2022 Theme - US Financial Conditions: Why Are They The Key Metric To Watch?
Last week we argued that one of the key factors to watch for the current volatility and asset rotation from growth to value to become a more serious market rout will be tightening US financial conditions.
So we thought we should begin this week with a quick update on that metric.
The good news is that, as we suggested earlier, financial conditions are still very loose.
Historically so, see here:
Yes, it is true they are coming up slightly relative to the record lows. This rise is largely thanks to more expensive mortgage rates.
US home loans are now back to pre-Covid levels. The average 30 year fixed rate is now over 3.80% and has climbed for 4 straight weeks.
That rise is representative of the negative side of the financial conditions debate.
The rapid rate of change (for mortgages) may be just as important as the level. As financial conditions have started to tighten the sudden and steady rise in the cost of some capital is driving expectations of more and, just as importantly, causing a psychological shift that is building its own momentum.
As they say in Dune, "fear is the mind killer." Well, fear of higher interest rates is also, apparently, the killer of certain speculative assets.
Some of this is the growth vs value trade off we have spoken about before and some of it is simply traders trying to adjust to the new normal of higher cost of funding and credit amid the real uncertainty of how fast the Fed will move.
We should find out more information - hopefully - this week with the Fed's FOMC meeting.
Still, on the question of whether this financial conditions tightening presents trouble for the actual economy, rather than just over priced assets, the evidence is mixed.
Normally, credit quality is central to the question, and high yield bond spreads are really not moving much. You can see a popular index of US high yield bonds here:
High yield bonds are named such because they belong to less creditworthy companies and so the thinking is that they will sell off first in the event of something that will harm economic growth.
You can see what the arrival of Covid-19 did to those spreads in late Q1 of 2020......
So, overall, what do sharply down markets+tranquil high yield bonds suggest?
Two key takeaways:
Volatile and "risk off" markets suggests that investors are worrying about a Fed mistake. A mistake would be if the central bank raises rates too quickly to combat inflation and the cost of capital becomes too expensive for the US economy.
However, at the same time, tranquil high yield bonds also argue that company profits are robust and therefore that the Fed can raise rates safely and, in fact, should!
So, net-net, the uncertainty is driving nervousness but there are very little clearly negative news, for Wall Street or for Main Street. In fact, inflation expectations may be coming down already.
And while it is leading to a fair share of dramatic headlines and somber talking heads, the S&P 500 is only down 8% this year. Just barely beneath its all time high after a spectacular 29% run in 2021.
What has changed significantly is, as we covered last week, that we are in a new interest rate hiking regime which is leading to a significant shift in what investors prefer to own.
Very evidently, there is zero appetite to own unprofitable companies and highly speculative assets like cryptocurrencies. Here is the ARKK ETF we mentioned last week compared to the S&P 500 since January of 2020.
Assets that did very, very well under the Covid regime of ultra loose monetary policy and ultra generous fiscal policy have now given up ALL of their outperformance.
If you own the whole market you are fine. If you own highly priced and "fashionable" ETFs du jour you are in major pain.
We are moving past Covid (we hope) and so we are moving away from what has done well under pandemic market conditions.
Why is this happening though?
Well, putting the fees of the likes of ARKK aside, owning companies that are unprofitable is very suboptimal when the cost of capital is rising. Meanwhile, companies that print profits are still holding their own because the economy is expected to be fine.
And that leads to the big question of the coming days and weeks.
The question is whether the Fed can manage to bring down inflation without hurting the real economy, not just overvalued and unprofitable financial assets.
If the high yield bond prices start to struggle anywhere close to the likes of Peloton or Rivian or Doordash then you will know it is time to move out of Value and into US bonds because the US economic cycle will likely be turning over - for whatever reason.
TLT is a good and cheap bond ETF to ride out the cold of an economic slump or, whisper it quietly, recession.
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