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December 2022 - January 2023
AAM Magazine
Dec 2022 - Jan 2023

Resisting the Market’s Persistently Wrong Signals

  • Asia
  • Global

From faster and lower to slower and higher -- that’s the latest chapter in the Federal Reserve’s inflation-fighting playbook. Such a plot twist should come as no surprise to investors who as recently as 12 months ago were confident that the Fed would raise rates only once in 2022. The market’s credibility in forecasting interest rates is demonstrably poor, and it has been dead wrong about the new inflation paradigm. Just like the Fed, the market is simply playing catch up with economic data. 

I sense that the economy is much more robust than most anticipated. While careful not to fall victim to anecdotal bias, I’m struck by the buzzing crowds in New York City at bars and restaurants – from Monday night dinners to Wednesday lunches. This observation seems to be corroborated by the resilience in economic data, suggesting the Fed will have more of a challenge to rein in inflation - and so, the risk is for more rate hikes, not less. Policymakers can hike more slowly but cannot afford to stop until inflation comes down, which won’t occur until demand for labor — a key input of services inflation — softens. This conclusion seems to be lost on many market participants, judging by credit spreads that still underprice recession risks and the drastic swings in risk assets whenever blips of favorable inflation data surface, even though the data don’t change the fundamental picture.

This environment produces enormous volatility that has been historic in scale and span, rendering the execution of long-term positioning a grueling endeavor. As such, we should respect the current state of the market and think nimbly and creatively about opportunities that shield us from the whipsaws of the broader market.

That means owning high-quality, shorter-duration products with a low probability of default and avoiding corners of fixed income that are particularly sensitive to the global economic cycle. We prefer structured products and agency mortgage-backed securities. Also, long positioning in the high yield basis appears attractive, as synthetics trade cheaper than cash securities. CDX generally outperforms cash during big selloffs, adding cogency to the long-basis trade. Meanwhile, we prefer to reduce our below-investment-grade exposure as well as our overall cash credit exposure. Long-duration, low triple-B credits are also an area of worry as we enter a downgrade/default cycle. While our research on credit migration indicates single-A long corporates are poor alpha generators over the long term, I fret much more about the short-term repricing risk of fallen angels in lower BBBs than in single-As.  The market will likely continue to reprice the risk premium of assets that are sensitive to economic cycles, even though investors get distracted occasionally by the reality of the persistent inflation impulse.

Similarly, another source of beta risk stems from money center banks. While banks are fundamentally sound and the sector has the benefit of healthy liquidity, we should seriously consider their contribution to overall portfolio risk. Ample issuance in the sector gives us ample opportunity to get invested again when the timing is right. In emerging markets, higher-rated, higher-quality paper seems quite expensive on a relative basis, while lower-quality issuers are fraught with restructuring risk. I view local rates as a high beta bet on global inflation receding – and an absolutely great place to invest when inflation trends lower. We’re not there, quite just yet. 

Nevertheless, I should emphasize that I am incredibly bullish over the medium and long term. Value has been created, and the sequencing of our risk-taking should be first getting long duration and then long spread risk. Markets will likely undergo a broad rate rally as central banks get closer to reversing the tightening path, provided that inflation cooperates by rolling over. When the turn arrives, we must take advantage of the full extent of our allotted risk budget. As such, it’s important not to get locked into high levels of risk long before the turn arrives.

We should buckle up, as it is going to be an illiquid, data-driven market heading into the year-end. The risk of market dysfunction remains elevated as dealers struggle with binding capital constraints; a balance sheet that’s already saturated with high-quality liquid assets; and hung bridge loans that banks are forced to keep on their books. Government bond auctions are increasingly delicate, particularly in gilts and Treasuries. Ultimately, extreme market volatility is a classic sign of poor trading conditions, which should generally be considered a red flag for risk-taking when the macro environment hasn’t yet given central banks the license to pivot.