Reuters
Even though some analysts are currently saying that silver looks extremely undervalued relative to gold (gold-silver ratio is still elevated relative to its long-term average), we do not think that the ratio will matter in the near future and we could have another divergence between the two precious metals. Figure 3 (right frame) shows that prior the Covid19 crisis, a surge in gold prices had historically been followed by a surge in silver 3 weeks later since the start of 2015. However, we can notice that the two assets have strongly diverged in the past few months.
In this chart, we look at the performance of US equities relative to Treasuries over time. As you know, price volatility differs among different asset classes; hence, in order to compare the relative performance of equities versus risk-free securities, we need to vol adjust. Using monthly times series of total returns of the Bloomberg Barclays US Aggregate Bond Index and the SP500 index, we calculate monthly returns of each asset class and then adjust our US Treasuries exposure using the 1-year realised volatility of equities. We also rebalance our portfolio every single month so that the volatility of each asset remains constant.
As you can notice, the SP500 index has lost 65% of its value relative to bonds since January 1974, with a high of 77% reached in the last quarter of 2010. Moreover, in the past two economic downturns, equities have lost 20% of their values between 1999 and 2002 and 12% of their value between 2007 and 2009. We saw last year that US 10Y nominal yield topped at 3.25% and struggled to break higher despite a nominal growth close to 6% in the United States. With yield plummeting to 2% in the past 6 months, the bond market is currently pricing in a sharp deceleration of economic activity and some practitioners are expecting rates to fall to zero percent as fear over a 2020 recession have increased dramatically. This raises the following question: should we expect Treasury bonds to significantly outperform US equities once again in the next economic downturn?
Chart. SP500 vs. US Treasuries – Total Return. Source: Bloomberg, Eikon Reuters