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Welcome back to Fourth Lane's Off the Charts podcast, where every two weeks we cover three market headlines that matter.
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I'm Andrew Siner, Portfolio Manager.
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And I'm Vanessa Hui, senior client advisor.
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Three big things to cover this week yields, equity market breadth, and building portfolios for an inflationary world.
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Okay, let's get started.
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Andrew, in your view, what's the most important factor driving markets right now?
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Yeah, this is a really easy question because it's one thing and it's having an impact over all financial markets.
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So the 10-year and the 30-year hitting levels not seen since 2022.
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The 10-year and the US Treasury bond curve is the instrument everything in finance is priced off of.
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Therefore, rising rates reverberate across the financial world.
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Whether that be hyperscalers, raising debt, highly levered assets like real estate and private equity.
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In these instances, it impacts cash flows, but even valuing a company.
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At the end of the day, everything is a DCF and the discount rate, which is tied to the yield curve, is used to value these companies.
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And then lastly, you have government finances.
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So starting with the first couple, the hardest part from a portfolio management perspective in a rising interest rate environment is everything is going down mostly due to this DCF dynamic.
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And that's why this year we've seen equity markets experience multiple contractions.
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And the only reason they're up is being driven by earnings growth.
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So in a month like last month, you're standing there fully invested, and you're just wishing you were just in cash.
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And that's really the only place to hide, whether it be equities, bonds.
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But even as interest rates rise, things like gold that don't even have cash flows, that don't experience this DCF dynamic, which is discounted cash flows, tend to come under pressure.
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This is because of really substitution effects.
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All of a sudden, it now feels like there's opportunity costs to owning a non-productive asset.
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Simply speaking, an investor says, Oh, five and a half percent, that looks good.
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Let me lock in that return.
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I'm gonna buy bonds instead of buying equity, or they sell their gold to lock in that five and a half percent.
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In this
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instance, most overlook the tax impact of buying those bonds, but nonetheless is driving behavioral finance.
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Outside of equity prices, two things I think about.
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One, systematic risks.
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There's this chart of a declining 10-year yield.
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And effectively every time the 10-year breached its channel, there would be some sort of systematic event.
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You don't know what it's gonna be.
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It tends to be black swan in nature, but it's something like the Yang Kerry trade blowing up or some other forced delevering event.
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So I just think of it simply as rising interest rates build pressure across the financial system.
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And then number two, remember Treasury Secretary Bassens 333, he wants 3% treasury yields.
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At current levels, the US government is like borderline insolvent.
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Maybe not exactly, but I think it was every shift up in the yield curve by 1% added $118 billion to the US deficit every single year.
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Over a decade, that's over a trillion dollars.
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So to balance the books, which the US definitely wants to move in that direction, they want to see a lower yield.
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So we can also look to an environment like the 1970s where, oh, they inflated away debt and interest rates rose dramatically.
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But I think the difference here is debt levels were much lower.
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So rising interest rates would really impact US government finances.
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Maybe they could thread the needle and still inflate away the debt with yields where they are, but I think it's a lot easier to get yields down to two to three percent.
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So it's really an instance where if something is unlikely to persist, it won't.
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And I think just the US government is so incentivized to bring the yields down, they'll find a way.
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So, how might this happen?
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Well, initially people were pointing to oil as driving the tenure.
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Well, oil fell a bit, tenure didn't really move.
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Then we can look to inflation and the hard part on the inflationary side, like we just got job and wage numbers.
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That's certainly not an issue.
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Housing is not an issue.
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So it's really just energy prices driving and flowing through the economy, and rising yields aren't gonna help create more energy or end a war.
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So, yes, this is impacting it, but there's nothing really they can do about it.
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So we look to economic growth, and that seems really the only path to getting out of this situation is they need to slow the economy down.
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Probably it's gonna be a situation where if you remember back to 2023, it's like this soft landing.
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So they want it not too hot, not too cold, but they need to slow the economy enough to bring the yield curve down.
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And the risk there is always like you over-tighten.
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All right, now let's look at equity markets.
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The SP 500 was up in September, but that doesn't paint an accurate picture of what's going on in markets, does it?
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Correct.
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So I would split equity markets into two camps.
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And I mean, this has been the framework for the past couple of years: AI and non-AI.
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So Meta released Muse last month, reigniting the excitement for the AI complex.
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Muse is like an AI personal assistant in your pocket.
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I wouldn't say it's revolutionary, but it's been onboarding more users onto AI and other AI uses.
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And we've seen the download trajectory of Muse is actually faster than Chat GPT.
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So AI continues to move at the speed of light.
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And the AI complex is inherently going to be narrative driven as the market grapples with is this a bubble or is it not a bubble?
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And increased use cases are ultimately going to increase demand for compute, which is going to prop up the entire complex because then the hyperscalers spend more money, and most companies within these supply chains are going to benefit.
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For non-AI stocks, the equal weighted SP 500 is now down seven weeks in a row.
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The SP 500 is just 2% off its highs, but the average stock is down 17%.
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If you decompose the sectors from last month's performance, you had tech and communication services in the green and then everything in else in the red, with the majority of sectors down more than 5%.
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If you looked at the WrestleMan worse.
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The Russell 2000 was actually in mid-August.
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So a month and a half ago, it was up almost 27% year to date.
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Now it's up only 15%.
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Pretty much the exact same as the SP 500, and it's given back almost half its gains year to date.
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And this is really just a function of multiple compression.
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Nothing has really happened on the economic side.
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There's been no earnings releases, so no
concern.
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And earnings have been the thing driving markets thus far.
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And even if we had taken a step back and looked at the market going into this month, the market actually had run into some multiple compression, and it's all earnings that are driving the show.
