Big Enough Belt

Neil Azous of Rareview Capital deciphers the landscape heading into the March FOMC meeting. Neil is looking for any changes in stance regarding the voting members’ views on the path of rates later in 2024. In this episode Neil also reads the technical picture on a particular sector and adds color to investment theme that could be the next big investment trend.

Summary – IBKR Podcasts Ep. 145

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson 

Welcome to another IBKR podcast. I’m your host, Andrew Wilkinson. Many say that it will be a non-event other than to learn if and how the so-called Dot Plot may have changed. To talk about this and all things Federal Reserve, I’m pleased to have back on the show Neil Azous Review Capital’s Chief Investment Officer. Neil Azous, welcome. How are you? 

Neil Azous 

Hi Andrew, thanks for having me and always great to be here with you ahead of the Federal Reserve meeting. I just want you to know I’m feeling great today. I even have some pizzazz in my step! So what do you want to talk about? 

Andrew Wilkinson 

Neil, since we last spoke before the January Federal Reserve meeting, the pendulum has swung the other way regarding the path of interest rates. 

As we head into the March FOMC meeting, what’s the market saying now? 

Neil Azous 

Sure, Andrew. Well, the bottom line up front is that the market be  lieves the March and the May FOMC meetings are non-events for cutting interest rates. And the first interest rate cut is not until June. For example, the short-term interest rate Futures market is pricing in a 1% chance of a cut at next week’s meeting, a 12% chance of a cut at the May meeting and a 60% chance of a cut at the June meeting, or 73% cumulatively by June.  

So, June is now the expected start date of the cutting cycle, Andrew. And beyond June, the market is only pricing in two more cuts in 2024. One in September and one in December for a total of three this year.  

Now, Andrew, there’s actually some symbology in all of this. At the Federal Reserve meeting back in December, when the Fed provided their last quarterly economic projections, the Fed penciled in. 75% of cuts by September of this year in their infamous Dot Plot.  

So the Fed said three cuts then, but the market is only pricing two cuts now. By September, that’s a mismatch in expectations. That needs to get reconciled next week, and perhaps we’re going to find that out. We’re going to learn that the Fed will lower their Dot Plot to two cuts this year or by September, instead of three. Or if they leave the Dot Plot the same at three cuts by September, the market’s going to have to pull forward another cut, and interest rates will rise incrementally to align with the Fed.  

Now, Andrew, that’s how far the pendulum has actually swung the other way, since you use that word pendulum, has swung the other way in a short period of time. In January, we were talking about five to seven cuts over the next 12 months, with the first cut possibly starting in March, and now we’re talking about only two to three cuts and the market being less dovish than the Fed.  

So anyway, Andrew, all that said, there may be something else to this meeting and that is a potential update on quantitative tightening. Or QT. And it’s not getting a lot of airplay right now.  

There is a reasonable likelihood that the Fed announces that QT will slow down or stop. I mean, after all, Andrew, numerous Fed members have referenced this concept recently, including Chair Powell. If that’s true, over here at Rareview Capital, we just assume the word slowing down means a three-to-six-month process. And on the margin that would suggest that yields should drop incrementally in the short term and that’s somewhat supportive on the margin, again, for risky assets as less equity would be drained from the system. So that’s the market setup heading into next week’s Fed meeting, Andrew. 

Andrew Wilkinson 

Well, Neil, at the beginning of the year, you said investors should buy stocks at new highs and bonds in anticipation of looser monetary policy later in 2024. Do you still share that same view, especially since stocks have appreciated even further? 

Neil Azous 

Yes, Andrew, I still maintain that same view in looking out over the medium term. However, there’s a big caveat, right? The US equity market, as you know, has appreciated quite a lot in a short period, I think approximately 25% in four months or has been up 18 out of the last 20 weeks.  

Therefore, like everybody else, over the next two months, we’re a lot less constructive. The model that we used to “pilot” different equity market regimes has recently shifted from a normal market to a complacent/exuberant state.  

And the model, just to be clear, the model doesn’t characterize the current setup as a “big short” opportunity. Instead, the probability of the price staying at or above the current level is just lower in the short term.  

And in this case, we would rather not own the market and instead seek to reduce equity beta. Because the risk will not be compensated with enough additional return in the short term. Regarding fixed income, nothing has changed in that view. We still favor owning carry and we believe overweight exposure is warranted in emerging market debt. US mortgages and US municipal bonds. 

Andrew Wilkinson 

Now Neil, your understanding and interpretation of policies at the Federal Reserve, along with your breadth of market knowledge is second to none. That’s why I love having you on these podcasts.  

You’re also pretty insightful when it comes to portfolio construction and you talk to a lot of influential institutional investors worldwide. So explain to the audience, if you will, what the dominant talking points are currently about asset allocation and portfolio construction when you start giving those institutions that pizzazz? 

Neil Azous 

I’m actually pleased you asked this question, Andrew. It’s actually very timely and just bear with me as my response here is going to be a little more long winded than normal because it’s so important.  

So there are certainly several noteworthy debates going on currently, but I’m only for the purposes of answering your question, I’m going to focus on just one because it’s such a dominant talking point to the degree that it transcends any other discussion in my circle at the moment.  

And that debate, Andrew, is about what is the appropriate weight going forward for US versus international equity exposure in a typical blended portfolio of stocks and bonds. So the starting point is the benchmark for global equities, which is the All Country World Index or ACWI.  

Generically it’s about 60% US equities and 40% international equities. And the problem is that international equities as you know have dramatically underperformed the US since the global financial crisis. And that should be no surprise to anybody, given the US is full of national champions like Microsoft and Amazon, Google, Tesla, Meta and more recently, NVIDIA.  

