Iceberg Dead Ahead!
By David Nelson, CFA CMT
The iceberg barely visible in my post from last week came into full view following Wednesday’s FOMC decision and the release that followed. If the analyst notes post the decision are any indication it seems Jay Powell and company caught the street by surprise.
While the overall hit to the broad equity indices was modest the reflation trade or economically sensitive stocks were a definite casualty. Add a significant unwind in fixed income steepener trades on the heels of a flattening yield curve, both fixed income and equity investors had a lot to digest over the weekend. Friday’s triple witch options expiration added to the pain ending with a sharp drop in the last few minutes of trading.
Fed Decision – What Changed?
The above begs the question; what’s changed? The Fed didn’t pull a surprise rate hike or reduction in Fed purchases currently at a $120 Billion per month. However, what did change is the conversation taking place inside the room. Some Fed Governors who weren’t thinking about thinking about a rate hike are suddenly thinking about it. The dot plot which Wall Street uses to judge the consensus estimate for the next rate hike has moved closer indicating potentially two hikes in 2023. The added assumption is that tapering would have to move up as well. Goldman’s Chief Economist Jan Hatzius believes the taper or slowdown in Fed purchases could be announced in December with the kickoff in January next year.
The emperor has no clothes
Whatever selling if any lies ahead let’s remember the only thing that’s changed is the tenor of the conversation. Maybe the timing is a bit of a surprise but given the rapid rise in some key inflation indicators and a potential Thursday Q1 GDP print north of 6%, a change in tone doesn’t seem out of line. Without it, critics would be chanting “the emperor has no clothes.”
It’s hard to believe a rate hike still two years away and the modest move up in the taper could force the frenzied trading of $Trillions in capital but that’s just what happened. In a world where market and asset class performance has been ever dependent on monetary policy and an implied Fed put or backstop, any hint of reduction in accommodation is going to trigger some selling.
The shape of the curve
Even small shifts in rates cause immense volatility especially when investors are caught flat footed like last week. The reflation trade has been a reflection of a steeper yield curve indicating increased economic activity. We saw this accelerate in the first quarter and as such helped propel the financial sector, one of the best performers in the last 8 months. The move up in the Fed’s timetable drove the short end of the curve higher and surprisingly forced 30-Year rates to slip. The chart below shows the recent collapse in the spread between 10 & 2-year yields.
10-2 Year Spread
If Wall Street is true to form the unwind will likely overshoot forcing investors out of some of their best positions. Reversion to the mean is a powerful force and given the outperformance of some themes expect a rougher ride while investors rush from one side of the lifeboat to the other.
All sectors closed lower last week but some of the best performers took the brunt of the selling. Energy (XLE) and Financials (XLF) up +38% and +21% year to date respectively were the worst performing sectors last week down -6.1% and -5.6% respectively. Technology (XLK) a laggard this year but showing better relative performance in the last month was a clear leader coming in just below the flat line for the week.
Inside the room
The Fed and Chair Powell’s thinking will evolve over time. It’s encouraging to know they aren’t making decisions in a vacuum. Jay has reversed on a dime in the past. In late 2018 following the Fed’s last hike the rhetoric changed almost overnight realizing that a calendar-based approach to rate hikes was a policy mistake.
Hero to Zero
Last week was the poster child of the need for balance in portfolio construction. Any sailor will tell you if you place too much of your cargo on one side of the boat you’re going to take on water. Overweights in sector, asset class and individual positions are part of any active manager’s tool set but there are limits. Unconstrained, you can go from hero to zero in a New York Minute.
*At the time of this article some funds managed by David were long XLE