Fed Up

It seems the U.S. monetary overlords have finally 'got religion' on inflation. That sudden clarity has provided a turning point for market participants that only comes once a cycle. The fuse has been lit for the end of the bull market in risk assets. For investors trained to buy every dip for years, it might come sooner than you think.

A stock market that has been nurtured on a steady diet of easy money for too long is unlikely to remain unscathed when the central bank is in catch-up mode. This tightening cycle may ultimately lead to a relatively soft landing for the economy, especially if the Russian/Ukraine situation is somehow diffused. But risk assets do not have any wiggle room from a valuation standpoint. The chart below (courtesy John Aitkins - TD Securities) shows the quick evaporation in the equity risk premium that has already occurred since the Fed moved to a more aggressive stance and bond yields spiked. Add to this, a short-covering rally in equities from the oversold lows, and the equity market is at its most expensive level relative to bonds, since the pandemic bottom.

This past week has seen an acceleration in the bond bear market, including fresh lows in the prices of high yield and corporate securities. Equities have been shielded from the carnage as investors have latched on to the 'inflation proof' argument for equities. Leadership groups like energy and materials are the new TINA trade as high PE stocks and banks are now lagging, seen as vulnerable to the bear flattening curve that has suddenly developed.

The explanation for this week's equity resilience is simple. Financial assets have been inflated by a monetary policy designed for a slow growth/low inflation regime that no longer exists. But getting to a neutral level for the price of money is hardly a given. They are starting from a long way back. Bonds still look 'expensive' to inflation. Yesterday's highly transparent trial balloon from chair Powell wherein he intimated a 50 basis point hike is in order, came only a week after the first 25 move. Now that they are suddenly jamming on the brakes, I don't believe they can actually get to anywhere close to 'neutral' without at least a fender-bender.

Equities are acting very much as they should, given the alternatives. As we review the history of the 1970's stagflationary episode, I'm reminded of the low equity risk premiums that existed back then. Long bonds yielded 9% while equity PE multiples were in the low teens. Terms like 'asset value' for hard assets stocks like oils and metals replaced normal price-to-book arguments and their PEs remained high. Bank PEs were single digits but became value traps. We could possibly see a similar collapse in the risk premium of equities over bonds, as the 'no alternative' argument for stocks gains credence? Stay tuned.

Realized volatility has recently outpaced implied volatility as investors thrash about in an illiquid market. This tells me that the bull market mentality has not gone away yet. Yet it has begun to narrow. Leadership has migrated to inflation beneficiaries. But commodities are an unsatisfactory replacement for bonds in the portfolios of the risk-averse aging boomer retirement plans due to their high beta volatility nature. And how long before the 'supply shortage' argument is replaced by the 'demand destruction' one, as real incomes become crimped by an intractable price spiral?

We have just entered spring, usually the time for renewal. For equities, the seasons are reversed. Winter is just around the corner. The equity market correction may have quickly abated, but the Fed has embarked on a path to a more existential crisis for the bulls. Is it too early for 'Sell in May' anyone?

Risk Model: 2/5 - Risk Off

As I noted above, implied volatility has dropped suddenly as the positioning of portfolios had become overly negative and the risk-on rush to rebalance met an illiquid tape. Major option positions were unwound, further squeezing the shorts. I don't expect this low implied volatility environment to persist.

The trend to higher volatility is still intact.

3 Month Implied Option Volatility