The Great Undiscounted Risk

Friday, August 5th, 2022

Our models expect a bear-steepening in the US yield curve

There is a widespread and unspoken assumption that the Fed will curtail QT if the US economy starts to suffer and that there are no circumstances in which it would accelerate it. We think this assumption needs to be tested. Our models suggest a bear-steepening in the US yield curve is more likely than continued inversion or a bull-steepening. If we are right, this can only be bad news for US and global equities, because our models suggest that the equity rally is completely explained by the recent collapse in 10-year yields. Indeed, equities have underperformed bonds on a risk-adjusted basis since the end of June. If the bond market becomes less supportive later this year, we think there is another significant down-leg in store for equities.

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Normality Reasserts Itself

Friday, May 27th, 2022

Monetary policy distorted the mechanics of risk and return

The huge monetary interventions during the pandemic in the US and other countries were designed to protect equities from a surge in economic and financial risk. They succeeded, but at the cost of distorting the normal relationship between risk and return: specifically, the excess volatility vs the excess return of equities vs bonds. This is now reverting back to normal. As the volatility of equities rises relative to the volatility of bonds – and this figure is well below its long-run average, let alone its potential peak – their return relative to bonds must decline. The only developed market which may escape the worst of this adjustment is Switzerland.

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Who Sets the Weather?

Wednesday, November 15th, 2017

US monetary policy vs the real economy in China

We may be about to witness a live experiment as to who sets the weather for global equity markets. Is it monetary policy in the US? Or is it the real economy in China? Conventional wisdom says it will be the US, but investors should know that our sector-based cyclical vs defensive indicator in China has started to move towards defensives.

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Walking, Not Charging

Wednesday, September 27th, 2017

The bull survives if the Fed can keep volatility low

If we understand Janet Yellen correctly, there are no constraints in the real economy which critically affect the speed at which US interest rates can rise. But there must be a critical constraint, and we believe it is the requirement not to upset the low volatility environment in US equities. If we are right, the Fed wants an environment where single digit returns from equity are seen as risk-efficient, and a correction does not turn into a bear market. If they manage this, the bull market can carry on, but it will be walking not charging.

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Financial Rotation

Wednesday, July 12th, 2017

No evidence of co-ordinated global tightening

The new big idea is that Financials are responding to the prospect of a co-ordinated tightening of monetary policy which will steepen yield curves round the world. At a sector level, there is some superficial evidence to support this, but when we look are individual stocks, particularly in Europe, we see that there are other and better explanations.

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The Hurdle

Thursday, June 29th, 2017

Excess volatility & how central banks respond to it

We use excess volatility as the hurdle rate by which equities must beat bonds, in order to be risk-efficient. In the US, it has just hit a new low going back to 1995. In the Eurozone, it is at a new 20-year low. Risk conditions have never been more benign. This means that they are very likely to deteriorate, possibly quite soon. We also think that central banks want this to happen – but not too much.

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Low Hurdle

Wednesday, January 11th, 2017

Excess volatility set to stay near historical lows

Many analysts cite a possible break in the regime of low volatility as a potential threat to the performance US Equities. They are right, but they only have half the story. A rise in equity volatility only matters if it is NOT accompanied by a rise in Treasury volatility. If it is, there is no change to the hurdle rate which determines the risk-efficiency of equities relative to bonds.

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