Strategy Note /

The Bend But Don't Break Markets

  • In American football a good defense bends but doesnt break - today's risk asset markets strike me as the same.

  • Risk #1, a Fed policy mistake, seems unlikely post Fed meet but now we have Omicron - focus on speed of science.

  • Sentiment, positioning, seasonality, strong nominal growth & negative real yields imply strong earnings & rising equity

Jay Pelosky
Jay Pelosky

TPW Founder & Global Strategist

TPW Advisory
17 December 2021
Published byTPW Advisory

Its late in the game (of 2021 performance) and the equity markets are under pressure, bedeviled by concerns about things they think they know (like the Fed) and things they don’t, like Omicron. Price action is chaotic, trading choppy so some have left the field, some stand bloody but unbowed, others have hunkered down.


Its also late in the American football season – the fan’s favorite time of the season because one can watch both college bowl games and the final stretch of the NFL season.


A football phrases one hears on occasion at this time of year is the bend but don’t break defense; as someone who grew up in Massachusetts, I remain a New England Patriots fan. Some say the Pats 2017-18 team was among the best at giving up lots of yards but few points – thus the bend (give up yards) but don’t break (don’t give up points) defense. A winning strategy when combined with a Tom Brady led O.


This equity market strikes me as similar in many respects. I have used the term “pothole markets” to describe the occasional 5% or so pullbacks, usually happening quickly and almost as quickly being forgotten in the steady march higher (at least in the US).


I don’t know if it’s the end of a grinding year or the concern about giving back a lot of good performance or the fact that the days are shorter but it seems to me that we are at the bend but don’t break stage of things for risk assets.


Last week’s Musings was titled “Sell the Rumor, Buy the News” which just about perfectly encapsulated the cross asset market reaction to the Federal Reserve’s decision to double the pace of taper and put three rates hikes on the dot plot. Off roughly 5% in the run up to the meeting stocks rallied powerfully while bonds did little as the Fed matched bond market pricing and addressed the raging inflation concerns of pundits, politicians and bears alike.


Given that most 2022 surveys have a Fed policy mistake as the #1 risk, this would seem to take that risk off the table and set up some open field running for the well rested offense (read bullish investors – an increasingly rare breed), waiting patiently for the bend but don’t break D to get off the field.


Well just when one thought it was time to bring out the Offense, a different O showed up, Omicron, hitting folks right where it hurts leading to school closings and holiday party cancellations from coast to coast and around the globe. I was looking at some UK stories to try and get a sense of things there and noted that it was almost exactly a yr. ago when the UK went into full lockdown because of a new variant that was “much more transmissible” – I mean, déjà vu for real.


There is so much Omicron news, analysis, twitter feeds, susbstack writings etc. that one is not sure where to turn in regard to just how bad Omicron could be. Clearly its uber transmissible but it also seems mild in its severity at least from the most recent S African reports of more non severe cases in hospital than severe for the 1st time in awhile. It also seems that positivity rates and cases may be peaking there suggesting that Omicron waves will be scary fast but quick to subside. JPM notes that Covid deaths in S Africa are down 95% from their Jan 2021 peak while global Covid cases are flat over the past two weeks. 


The risk is that both Europe and the US are dealing with Delta case loads and piling Omicron surge loads on top could overwhelm the health system – the UK for example already has record cases and projections are for the US case counts to increase from current 100k per day to perhaps 5-10x that number, a worrisome thought.


Japan has done an admirable job reducing deaths to almost a handful a day while China remains wedded to its zero tolerance policy. As a China bull, I worry about how such a policy will work against a transmissible variant like Omicron. China also has limited #s of prior infections which appears to give the best protection followed by being vaccinated, especially against severe illness. The offset is an imminent policy turn towards easing with a full policy quiver as the Politburo notes “stability as the top priority” and the need to “front load” economic support. 