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So as we approach Q3, potentially we see a world where earnings take hold again.
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It gives the market something to fixate on.
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And then maybe you get a double whammy of falling yields, which would do even more work and allow potentially for multiples to mean revert.
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Again, the risk is just like there's over tightening and the economy slows too much.
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And then you really end up in an issue where the government has to spend more money.
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And that's probably another good point.
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We talk about an elevated yield curve and this multiple compression.
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Realistically, if the government wants to cool the economy, they need to figure out a way to cut fiscal spending.
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And it's the easiest lever to pull.
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And then just lastly, the other thing I'm watching is midterms.
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So no more red sweep.
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The market will appreciate the certainty post-midterms.
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If you look at any seasonality chart, the market tends to rally beginning around now as the market no longer has to deal with the uncertainty of midterms.
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And we we're likely to get a gridlocked Congress, which you know what could allow markets to rally.
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Now for our last topic, oil prices and inflation seem to be rising again.
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Andrew, how do investors prepare for re-emerging inflation?
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This is a good question.
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So first let me explain the dynamics that ultimately hurt asset prices and it ties into the portfolio construction conversation.
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So what you tend to see in these inflationary environments is commodities appreciate in price, which then commodities are large input into inflation calculations.
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So inflation then rises, and then the yield curve and interest rates follow.
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So as we found out in 2022, most portfolios contain a hidden bet on low stable inflation.
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And this is why effectively everything was down in 2022.
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Equities, credit, private equity, real estate, etc.
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They all benefit from good growth and low inflation.
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So the first thing you want to do is evaluate your portfolio and see how much exposure do you have to highly levered asset classes and the asset classes previously mentioned.
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You can also look, I think like a backhand exercise is just look at how these asset classes performed in 2022 as a good sense.
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If you want to expand that exercise, expand it to the 1970s.
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And there's some good papers out there that evaluate how various different asset classes perform during various inflationary shocks.
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The hardest part for your average investor is really that inflation breaks the classic stock bond diversification relationship.
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So typically how the 6040 portfolio works is if my equities are down, my bonds are up.
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That's what makes it such a nice, simple framework.
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But in an inflationary world, what tends to happen?
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Inflation hits, interest rates rise, it hits the value of your bonds.
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And then next thing you know, it hits the value of your equities through multiple compression.
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So both sides get hit at the same time and there's no diversification.
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And as we know, diversification is only free lunch and investing.
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So if you're going to own equities, you want to skew towards value equities.
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This is because, as I've spoken about in this podcast, these inflationary and high interest rate periods, they tend to hit multiple.
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So if you're investing in these high multiple stocks, there's just less margin of safety than buying at something at eight to 10 times earnings.
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So that's the first thing you're going to want to do.
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Next thing you're going to want to do is probably sell your bonds.
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But again, in a broader portfolio construction context, the issue is if we do get a deflationary environment or if we do get a major financial crisis, there's a reason to own bonds.
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And I think that's the beauty of the all-weather framework that we use, that no matter what's happening in the world, we own something that is going to be benefiting from the economic environment.
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So turning more to pure play inflation, the best thing to own in these periods, as mentioned, is commodities.
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And that's effectively because definitionally commodities are a large part of the inflation calculation.
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So if commodities are up, that actually is the one driving inflation.
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And the thing is, commodities are grossly underowned.
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So one of the things I look at is the UBS family
office survey.
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And it's like your average family office owns only 2% commodity and real asset exposures.
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So everybody's underweight.
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Even living through 2022, nobody is prepared for this world.
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Most are skewing towards things like growth equities, which are actually on the opposite end of the spectrum.
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And look, it's just recency pies.
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They've done so well over the past 40 years.
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People just extrapolate that into the future.
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Next thing I would look at would be stores of value.
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So something like gold.
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Maybe you could even look at something aspirational as a store of value like Bitcoin.
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But the challenge is, is like every episode of inflation is going to be different.
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In 2022, gold didn't do great, whether that's because a lot of the returns were pulled forward in 2021 or they lagged and we're seeing the rally now because of it.
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The issue is if there's a sharp rise in interest rates, you may suffer from that substitution effect.
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Then we can look at things like breakevens and inflation-link bonds.
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So breakevens should do pretty well here.
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And a break-even is effectively you're long the inflation-link bond and short the treasury to extract the inflationary tracking component of the inflation-link bond.
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The challenge is what we're seeing right now is breakevens aren't moving despite inflation moving up.
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And we're seeing everything flow to real yields, which, you know, maybe this is a function of markets are thinking CPI might be manipulated lower and you know the inflation tracking component won't benefit.
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And then looking at inflation-like bonds, well, they did pretty terribly during 2022, which despite what the name might suggest, it turns out inflation-like bonds have duration.
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So that's why we would look at something like break-evens probably to return well.
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But inflation-like bonds could do quite well in the world where there's yield curve control and they wouldn't be impacted by inflation.
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The quants who tend to write these papers, they always love trend following.
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But I think of it more broadly that you know what hedge funds do okay.
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Multistrats were one of the few sort of categories of investments and broader absolute return hedge funds that were up in 2022.
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Now, these aren't broadly available to retail investors, but these can be very valuable in a from a portfolio management construction, despite the fees, because again, there's no duration and they can provide diversification benefits when everything else is selling out.
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And then every inflation episode is going to be different.
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So you want to take a basket approach on a little bit of all these types of asset classes if you believe that inflation is coming.
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So to summarize the three topics we're looking at this week, rising yields are the most important factor in financial markets right now, from our perspective.
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Equity markets continue to be bifurcated between AI and everything else.
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And finally, commodities tend to be the best inflation hedge, but there are a variety of exposures to seek in an inflationary world.