Federal Policy, Risks and Investment Q1 2023

US nominal GDP has recovered 35% from the Covid lows in 2020, which is the fastest recovery since the end of World War II and the Marshall Plan in 1949. This increase in nominal GDP is a result of the fiscal and monetary stimulus that has been injected into the US economy since 2020, totaling $5.2 trillion in fiscal stimulus and $4.8 trillion in Fed QE stimulus. The fiscal stimulus spending has led to an increase in the US deficit by $700 billion, which includes spending on war, infrastructure, and Social Security.

The Federal Reserve has also been injecting liquidity into the economy by expanding its balance sheet by $370 billion in the past four weeks. The statement suggests that there is more to come as the next round of spending has only just begun. The current liquidity injection by the Fed is said to be on par with the start of the Global Financial Crisis.

The growth in US economy has been due to significant fiscal and monetary stimulus and that has led to inflation. 

Inflation 

Take a closer look at the stock market’s performance during an inflationary period from 1966 to 1982, where there were many boom and bust cycles in macroeconomic conditions. In this period, inflation assets such as gold, small-cap stocks, and emerging markets performed well while stocks delivered zero real returns. Ironically, these same inflation assets are now considered contrarian investments after the Q1 “long duration” whipping, meaning they may be viewed as undervalued or out of favor by investors.

Global Destabilisation

The flow of funds shows a continued trend of deposit outflows from small banks into money markets (due to attractive interest rates), which could destabilize the global banking system if not addressed by the Fed.

When customers of small banks move their deposits to money market funds (eg. Fidelity Government Money Market Fund, BlackRock Liquidity Funds), it reduces the small bank’s deposit base, making it more difficult for them to lend to their customers. This can lead to a decrease in lending by the small bank, which in turn can reduce economic activity in the local area.

If the small bank becomes insolvent due to a loss of deposits, it could also trigger a chain reaction in the broader financial system. For example, if the small bank holds securities or other financial assets that are used as collateral for loans from other banks or financial institutions, the decline in the value of those assets could lead to losses for other banks and financial institutions.

Furthermore, if deposit outflows from many small banks occur simultaneously, it could put pressure on the entire banking system, potentially leading to a broader financial crisis. Money market funds, which are often used as an alternative to traditional bank deposits, can be subject to runs if investors begin to lose confidence in their ability to maintain their value or liquidity.

Long Duration Inflation Assets and EM Equities 

The dominance of long-duration inflation assets and the continued inflow of funds into cash and emerging market (EM) equities can be attributed to several factors.

Firstly, concerns about inflation have been a major driver of demand for long-duration inflation assets. Inflation expectations have risen due to a combination of factors, including supply chain disruptions, rising commodity prices, and loose monetary policy by central banks. As a result, investors have been seeking out assets that can provide a hedge against inflation, such as Treasury Inflation-Protected Securities (TIPS), Real estate (that generates rental) and commodities (gold, silver, oil, and agricultural products).

Secondly, the continued inflow of funds into cash may be driven by investors’ cautious outlook on the economy and uncertainty surrounding the COVID-19 pandemic. With interest rates remaining low, investors may be holding onto cash as a safe haven asset while they wait for more clarity on the economic recovery.

Finally, the inflow of funds into EM equities may be due to the attractive valuations of these assets compared to developed market equities. EM economies have been recovering faster from the pandemic than developed economies, and their equity markets have reflected this trend. Additionally, EM equities offer diversification benefits and the potential for higher returns over the long term.

The Shift 

There has been a shift in market sentiment and conventional wisdom over the course of Q1 2023. In January, the conventional wisdom was that China’s reopening would benefit energy, commodities, and emerging markets, while a Fed pivot was imminent, so the consensus was long yield curve steepeners, and investors should avoid stocks because Q1 would see an EPS recession. However, just three months later, as we enter Q2, the new conventional wisdom is that the Fed will cut rates by 160bps after May, so investors should go long Big Tech, short small cap and banks, and sell commodities as China is no longer surging. Additionally, investors should long gold as the US dollar is in a bear market. The dominant pain trade of Q2 is expected to be that the recession will be delayed by stimulus, the labor market will remain strong, inflation will stay high, and the market will reprice lower but cyclicals will outperform. The author suggests that the market is frontrunning the Fed pivot/QE trade, as evidenced by the strong performance of crypto, gold, megatech, and homebuilders.

Winners Vs Losers

YTD inflows to EM (emerging markets) equities have been strong at $37.4 billion, which would be the largest ever if inflows continue at this pace, which is likely being driven by investors front-running the Fed pivot. The inflows into EM equities have been high as a percentage of assets under management (AUM), with 2.52% YTD and 10.3% YTD annualized, which is the highest since 2010 (14.7%).

There have also been continued inflows into tech for the 6th week in a row, which is the longest streak since Apr’22, while financials saw their largest outflow in 10 weeks at $0.6 billion and consumer had their largest inflow in 11 weeks at $0.7 billion.

The passage also provides a “return quilt” that shows the Q1 winners and losers in terms of returns. Bitcoin has been the undisputed winner with a 73% YTD rise, followed by FAAMG (Facebook, Amazon, Apple, Microsoft, and Google) at 35%, SOX (Philadelphia Semiconductor Index) at 27%, and homebuilders at 16%. The losers include natural gas with a -52% return, US regional banks at -24%, oil at -8%, biotech at -6%, and energy at -6%. This information provides insight into what is driving risk returns in 2023.

The author concludes by highlighting the shifting conventional wisdom around the Fed, inflation, and market performance, and suggests that the dominant pain trade for Q2 is that the recession will once again be delayed by stimulus, the labor market will remain strong, inflation will stay high, and the market will reprice lower but cyclic.