Strategy note

Don’t get carried away with the hype: Galactic Mean Reversions don’t end overnight!

A new strategy note from Chief Market Strategist Troy Gayeski

Troy A. Gayeski
February 1, 2023 | 13 minute read

2023 has started with a bang for the 60/40 after last year’s Nightmare on Wall Street. My message is simple: Don’t get carried away with the hype, particularly for equity markets and, to a lesser extent, long duration fixed income.1 Let’s hit some macro and then talk about some timely strategy ideas:

  • There has certainly been meaningful progress on inflation, particularly CPI and core PCE, but service inflation ex-Shelter is still close to 40-year highs. Remember: Once inflation spreads to services and inflation, it is much harder to break.
  • There has also been better news from Europe and China. Europe, both politically and economically, has fortunately benefited from an incredibly warm winter and may avoid near-term recession. In China, it appears (key word appears) that Chairman Xi is going for growth again after a series of suboptimal policy decisions.
  • However, the Fed still has a few more rate hikes ahead and, more importantly, is still shrinking their balance sheet and draining liquidity (M2) at an unprecedented rate.2
  • Additionally, the Fed still wants tighter financial conditions to weaken economic growth and curb sustained inflation. So far this year, markets have told the Fed to pound sand as financial conditions have loosened significantly (higher equity multiples—S&P 500 back to 18X 2023 earnings, lower long-dated interest rates—10-year yield back to 3.5%, tighter credit spreads—high yield bond spreads back to 423 bps). Remember, the Fed always gets what they want…eventually.
  • As discussed in prior strategy notes, the U.S. consumer had been single-handedly keeping the global economy afloat, and two months in a row of declining consumption does not bode well for future economic growth.
  • Earnings growth is still deteriorating, driven primarily by margin compression, slower nominal GDP/revenue growth (from a combination of lower real economic growth AND lower inflation) and eventually, by a high probability of recession sometime later this year or early 2024.3 All of these factors do not bode well for continued appreciation of equity markets.
  • In the very short term, however, since the labor market is still incredibly resilient, government spending has increased, and non-U.S. growth has been an upside surprise, growth and inflation could persist for long enough to drive at least one more round of higher yields and price declines in bonds.
  • For equity markets, we still expect a lower low, based on monetary tightening and money supply contraction driving another leg down in equity multiples. After that, the final low will be driven by margin compression and a recession driving a substantial earnings decline. However, it is possible they merge together later this year into the ultimate cycle bottom.
  • The bottom line is there will almost certainly be more downside for the 60 and more than likely another modest hit to the 40 in the short term. Additionally, with the 10-year yield dropping from 4.25% to around 3.5% recently, investors have lost approximately 75 bps of recession protection from longer-dated fixed income.

  1. My last quick, broader macro point is that risks to markets have now evolved from all about the Fed coming into 2021, to the Fed and geopolitical in late Q1 and Q2 of last year, to the Fed, the economy and geopolitics up until recently. Now, there is a new risk that, in my opinion, has leapfrogged geopolitics for the time being: The debt ceiling. It may turn out to be much to do about nothing, but given the dysfunction of the voting process to elect Kevin McCarthy to Speaker of the House and continued polarization in D.C., it is hard to have much confidence that the debt ceiling increase debate will go smoothly. If it is a messy process, the market reaction could be violent. So now, in order of importance, the known risks to markets are the Fed, the economy, the debt ceiling and geopolitics.
  2. So, what to do in this environment?
    • Continue to focus on the northwest quadrant of the efficient frontier strategies. Maturely guide clients to more realistic return expectations and do not aggressively reach for risk.4
    • If you are going to reach for risk, make sure you remember “Cash Flow is King.
  3. Now, on to timely strategy ideas: The first idea is known as a “Yield Curve Steepener,” which, given the starting point, has, in my opinion, one of the more attractive risk/reward profiles for playing an eventual normalization of nominal GDP to real GDP (inflation gradually receding). It is an exciting new opportunity for multi-strategy funds that can, at times, behave in a noncorrelated manner to other widely held assets like equities:
    • First, the background: It is rare for the U.S. Treasury yield curve to be “inverted,” meaning longer-dated interest rates like the 10-year Treasury Yield are lower than the Fed Funds rate or the 2-year Treasury yield for a variety of reasons. The most important reason being the U.S. banking system and investors in debt securities have little incentive to lend money for long periods of time if they can just hoard cash at a higher rate of return.
    • Typically, inverted yield curves only occur when bond market participants are fairly certain the U.S. economy is about to enter a recession, which will cause the Fed to cut interest rates to normalize the curve OR the Fed is acting aggressively in a temporary fashion to crush inflation (real or imagined) OR BOTH! In the current environment, I would definitively say BOTH are causal factors.
    • As you can see from the chart below, the current level of yield curve inversion (10-year yield—2-year yield of negative 69 bps) is as high (or as low to be mathematically correct) as it has been since the late the early 1980s…ring any bells? As you know the current environment has many similarities to the early 1980s:
      • A previous period of time where inflation surged.
      • A previous period of time where financial assets got torched.
      • A Fed driven to crush inflation after underestimating the probability of inflation surging and its pernicious effects on the U.S. political system and economy.
      • A majority of investors expecting an inevitable recession driven at least partially by aggressive Fed tightening.
    • As you can also see from the chart below, the yield curve has historically typically steepened up substantially prior to a recession and then continued to steepen further as the economy began to grow again.
    • In the short term, the curve could certainly invert further if the Fed keeps hiking aggressively and the bond market keeps saying recession is right around the corner. However, if either turn out to be correct, the strategy may be profitable:
      • If the Fed is correct and the economy stays stronger for longer, it’s hard to imagine that back-end yields don’t pop back up at least temporarily and reduce the level of inversion as it becomes more apparent that inflation has become even more entrenched.
      • If the bond market is correct and we enter a recession soon, the Fed may end up cutting sooner than they expect and reduce the level of inversion as they cut rates.
      • Additionally, if the Fed can somehow achieve the fabled “soft landing” and constrain inflation without causing recession, the curve should normalize to some degree and at least revert to flat.
      • Further out in time, unless we enter a 1970s-style stagflationary nightmare (which we doubt given the fact that M2 has been contracting now for almost 10 months vs. never-ending mid-teens growth of the 1970s), we are at a loss for explaining an environment where the yield curve does not once again have a positive slope (10-year yields are greater than 2-year yields).
    • So how do you try to take advantage of this phenomenon? Well, the trade expression is actually fairly straightforward: Consider taking a duration1 neutral long position in 2-year Treasuries or 2-year Treasury futures and take short positions in 10-year Treasuries or 10-year Treasury futures and sit back and wait. Given the current level of inversion vs. typical historical yield curve slope (positively sloped), I estimate this trade has around 3 units of return per 1 unit of risk (hence the statement “arguably one of the best risk/reward profiles for playing an eventual normalization of nominal GDP to real GDP as inflation gradually recedes).
    • There are a few important considerations:
      • Initial sizing is important, not only because it will be volatile but can easily go at least slightly against you in the short term (a 69 bps inversion can go to 75 bps or 80 bps or even 100 bps).
      • If the curve inverts further (and thus, longer-term expected returns and return vs. risk profile increase), you need to have the capacity to increase the exposure into short-term mark-to-market losses. If you max out at initial sizing, it is much harder, if not impossible, to ramp up the exposure further into short-term mark-to-market losses.
      • Targeted return expectations may take at least quarters, if not years, to achieve.
      • As a reminder, this may be one of many different strategies in a well-managed multi-strategy portfolio.

