The risk rally is back, for a while

Christopher Joye

Coolabah Capital

In the AFR I write that the risk rally was back until yet another nuclear threat. This time it was the US Defense Intelligence Agency warning that Putin may have to engage in nuclear sabre rattling as his conventional arsenal is depleted by the war of attrition with Ukraine. The West has actually done a brilliant job of validating the efficacy of its intelligence gathering by publicly front-running almost all of Putin’s moves.

Last week I explained that our analysis suggested that a pragmatic and intelligent Putin would recognise his existential miscalculation and seek to engineer a face-saving off-ramp. This will most likely come in the form of a cease-fire agreement that allows Russia to keep Crimea and the separatist states (aka the Luhansk and Donetsk Peoples Republics), while forcing Ukraine to agree to not join NATO and/or the European Union.

These were, after all, Putin’s primary goals: that is, to protect Russia from NATO encroachment. He would have ideally liked regime change as well, removing the threat of a flourishing democracy on his border, but that no longer appears possible.

With tape-bomb after tape-bomb during the week confirming our hypothesis that a cease-fire would emerge during the coming days, weeks or months, risk began to rally. The S&P500 Index has managed to pare its peak-to-trough loss in 2022 of 12.8 per cent to 7.1 per cent as at Thursday’s close. The Nasdaq Index has likewise truncated its losses from 21.5 per cent to 12.8 per cent. And Bitcoin has bounced from a low around US$33,000 to circa US$40,000.

Regular readers will recall that since late 2021 this column has argued that one would ideally be long cash, short equities, short credit, short crypto, and short interest rate duration risk. Our central case was that market pricing for 3 Fed hikes in 2022 was bogus and needed to increase to 6 to 7 hikes. Following the Fed’s meeting in January, the market moved to price in 4 to 5 hikes.

And after Jay Powell delivered his March press conference this week, explaining his first 25 basis point rate increase and the end of his bond purchase program, markets had moved to pricing in 6 to 7 hikes. We believe the probabilities are skewed to a more aggressive profile, with Powell signalling that he is open to the possibility of moving in 50 basis point increments. He is not alone: 7 of the 16 Fed board members are forecasting at least one 50 basis point hike in 2022 (the remainder expect 7 or fewer standard 25 basis point increases).

Yet since there was no shock of a 50 basis point hike in March, and Powell stressed that the Fed’s financial conditions index was already putting material downward pressure on inflation, the Fed’s communications were received as highly benign. Indeed, Powell even repeatedly tipped his hat to the importance of the Fed maintaining “financial stability”, which was code for “I still have the market’s back” (or the Fed’s put option is alive and kicking). While we believe the put option is all but dead and buried, these were exactly the soothing words investors wanted to hear. And so equities went on a tear.

In our own portfolios, we had monetised a lot of our hedges, and positioned for risk to rally through both the Fed meeting and positive news flow on developments between Russia and Ukraine. We remain constructive on the short-term, although forecast that issuers of debt and equity capital instruments will have to come to fragile markets with large new issue concessions, as they have been doing.

Over a 6 to 12 month horizon, further risks lurk. In particular, we have been forecasting the emergence of a “terminal cash rate debate”. Markets are only currently pricing in a circa 2.1 per cent Fed Funds Rate. And yet the Fed’s latest “dot plots” signal that its cash rate will rise to between 2.5 per cent and 3.0 per cent in 2023. That is, into contractionary territory.

This is a real problem for risk asset-classes, including equities, interest rate duration, property and highly correlated crypto. The Fed is hell-bent on getting to its neutral cash rate of 2.5 per cent as quickly as it can, emboldened by the spectre of having to deal with yet another supply shock in the form of the sharp increase in agricultural and commodity prices care of Russia’s invasion of Ukraine.

The Fed will be deeply concerned that these supply-side inflationary pressures combined with the emergence of a demonstrable wage-price spiral will entrench consumer inflation expectations at much higher levels than they have been in the past. This will in turn make the task of returning core inflation back to the Fed’s 2 per cent target in the absence of a recession all the more difficult.

A Fed Funds Rate north of 2.5 per cent all but guarantees that the US 10 year government bond yield, which is the secular discount (or risk-free) rate that is directly or indirectly used to price all assets, soars above 3 per cent, as it did in 2018.

