While I have never applied to the college, the question on my mind right now is equally as challenging. The Fed has been vocal and steadfast in its approach to addressing inflation; its main monetary policy tool is seemingly acting as a catalyst to a new savings & loan crisis.
Is this a storm in a teacup? A precursor to a Lehman Brothers-type event? And what is in the toolbox to navigate the road ahead?
Three decades in three years
This week’s FOMC meeting is set against a backdrop of sticky inflation, several US regional banks looking for white knights and the knowledge that US banks have tapped the Fed’s various short-term funding facilities to the tune of $165bn (discount window and BTFP) in a week!
The parallels with the monetary policy and economic conditions of the 70s, 80s and 90s are worthy of the often-touted Mark Twain quote. And while the Fed might be determined to control inflation, causing another banking crisis would not be a desirable result.
A delicate balancing act or stuck between a rock and a hard place
By the close Monday, the dollar had softened, treasury yields were a touch higher, and credit spreads had tightened in after blowing out early in the session. So far so good: a general indicator of a rotation (albeit a cautious one) back into risk assets.
But – and it is a big one – the Fed still need to hike rates and by doing so they risk aggravating the delicate funding situation in the US banks, which clearly over the last fortnight has been exposed as a somewhat systematic risk. Of course if it does not do anything, then it risks sending the wrong message to the market, and would likely fail in its mission to control inflation.
The market is pricing in 2x 25bps hikes: one this week, and again in May; June is too close to call and then we head into summer with a rate cut from July: changing gears rather than a pivot at this stage, one would say.
But I had caution that Lehman collapsed six months after the Bear Stearns bailout, and the effect of the rate hikes might take months to filter through into the real economy.
So, what about risk assets?
What I like (in no particular order), but on the proviso that one needs to be in the market!
Firstly equities: businesses which generate cash, not companies that burn it. Non-cyclical and staples, defendable business models with moats.
Secondly bonds: as Credit Suisse AT1 bond holders found out this weekend, not all bonds are issued equal. Investment grade credit often has more duration risk, and high yield more credit risk (very generally speaking), keeping duration short makes sense, but not if default risk is material.
Thirdly, real assets: I like the cheap inflation-linked cashflows, the critical nature of the assets, underpinned by structural factors and the generally lower volatility and correlation than to traditional equities and bonds.
But we do need to see net asset values become more dynamic, reflecting the observable comparable data points in the public markets.
In summary, the market is looking for direction, the Fed is looking for data points and investors are looking to preserve their capital and generate returns.
Optionality is invaluable right now, so swapping out long-duration credit for short-duration credit makes sense to me, as does picking up cheap inflation-linked cash flows.
This gives investors a free option on the direction of the markets. Green shoots appear, increase the equity bias, deep recession, extend the IG credit/duration bias, inflation remains sticky or sideways market, increase the listed real asset bias. Simple.
Pietro Nicholls is the lead fund manager to the VT RM Alternative Income fund and chair of Empowered Brands.
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