S Africa has yet to raise its Covid warning from Level One, its lowest level, and if cases are already peaking it is unlikely to do so. The response elsewhere is much more aggressive and begs the question of whether lockdowns will re appear. The political appetite is clearly not there for such either in the UK or US where the Biden Admin has already ruled it out.


How will markets take such surging case levels and potentially overwhelmed health systems? Over the past month both S Africa and the UK have been down in line with ACWX as measured by their respective ETFs. Over the past 10 trading days, when Omicron has really made the news, S Africa is flat while the UK is off 1% and ACWX off roughly .5%. Last year’s lockdowns are barely visible on the market charts.


Given where we are in the Omicron cycle it would seem that the UK is roughly a month or so behind S Af and the US is behind the UK suggesting that Omicron will be with us as a market issue for the next month or so at least. As time passes information around severity will become clearer allowing investors to make more informed decisions. Science is moving fast as well – anti viral pills with V strong protection against Omicron have just been approved by the EU and are likely to be approved in the US within weeks if not days. 


I noted last week how we might have to get used to new variants acting as steam release valves – making noise and being scary for a bit but serving a positive purpose in keeping things from getting overly frothy – and at this point it is mighty hard to find the market froth amidst the blood. For all the talk about expensive markets, SPY, for example, trades at roughly the same forward PE level as pre Covid even though rates today are 50bps or so lower and growth is roughly double. Hong Kong’s Hang Seng Index now sells for less than book value – one of only a handful of such discounts over the past 40 + years.


Does one sell here and look to buy back when there is more clarity? What about the Q4 earnings season which should be V strong given likely double digit nominal growth rates in the US and elevated growth in Europe. Is it worth selling now and buying back in a few weeks?


Selling now might work for adept traders but as an investor, I think it is tough to sell and then buy back at the right levels in such a compressed period. Equity Markets are approaching oversold conditions again, US investor sentiment is so bad its good with AAII bulls at roughly 50% of YE levels over the past two years while bears have doubled. BofA’s famous FMS shows cash levels at their highest since May 2020 and equity positions at their lowest since October 2020. 


Positioning is much more favorable - MS reports US L/S HFs gross positioning in bottom 3% of past year- while JPM notes systematic and discretionary investors are in the bottom third of historical positioning. Seasonality as we know is as positive as it gets. Amidst all the noise and thrashing about, Value is doing well while defensives are not showing break outs that one would expect in advance of more significant equity declines. 


Big losers of later: small caps, China tech, US thematics, reopening proxies like JETS, seem to be finding a bid at mid day Friday. The USD is key to watch here – we have long felt that the Fed policy pivot could mark at least a near term high for USD – should the USD roll over here (and commercial hedgers huge short position suggests it may) that would be very constructive for risk.


Fundamentally, our 2022 global outlook for above average growth and declining but above trend inflation remains intact. We do not expect Omicron to derail a synchronized global expansion. Citi ESI in US, EU and Asia have all turned positive. Supply chain concerns are ebbing already and inventory restocking + strong consumer demand are likely to support growth next year aided by a cap ex boom as climate and infrastructure efforts get underway around the globe. Non market sentiment is lousy as well – the US Natl Federation of Independent Business (NFIB) most recent survey polled an all time low on whether the economy is expected to improve – an all time low.


Strong nominal growth & sustained negative real yields should lead to solid earnings growth and risk asset appreciation as the year unfolds. The negative real yield environment does not get enough attention – real rates in the US are as negative as they have been in the last 40 years (10yr UST – inflation). Very low risk free real rates suggest lousy real UST returns (worst in 40 years), support risk assets and should lead to renewed inflows. It may not seem like it today but the bend don’t break market should allow the offense to get back on the field and take advantage of some very attractive entry points across the non US space especially given ACWX up less than 3% YTD.

Enjoy this Bloomberg Radio clip from Tuesday night where I cover The Fed, Omicron, Splinternet and the China 2022 glide path thesis.


TGIF, no kidding, TGIF!