Strategy note

The Sloppy, Choppy Mess in Markets continues!

A new market update from Chief Market Strategist Troy Gayeski

Troy A. Gayeski
May 5, 2022 | 7 minute read

Yellow light caution has now turned Orange light extra caution…Surprise, surprise 60/40 Equity/Bond allocations had another rough month…and now M2 growth has already slowed considerably prior to the Fed hiking aggressively and pursuing any material QT (Quantitative Tightening or balance sheet reduction)! The time for Alts is now!

  1. Another month of 2022 in the rearview mirror and another terrible outcome for the 60/40 asset allocation…the galactic mean reversion between financial assets and the real economy, particularly the hyper tight labor market, continues at a rapid pace.
  2. Since the S&P 500 Total Return is down around 12% and the Barclay’s Agg is down roughly 10% YTD (more than 3x the losses of 1994 so far for bonds…ouch). If I break out a slide rule or an abacus, I can calculate that a 60/40 allocation to the S&P 500 TR and the Barclay’s Agg is now down over 11% YTD. Holy cow…the time for ALTS is now!
  3. The good: The economy is still in reasonable shape driven by the consumer, business fixed investment and the potential for a major inventory rebuild. Recession risk is still low for the next 12 months, corporate earnings growth is still in good shape and markets have already priced in some degree of Fed Tightening as the S&P 500 forward P/E multiple has compressed by around three turns (from 21 to 18) and 10-year Treasury Yields have climbed by 144 bps so far this year.
  4. The bad: All the Fed has done so far is hike by a whopping 75 bps and brought themselves to stop buying stuff and drain a paltry $26 billion from the April 13 peak of $8.965 trillion (TR). Additionally, there is now a far greater probability of sustained real economic inflation for at least several more years than one could predict coming into the year, and investors are woefully unprepared for that scenario.
  5. The ugly: Now that both the February and March M2 Money Supply data have come out, we have seen a clear deceleration in M2 growth from 25.1% in 2020 and 12.3% in 2021 to mid to low single digits in February and March, despite the fact that the Fed was still expanding their balance sheet then. As those who read our Money supply growth report released last year know, when M2 grows faster than nominal GDP growth, financial assets tend to go up. When M2 grows slower than nominal GDP, financial assets have a much harder time going up and can, gasp, even go down. Given the forward trajectory of Fed policy, it is unlikely that M2 grows faster than nominal GDP again anytime soon. Yellow light caution has turned to Orange light extra caution! And if they follow through with unwinding $95 billion per month from their balance sheet later this year, look out below!
  6. Given the following economic and market backdrop: Sustained higher inflation and nominal GDP growth trouncing real GDP growth, a Fed that is behind the curve and moving to catch up with more aggressive hikes and potentially meaningful balance sheet reduction, M2 Money Supply Growth now at mid to low single digit annualized monthly growth rates in February and March, the potential for further increases in fixed income yields (aka losses in bonds), and the potential for further equity multiple compression (aka equities continuing to take it on the chin).
  7. The near-term asset allocation ramifications are pretty clear:

    Don’t Fight the Fed, High Five the Fed—Invest in strategies that have the potential to actually benefit to some degree from higher front-end interest rates such as floating rate Senior Secured Commercial Real Estate Debt, Interval Fund Credit Strategies that have a healthy exposure to Floating Rate CLOs or BDCs with assets that are primarily floating rate.

    Or can monetize heightened levels of market volatility or benefit from an inflationary environment: Market neutral multi-strategy, real asset focused funds that may continue to benefit from supply constraints and strong demand, an environment when Nominal GDP growth continues to vastly exceed Real GDP growth, or global tactical asset allocation strategies with an overweight to “Real Assets.”

Fight inertia and embrace strategies that have the potential to reduce volatility and increase return!

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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.

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Troy A. Gayeski, CFA

Chief Market Strategist

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