Explaining my shift in tone briefly

I have an interview with Mark Ritchie coming up in an hour and I wanted to write a specific post about the changing tone on Credit Writedowns because of it. I last spoke to Mark in June. And he was a wide-eyed bull, telling me that the 3- 6- and 12-month technical indicators were all green for him. This was at the time of the re-opening when I was telling you the recession was over.

If you look back, despite calling the recovery, it’s clear that since that time, I have been focused on downside risk – and perhaps excessively so. Time and again since then we have seen pandemic-related economic problems, which is the reason for my caution. Yet, time and again we have also seen the global economy power forward, overcoming those problems. And risk markets have done well as a result.

Early this year, I started with a glass half full mentality – writing about hope and risk on January 7 and previewing my shift toward thinking about upside more and downside less.  Around that time, I spoke to Darius Dale and Lakshman Achuthan, who operate different forms of macro forecasting models. They are both looking at accelerations and decelerations in macro growth for signals to think about upside opportunities and downside risks. And both gentlemen told me in January that we had a green light at least for a quarter, if not more.

It’s taken me a long time. But slowly I have come to discount the pandemic as a driving economic force. The light at the end of the tunnel is palpably close. And I believe policymakers will indeed do whatever it takes to get us through the tunnel without another major economic downdraft. I also increasingly believe this effort will be successful.

So, I have moved from talking about downside risks to upside opportunities (and risks). That’s what’s happened here. And it basically means tail hedges in bonds are more in my mind than in equities.

As markets undergo jitters, the August 12, 2020 post I wrote on “Momentum stocks as a long duration secular stagnation play” is the one I am now using as a frame. So re-read that one to get a sense of where I am coming from.

Here’s the salient point that I mentioned in today’s post – thinking of earnings from an options framework:

if you think of all of this from a derivatives market perspective, with low earning or long duration momentum stocks, you’re effectively buying a long-dated call option with huge amounts of implied volatility. The premium is huge because of the huge optionality.

The problem is that the time-value decay is also huge. And that can be measured based via the discount rate. If the discount rate goes up, the option value gets crushed. And that’s what happens when interest rates rise in a world of secular stagnation.

If there is even a brief interest rate or inflation expectation shock, interest rates go up. And then, the option value of a Nikola or a Tesla goes way, way down. That’s a world of huge portfolio rebalancing, equity fund and ETF withdrawals, margin calls, and rising volatility.

It’s not necessarily a down market per se. You could see a rotation out of growth into value due to a reflation-associated rise in inflation expectations and rates. That means bear steepening in bond markets and increasing nominal and real GDP growth plus increased earnings growth due to GDP and operating leverage.

But, the (temporary) rate shock could also be one in which growth remains weak, and therefore earnings for both value and growth are reduced. That would be a scenario of rising volatility, lower equity prices and lower bond prices, a perfect storm.

This is what I believe is playing out right now. And while there is likely to be higher volatility, absent a decline in real GDP I find it hard to believe we will see a durable bear market. It’s a situation in which you have five possible outcomes:

  1. A halt to curve steepening
  2. Rising long rates met by policy intervention
  3. Rising long rates followed by a shift in policy and rising short rates
  4. Rising long rates causing a shift in private portfolio preferences away from growth and toward value
  5. Rising rates triggering a credit cycle end and recession

That’s where I am now. I hope this is clarifying.

Now, it’s to Mark Ritchie.


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