The problem gets amplified though when you think about the next 10 years regarding artificial intelligence, the Metaverse, and that climate transition or decarbonization being key drivers of returns.  

None of that upside optionality exists internationally to the same degree that it does exist in the United States. So the question is what do you do? Do you ignore the last 40 or 50 years of historical data when making asset allocation decisions? Or do you use the last 10 years of prices only and then incorporate a subjective view of what’s going to happen over the next 10 years, given those fast-growing industries?  

The answer is difficult, but investors are really struggling with this decision. Now, Andrew, this is where it gets even more challenging. That debate dovetails into “Style Premia Selection”, meaning how much Large-Cap versus Small-Cap exposure is appropriate in the United States once you made that first decision? And again the issue is similar to domestic versus international as Small-Caps have been dramatic underperformers for a decade. And outside of a cheap valuation call, there’s just no bait just to be overweight that style.  

And again, that should be no surprise. So firstly, as anytime a company grows fast, it’s removed in the Russell 2000 and becomes a Mid-Cap or Large-Cap. So the index cannot hang on to its winners.  

Here’s a good example or more recent example. Everybody’s watching this high flank stock called Super Micro Devices. It just recently became the largest weighting in the Russell 2000, at around a 2% weight. And right away it got announced to go into the S&P 500. So Russell’s losing its biggest winner.  

Secondly, the US government, in my opinion, eradicated the concept of a default cycle following the global financial crisis. They just would not let any company go bankrupt and let market forces work things out. They kept interest rates at 0, so you could extend and pretend for a very long time. And as a result, Russell 2000 is now an index with a large amount of walking zombies, to the point Andrew, where 50% of the earnings in that index are just negative year over year.  

So why would someone want to own that index or be overweight? And finally, Andrew, you can apply the same thought process or concept to emerging markets.   

In the old days, during the brick build up from 1990 to 2008, the reason we invested in emerging markets was simple. Their GDP was 3 to 5% higher than the United States. So you had this generous premium to absorb the risk. You were underwriting. You fast forward to 2015, 2017 period and US GDP surpassed that of emerging markets, and that happened at a time when China’s GDP was effectively cut in half.  

Again, if there’s no cushion for the risk you’re taking or you’re not being compensated enough, why do you want to own that space? And you can take that a step further in emerging markets, especially regarding China and geopolitical risk.  

Who in their right mind at the moment is building an overweight position in China if there’s a risk that their assets could be confiscated? Like what happened with Russia at the beginning of the Ukraine War. Or if President Trump wins the US presidential election and he dramatically raises the stakes again in the trade war regarding Chinese tariffs. The answer to that, Andrew, is that very few in the foreseeable future are going to take that risk. 

So that’s the debate currently going on regarding asset allocation and portfolio construction. And you have to ask, well, what side of the debate do we come out on, Andrew? Well, we come out on the side that we care more about the last 10 years of data and the next 10 years of capturing the themes and the products that we are using in our everyday lives.  

And we are placing less emphasis on the last 40 years of historical prices or data, albeit in a measured and responsible way. So Andrew, just to highlight the gravity of this discussion or how seriously we are taking it, we are implementing NASDAQ 100 exposure and reducing Russell 2000 and MSCI emerging markets in our active equity strategy. This was done after careful thought, deep analysis and certainly at the request of many of our investors.  

My point is this isn’t just a talking point. It’s a new reality developing in the industry and I believe that it’s the dominant talking point amongst asset allocators. 

Andrew Wilkinson 

And sticking with that regional emerging market theme, Neil, about a year ago, I think you were one of the first portfolio managers to my knowledge to highlight two regional equity market themes that have performed very well. Namely Japanese equities and Indian Small-Caps.  

Do you have any additional pearls of wisdom or ideas that you can share with us today? 

Neil Azous 

Ah, thanks Andrew for recognizing those calls. That won’t always be the case. I get things wrong a lot too, but I appreciate you saying that for now.  

I guess as a starting point for new ideas, we really like it, Andrew, when both the technicals and the fundamentals line up at the same time. And that’s especially true when your time horizon is a 6-to-18-month investment space and there’s an asymmetric setup in a stock price. I believe the US biotech sector, Andrew, meets this criterion currently.  

The dominant classical charting pattern for any biotech index or sector metric is a complex head and shoulders pattern, and it’s atop on the monthly chart. The pattern began to form in early 2019 and extends today.  

And that sector or any benchmark that you’re looking at is close to invalidating that monthly complex head and shoulders pattern. And it could close above the neckline this month. So that is the first step regarding the entry. 

Fundamentally, I am very, very intrigued by the potential of combining biotechnology with AI. Let me explain what that means.  

So, with AI, we all know there’s going to be real progress across some industries like telehealth or software, payer operations, insurance preauthorization, but this is where it’s most important. In the drug discovery and development part.  

And that right tail of discovery and development becomes so fat, Andrew, that no investor will be able to find a belt size to hold up their pants. And let me explain. The process of discovering and developing a drug spans over a decade. However, with this convergence of biotech with AI, the industry may undergo a paradigm shift faster than expected. This is very much like Operation Warp Speed. The name of the response during the pandemic.  

Andrew, imagine having drugs available in 1/10^th of the time from discovery to patient treatment, like the vaccine came during the pandemic. This acceleration, Andrew, could revolutionize medicine. And so in my opinion, the first sign of “years” being taken off of that  ten year discovery and development process is a catalyst to revalue the space at warp speed.   

Andrew Wilkinson 

My guest has been Neil Azous, CIO and Founder at Rareview Capital. 

Neil Azous 

Andrew, thank you for always having me. I appreciate it. Look forward to talking to you soon. 

Andrew Wilkinson 

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