Yield curve is at a historic extreme

10-year minus 2-year Treasury yield

Source: National Bureau of Economic Research, Bloomberg Finance L.P., as of January 26, 2023. Shaded areas represent NBER dated recessions.
  1. The second example is less of a single strategy and more of a long-term potential secular shift: Overweight small to mid-cap domestic stocks vs. U.S. large and mega cap stocks. This is an exciting long-term opportunity for tactical asset allocation strategies and a shorter-term idea for multi-strategy funds:
    • Ever since the Lost Decade for U.S. Stocks (also known as the decade of Emerging Markets or the BRIC’s (Brazil, Russia, India, and China) to the few who were fortunate enough to have had meaningful exposure), investors have struggled to find a new secular theme to provide some degree of meaningful outperformance to U.S. large cap and U.S. large cap tech stocks in particular…all to no avail (until January of this year, of course, courtesy of a weaker dollar and modestly less bad growth overseas, which we see more as a countertrend move).
    • As we think through the ramifications of deglobalization and how it predominantly impacts multinational corporations in terms of access to cheap labor, supply chains, non-U.S. demand and earnings/free cash flow margins, in general, I keep coming back to the same conclusion: Over time, small and mid-cap domestic stocks finally have a potential chance to meaningfully outperform U.S. large and mega cap.
    • Remember, Corporate America—particularly large cap multinationals—was the biggest beneficiary of globalization due to plentiful access to cheap labor, but it also relied on efficient supply chains to deliver the goods (no pun intended) to American consumers. As globalization turns to a more fragmented world order, American multinationals may suffer disproportionately. For a more detailed read on the potential impact of deglobalization on S&P 500 earnings and free cash flow, please take a look at the wonderful paper my colleagues Lara Rhame, Brian Cho and Andrew Korz recently wrote on the subject.
    • Small and mid-cap (SMID) U.S. SMID Cap’s with primarily domestic production and labor pools could potentially suffer less from additional margin frictions. Thus, SMID cap earnings power should deteriorate to a far lesser degree.
    • Additionally, the current valuation discrepancy between U.S. SMID cap and large cap is near the highest levels it has been in over 20 years.
    • Now, obviously when one is substituting one long U.S. market cap focus for another, you will still have beta and volatility, particularly when liquidity is draining away, which could potentially cause SMID cap underperformance in the short term. However, over the following three, five and 10 years, the fundamentals of deglobalization favor SMID cap total return to U.S. large and mega cap stocks.

Now, fight inertia, embrace democratized alternatives, try to improve client outcomes and grow your wealth management business!

Investing in alternatives is different than investing in traditional investments such as stocks and bonds. Alternatives tend to be illiquid and highly specialized. In the context of alternative investments, higher returns may be accompanied by increased risk and, like any investment, the possibility of an investment loss. Investments made in alternatives may be less liquid and harder to value than investments made in large, publicly traded corporations. When building a portfolio that includes alternative investments, financial professionals and their investors should first consider an individual’s financial objectives. Investment constraints such as risk tolerance, liquidity needs and investment time horizon should be determined.

  • Duration: A measure of a bond price’s sensitivity to changes in interest rates. Given the inverse relationship between bond yields and prices, a bond with a longer duration should theoretically experience a larger price decline when rates rise or increase than a bond with shorter duration.

  • M2: M2 consists of M1 plus (1) small-denomination time deposits (time deposits in amounts of less than $100,000) less individual retirement account (IRA) and Keogh balances at depository institutions; and (2) balances in retail money market funds (MMFs) less IRA and Keogh balances at MMFs.

  • Margin compression: Margin compression occurs when the cost to make a product or conduct a service increases faster than the sale price of that product or service.

  • The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are suboptimal because they do not provide enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are suboptimal because they have a higher level of risk for the defined rate of return.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Troy A. Gayeski, CFA

Chief Market Strategist

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