In August last year, the US 10 year government bond yield was only 1.2 per cent. It has now risen to 2.2 per cent, which is a key reason why equity and crypto valuations have been getting crushed. One should expect large future drawdowns in these asset-classes as the 10 year yield climbs above 3 per cent.

Similar dynamics are playing out in Australia: our 10-year Commonwealth government bond yield has jumped from 1.1 per cent in August to 2.7 per cent today. That means the cost of borrowing 10-year money for a State government like Victoria has doubled from circa 1.5 per cent last year to over 3.0 per cent right now.

Significantly, Aussie 10-year Commonwealth bonds are paying about 40 basis points in extra interest above equivalent US treasuries, which is attracting chunky global, and particularly Asian, demand for Aussie assets. This is being amplified by what appears to be a safe-haven rotation by global asset-allocators into Australia, which has helped the Aussie dollar appreciate to US74 cents.

Australia is one of the few beneficiaries of the global contagion: we are profiting from higher wheat, coal, LNG and iron ore prices. We will also benefit from a tsunami of skilled migrants seeking a more prosperous and geo-politically stable destination for their talents. With the belated opening of borders, this is something that both Commonwealth and State governments are promoting. And there are few more potent drivers of demand than population growth.

The extraordinary strength of the domestic economy was highlighted by the upside surprise to the employment data during the week, with the jobless rate falling to just 4.0 per cent. The last time we had the unemployment rate with a 3-handle on a sustained basis was 1974. It is also being reflected in the State budgets.

Our chief macro strategist, Kieran Davies, found that based on the latest January financials, NSW's budget deficit is likely to be $4 billion to $5 billion lower than the government's full-year forecast released in December, even allowing for the costs of the tragic flooding and higher capex. Victoria’s budget is following the NSW result, narrowing sharply in the fourth quarter and is already on track to beat the State's full-year forecast by about $2 billion. It is highly likely that there will be further substantial downgrades to these deficits before 30 June.

One lesson from the geopolitical shock Europe is the importance of only ever allocating capital to democratic states and the companies domiciled in them. Russia is on the cusp of defaulting on up to US$150 billion of foreign currency debt it owes global investors, including many large Western institutions, in what could become one of the biggest emerging market defaults in history.

And if China consents to reports of Russian requests of military support for its invasion of Ukraine, the Middle Kingdom would almost certainly be slapped with similarly harsh global sanctions.

According to the FT, China has signalled its willingness to provide weapons to Russia, which beggars belief: this would only further reinforce the profound economic ostracization, or decoupling, China has suffered in response to its relentless efforts to force the liberal-democratic world to bend to its Communist will under President Xi's zealously ideological leadership. Back in June 2020 we predicted that Chinese decoupling from the West was set to markedly intensify.

Last year we repeatedly advised investors that they should adopt our unique "democratic criterion" as part of their ESG overlays, which prevents us from allocating any capital to non-democratic states like Russia and China. We explicitly warned the NSW government that it should immediately stop lending hundreds of millions of taxpayer dollars to Russia and China because doing so failed this important ESG test.

This is not just a moral or ethical issue: it should be patently obvious that if you cannot have confidence in the rule of law, property rights, and the enforceability of contracts in countries run by despots and dictators, then you cannot invest in equity or debt instruments issued by them (or by companies based in these nations).

Global markets clearly have had large lazy longs in Russia and China because assets located in these regions appear superficially cheap. But is impossible to monetise these opportunities when the country in question unilaterally appropriates your assets, bans investors from exiting, as both Russia and China have done (in 2015 in China's case), and/or Western states force you to dispose of these assets at precisely the time that there is no durable bid for them.

Scores of large offshore and local institutional investors are presumably sweating on their horrific Russian losses and wondering which country could be next. Well, if President Xi does indeed attempt to forcibly unify with a resistant Taiwan, as he has promised during his term in office, we will see the West applying exactly the same playbook, albeit with even greater force. The West has arguably much more at stake with Taiwan.

This is starting to precipitate an exodus of capital out of China as the uninvestable nature of non-democratic states dawns on investors (witness the enormous decline in Chinese tech stocks and huge increases in credit spreads on Chinese bonds). 

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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