Critical Regime Shift Confirmed for Global Equities

While the FOMC continues its gentle tapping on the brakes, Rareview Capital’s CIO Neil Azous discusses recent signs of optimism for US stocks taking place earlier in January. Neil explains why disinflation is now more important for the US economy than recession talk.

Sponsor Information:

Email:  nazous@rareviewcapital.com   

Web:   www.rareviewcapital.com

Note: Any performance figures mentioned in this podcast are as of the date of recording (January 26, 2023).

Summary – IBKR Podcasts Ep. 58

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 everybody to another IBKR podcast. I’m your host, Andrew Wilkinson and this week’s guest is Rareview Capital’s Chief Investment Officer Neil Azous. Welcome Neil.

Neil Azous

Hey Andrew, thank you for having me again, appreciate it.

Andrew Wilkinson

Always a pleasure. So Neil I think we named our prior podcast with you in December, Stairway to a Bull Market. We always like to have you on the show whenever the FOMC meets because we know you’re a keen fed watcher. So, how do you see things heading into the February FOMC meeting or what is the market pricing in from your perspective?

Neil Azous

So I think Andrew this is our 4th podcast ahead of a Federal Reserve meeting. We conducted one of these, I think in June, September and December and now here we are heading into the February 1st meeting, and I think we’ve come full circle in this rate hiking cycle. The bottom line up front Andrew is it is no longer about how many more hikes, but when is the first interest rate cut and how many cuts will there be? Secondly, what is priced going into this meeting so the modal outcome for 2023 now is 50 basis points of interest rate hikes over the next two Federal Reserve meetings. So 25 basis point hike in on February 1st and then another 25 in March and then we have 50 basis points of interest rate cuts beginning in the fall. And interest rate cuts will accelerate to 50 basis points at each meeting starting in 2024. That’s what’s priced into the market at the moment.

Regarding the theme of higher for longer: The most strongly held view by the Fed and the market is that they’re going to keep interest rates high for an extended period. In this case, call it six months. So the market pricing reflects that view. And then finally we always ask ourselves as we go into these meetings, where is the asymmetry? Meaning, where is the convexity? Where can something surprise you? The first one is, if the Fed raised by more than 25 basis points or they didn’t raise at all, those would be, quote unquote, asymmetrical surprises, and then also if we find out additional information during the press conference after the statement is released, it could lead to more interest rate cuts priced at a faster rate, or larger in magnitude. You know, for example, they did hike the interest rate 3/4 of a percent four times in a row, so why wouldn’t the Fed cut more than 25 basis points at that first cut? That would be another sample of something that could get priced asymmetrically into the market.

Andrew Wilkinson

So Neil you calculate that the neutral rate for this cycle is 2.14% and that on average it usually takes 4.2 months following the last interest rate hike for the treasury yield curve, i.e. at all maturities to revert to that neutral rate. Just to expand on what you’re thinking there.

Neil Azous

Sure Andrew, so here are the facts. On average the Fed has cut an interest rate 6.5 months after the last interest rate hike. The shortest that they have ever done that is 1.4 months and the longest is 14.7 months. And notably, as you said that the Fed cuts interest rates 2.4 times faster than they hike on average. So the Fed right now in the backdrop the Fed’s total hikes have been exceeded by more than two times the most ever. So on average, the market tends to start to price in a full return to the cycle’s neutral rate in 4.2 months across all treasury maturities. So what we should see is that you know, in layman’s terms, if the Fed comes out and raises an interest rate in February, March and says this is the last time, and we put a piece of the puzzle together, we say, OK, they’re going to cut an interest rate on average 6 1/2 months. Well, the market pricing knows that the first cut is priced Andrew, in September, so there’s your 6 1/2 months roughly and then between now and June the market should extrapolate out across all maturities, where they belong in relevance or in relation to that neutral rate around 2.14%. And that tends to happen very quickly, as we said 4.2 months across all maturities. So in this case, we would have to cut more than 250 basis points, the market would start to price those 250 basis points of cuts over the next four months between February and June of some sort. So it happens very fast and if you missed that low hanging fruit, it’s a lot of the total return in asset prices.

Andrew Wilkinson

Let me throw you a bit of a curveball here, Neil. It seems to me that your base case is that the Fed has over tightened, or at least it will have over tightened following additional moves in February-March right? And that then there will be forced to cut rates significantly to get back to that neutral level. However, the typical impetus for easing policy is some kind of a financial panic. Is it the case that you’re maybe fitting the story to the historic data? Especially since we’re not really seeing tighter policy impacting the labor market at this stage.

Neil Azous

That’s a fair and balanced question, Andrew, I appreciate that. I would just say no, I’m not fitting the story to the historical precedents. It’s entirely possible a financial panic or financial accident that you referenced already occurred and the market is missing it. Let me give you an example of that. So yes, the stock market closed down in the double digits, in the teens last year, but at one point it was down over 25%. I think the NASDAQ was down 35%. For all intents and purposes, that constitutes a financial panic or financial accident. But more importantly, when you apply that same methodology to how much the bond market fell last year, it’s extremely pronounced, and let me make it easy for you. If the bond market had the same volatility as the S&P 500, and you volatility adjusted the degree of the drawdown in the aggregate bond index so that the benchmark that makes up the 40% of the 60/40 portfolio, the drawdown in the bond market in equivalents to what a stock market would do. It was down over 70% last year, more than the financial crisis back in ‘08, of what stocks fell. So by all measures there was already a financial panic or an accident regarding that.

