The real world
My wife and I have both had COVID in January. Markets are down and there is the threat of war in Eastern Europe. No wonder I am feeling grumpy. On the upside, the bond market might be taking a break from worrying about an even more hawkish Fed. Elsewhere, equity markets are becoming better valued (although not cheap enough for the bears). It could be worse. You could have bought Bitcoin at $68,000 and be sitting on a 58% loss. For all its faults, give me the real world any day.
There are some big corrections underway in markets. I calculated current total return index values as of the close of markets on the 20th January relative to their highest levels of the last twelve months for a range of fixed income and equity assets. The Nasdaq composite index has lost 11.8% compared to its peak and the S&P growth index 10.8%. On the fixed income side, market peaks came earlier than has been the case for equity indices, but the moves are still spectacular. An index representing the 10-year maturity and above part of the US Treasury market is down 8.9% while a representative UK gilts index has fallen 7.8% in total return terms. The best relative performers have been fixed income assets with limited interest rate sensitivity (leveraged loans flat, short-duration US high yield just losing 0.43% and European inflation linked bonds being less than 2% below the high in terms of their total return index). The outperforming equity indices have been the FTSE-100 and the major European indices such as the Stoxx 50 and 100. Value is beating growth, low-risk is bearing high-beta.
Valuations are adjusting, and risk premiums are rising. The drivers are clearly the impending shift to a tighter monetary environment, the deteriorating growth/inflation trade-off and the rise in geo-political tensions. In terms of monetary policy expectations, we might have done most of the travelling with now four rate hikes priced in for the Fed for 2022 and an additional three priced in for 2023. I would have thought the global economy and financial markets can cope with that – after all the context is that it will take the Fed the best part of two years to reverse the interest rate cuts it put in place in the space of less than two weeks in March 2020. If market pricing is correct, we will be back to where we were in terms of interest rate levels on the eve of the pandemic – no more than that. I also doubt that the Fed’s balance sheet will be reduced to below where it was as a percentage of GDP in March 2020 (20%) over the same time period. Yes, financial conditions will tighten but we are not talking Volcker levels of monetary restraint here.
Bit of duration anyone?
The bond market is already showing signs of stabilising – at least temporarily – and perhaps that most of the heavy lifting has been done. I still see a core scenario what pushes nominal US Treasury yields to 2.5% as an intermediate target in this cycle, based on real yields moving to around 0% and a break-even inflation rate in the 2.25% to 2.50% range. But the fixed income market is littered with torn-up research reports from the last decade predicting higher yields. It may happen but perhaps not in a straight line. As markets wait for the Fed and in the knowledge that the next couple of inflation prints will still be in the 6% to 7% range, higher yields could tempt some buyers. Despite pricing in higher Fed rates, the hedged yield from US fixed income assets into Euros or Yen or Swiss francs is still significantly superior to yields available in local markets – even with the Bund yield poking its head above zero percent this last week.
Away from considerations of inflation and rates, markets are also watching the situation on the Ukraine-Russian border. I don’t for the life of me believe that markets can price what might happen in these kinds of events. The outcome is only binary at a very simplistic level (Russia invades or doesn’t), but even that begs the question of what markets should respond to. Of course, safe assets would perform very well, equities would tank because of the risks to economic growth, and the dollar would soar against the Euro because a war in Ukraine would be very much Europe’s immediate practical problem (refugees, even higher natural gas prices, the need for a united response by EU nations). But it would get complicated very quickly in terms of the response from the West, how brutal the conflict would become, whether Belarus would be brought into the fray, and what financial and economic sanctions or actions would be taken by either side.
Russia does not want NATO on its doorstep, which would be the result of Ukraine joining the organisation. There is also a school of thought that a key driver of Russian political ambitions for many, many years has been to secure access to a warm-water port for its naval forces. Many western observers argue this was the reason for the annexation of Crimea in 2014. Exerting more control over Ukraine would be a way of securing more access to the Black Sea. A way out of the current crisis is for Russia and Ukraine to strike some new relationship which rules out Ukrainian membership of NATO but who knows whether that is realistic. In the meantime, Russia has a strong card to play in terms of natural gas supplies to Europe and further increases in prices could do real damage to European economies, including the UK. At the time of writing it doesn’t look good and I suspect that some of the market moves outlined above might extend even further should the situation deteriorate over the next few weeks. After COVID, we could really do without a war in Europe.
Tanks on the ground, disruptions to energy markets, volatility in the prices of financial assets. These are real world things. The real world is where food is grown and distributed, where health professionals treat illness and save lives, where natural disasters happen, threatening communities and businesses. Yet there is a growing obsession in some quarters with a virtual world. We have virtual “money”. The metaverse is enabling the creation of virtual real estate and businesses. All things crypto are starting to be part of the financial infrastructure and are even being considered in asset allocation decisions. Am I missing something here? I can see the value in the extension of digitalisation to make online transactions more interesting and efficient (Walmart is apparently developing a virtual super-market!) and clearly gaming is a major form of entertainment for millions across the world. But real utility comes from the consumption of real goods and services and wealth can ultimately only be created through value added in the real world. I note that Bitcoin and other crypto prices have tumbled this week with Bitcoin down 58% from its November dollar price high. Not exactly a stable store of value is it? I guess what gripes me the most is that a vast amount of attention is being devoted to the virtual world and a vast amount of computing power as well. I would rather see the effort and the resources put into developing more quickly renewable energy, electronic vehicle charging infrastructure and the development of alternative fuels like hydrogen. If we don’t get our priorities right, the real world will end up like on the of those dystopian world’s beloved by gamer.
I think a lot of soccer fans these days think the game is like as it is represented on Football Manager or FIFA. The reality is hard training, emotion, well-being, tactics, skill and luck. It’s great when all these come together, it’s frustrating when they don’t. For 45 minutes they did for Manchester United this week, the result being a 3-0 victory over Brentford. The scorers, all products of the youth academy (do they even have that on Football Manager?). Thank goodness those players spent a lot of their time as youths training rather than all of it in a dark room playing fighting games on a PC.