Now, a couple of other things to take into consideration, and I’m not making these calls, but these are things that people or investors should be open minded to about not having the ability to see the other side of the discussion. So maybe for the first time Andrew, the stock market did bottom ahead of a recession or a weakening in labor market. Maybe earnings growth is important, but it’s not everything. Meaning really, since 1960 earnings have declined in 14 calendar years and in 9 of those years the S&P was still positive. And then you know one other thing to really take into consideration right now, while I know there’s a lot of emphasis on recession probabilities or that another financial accident needs to happen, there has been a different factor driving the regime right now, and that regime is disinflation. We had a very strong move up in inflation and now we’re having a very strong move down in inflation or disinflation. And there are lots of examples of, I think there’s 19 episodes over the last 100 years, where inflation is falling in the same degree as it is now, and really only in one of those 19 instances, did the S&P have a negative real return during that episode. Across all 19 of those episodes, I think the real annualized return was close to 14%, so there are examples where disinflation leads to no financial accident. While it is challenged, it doesn’t necessarily need to meet a financial accident. And also, it’s entirely possible that the markets did bottom, both stocks and bonds, ahead of this recession because the market is so efficient in pricing in the speed at which the Fed raised interest. So the real question to me is not, are we backfitting something to a story, it’s what if everybody’s wrong and the recession already took place, or the financial accident already took place and people aren’t looking in the right place.

Andrew Wilkinson

So Neil, we always talk about the yield curve on these podcasts ahead of the Fed. Since we spoke in December, the yield curve became far more inverted and it stayed that way. What’s happening there?

Neil Azous

OK, first a little context. If you have to get one thing right in fixed income in 2023, we believe it’s capturing the transition to a steeper from an inverted yield curve, and I’m going to reiterate that view today. As you said, the yield curve actually is by far the most inverted it has ever been since the Fed began targeting interest rates in 1982. There are lots of reasons for it, but the primary reason for it is that the Federal Reserve hiked the interest rate above the neutral rate beyond the extreme that it ever has done before. So keeping things real simple, if the Fed thought that the neutral rate it was 2 1/2% and the most extreme prior to this cycle that they ever hiked above it was 172 basis points. So what is that? Sorry 5.2%. Where we are now, I believe 250 basis points over the neutral rate, so it shouldn’t be a surprise that the the inversion is this deep. The question for the yield curve, is what expression do you put on to capture the reversal of that inversion into a steeper sloped environment? And that has the capacity to absorb significant dollars in the professional investment community, and the question is timing and how do you stay solvent during it while it waits, finally turned positive. But that’s where we’re at right now, and again, there should be no surprise given how much we overshot by the most in history above the news rate. The opposite should be true when it reverses.

Andrew Wilkinson

So now looking at your newsletter recently Neil, you observed the potential major turning point for equities in mid-January I think. Do you want to talk about that a bit?

Neil Azous

Sure, of course it’s a very important feature alongside with the Federal Reserve, you know turning to a cutting cycle from a from a hiking cycle, it goes hand in hand. But before explaining what I mean by a major turning point, let me just provide some context about how we invest in equities, largely because everybody has a different discipline of how they go about things and when they look at pricing very large signals, they can have different interpretations. So I’m going to give it to you from our angle.

So, Andrew, our approach to equity investing is both long and short. Our process is driven by quantitative models and behavioral algorithms, and our models really seek to predict turning points, and we construct algorithmic processes to exploit those turning points. And we focus on regional sources of equity market returns. So when I tell you about this signal, it’s really more about the different regional indices that we focus on, which is US large cap, US small cap, non-developed markets and emerging markets. We really remove anything around style premium, meaning we don’t care about value versus growth, cyclicals versus defensive, et cetera. We’re just focused on the index beta. OK, so with that background in early to mid-January our primary long-term model for US large caps transitioned to a long S&P index position from a short position. For this model, Andrew, to be activated it requires a significant change in market behavior. Said differently, it’s only activated near market bottoms after bear markets. And interestingly, of the four regional indices that I referenced, the US large cap component was the only one that had not triggered in our long-term model. So when it did trigger in early to mid-January, really for the first time since the summer of 2021, so over 18 months ago, we now have all four regional indices aligned, using the same term the same long term behavioral model.

And here’s what that means. So we look at things again quantitatively and we break up markets in different regimes, you know keeping things super simple, you know 1% of the time the market is super complacent or exuberant. Another 1% of the time, the market is panicking and there’s no informational value. 17% of the time, last year is a great example of this, the market is in a stressed regime. And then the other 81% of the time the market is normal. This is the period that we all know in most of our investing life. And when you’re in a normal market environment, it’s a buy and hold environment and then you can drill down afterwards on style premia, factors, et cetera. But what it’s really saying is that, after being in a stressed market all of last year, which happened 17% of the time, we have now transitioned to a normal market environment which tends to happen 81% of the time, which is your buy and hold. So the fact that we had that confirmed on all four of the regional indices that we track is a statement for us. And we invest along that. It means investors who vote with their capital are behaviorally acting in a different way than they did all last year. And like I said, it happens at cyclical bottoms or near the end of bear markets.

Andrew Wilkinson

Neil, where can somebody sign up for your newsletter?

Neil Azous

We put out investment commentary on our website at www.rareviewcapital.com. You can sign up in multiple places for that. This newsletter that you’re talking about, what we call Sight Beyond Sight, where we include a lot of the context of this conversation in it is generally reserved for our investors. So if you’re interested in learning about our research and consulting services, you know that would be part of that. So just reach out to us directly.

Andrew Wilkinson

My guest in this podcast episode has been Rareview Capital’s Chief Investment Officer Neil Azous. Thank you very much for joining me Neil.

Neil Azous

Thank you, Andrew and good luck, on next week’s FOMC meeting. Hopefully it’s the last hike of the cycle.

Andrew Wilkinson

Thank you very much and don’t forget folks check out more episodes at ibkrpodcasts.com or wherever you download your podcasts.