Summary:
Last week saw more persistent than expected inflation and very strong January retail sales in the US. Fed officials took to the microphones, suggesting that markets should expect potentially more than the two rate hikes they are expecting now. Bullish markets heard that as “we may not cut rates this year” and took some profit off the table.
The larger question in the back of my head, and one I suspect will go unanswered for some time, is whether traders and investors have accepted that the probability of more QE, outside a very severe liquidity crisis, is now off the table. If investors collectively believe in the second coming of QE, then at some point, we should expect a severe market retrenchment.
But what if markets are more sanguine than that? What will be the major catalyst, to unleash market forces for risk assets to escape their narrow bands? Residual liquidity is an important lubricant, but alone, it can’t create long-term optimism. Here are our best candidates (so far) to lead the next bull market.
The Alpha Bull Market: Where good funds would win out against the wider market.
The Deregulation Bull Market: Where the economy and markets would benefit from banking deregulation.
The Efficiency Bull Market: Where new technologies, like ChatGPT, would drive efficiencies.
The EM Bull Market: Where a new competition begins in Emerging Markets as global supply chains shift.
The Private Bull Market: Where more companies go private, diminishing the available set of opportunities for publicly traded securities.
Last week was somewhat disappointing on the inflation front, as US data suggested that prices were dropping at a rate slower than expected. After a blowaways retail sales report, Fed officials took to the microphones, suggesting that markets should expect potentially more than the two rate hikes they are expecting now. Bullish markets heard that as “we may not cut rates this year” and took some profit off the table.
We have often said that in a “game of chicken”, the Fed would usually win. Liquidity, by and large, does drive markets.
The Fed hiked at the fastest pace in over forty years, causing one of the sharpest retrenchments bond markets have experienced. Looking around, nothing is broken. Excluding the fact that Big Tech capitalisation is now back to normal levels, the economic and financial system has easily weathered the storm.
The larger question in the back of my head, and one I suspect will go unanswered for some time, is whether traders and investors have accepted that the probability of more QE, outside a very severe liquidity crisis, is now off the table. Statistics suggest that 30% of fund managers are below 40 years old, and on average the age is 43. This means that most institutional money managers have spent more than three-quarters of their professional lives, and certainly the more senior part, under the QE regime. Have they really accepted a world of higher rates and inflation, steeper yield curves and more expensive margin loans? Have consumers accepted the possibility of paying 5%+ on their mortgage over the long term?
If investors collectively believe in the second coming of QE, then at some point, we should expect a severe market retrenchment. At the very least, considering that the Fed is very data-dependent, and that data could be jumping around for the next 2-3 years as global economies realign, we should expect risk assets to be treading water for the foreseeable future.
But what if markets are more sanguine than that? One reason that I hate metaphors is that the cleverest ones catch on, but since their popularity is not grounded on research but general approval, they can lead to very wrong conclusions. We often compare traders and investors to addicts, just waiting for the next cheap money fix. What if, to use mixed analogies, market professionals are not liquidity junkies? Rather, what if they are like the diabetic who loved chocolate but is now discovering that life without sugar is possible -and healthy? Healthy minds adapt easily.
So if that is the case, then what may drive the next bull market? What will be the major catalyst, to unleash market forces for risk assets to escape their narrow bands? Residual liquidity is an important lubricant, but alone, it can’t create long-term optimism. Here are our best candidates (so far) to lead the next bull market.
The Alpha Bull Market: A good candidate would be plain old fundamentals. Doing the legwork and discovering good companies has always been the bread and butter of good fund managers, but in the past few years, it had all really turned into a competition of who owns the most tech. Yet, last year, active managers outperformed passive benchmarks for the first time since 2008. If the trend continues, then the next bull market would be more about Alpha, the performance of individual portfolios, than Beta, i.e. indices going up sharply as a whole.
The Deregulation Bull Market: In the past year, the UK looked into ways it could lower the cash buffers for some smaller banks. Lowering demands on banks is a well-established road to creating economic wealth for societies. Allowing banks to lend 1.1x instead of 1x on their current deposits could unlock huge amounts of wealth. And, unlike QE, banking professionals can direct business loans towards healthier businesses. While bank deregulation is politically toxic (more so when 2/3 of the US government is in Democratic hands), if investment grade bonds continue to yield nearly 4%, we suspect the demand for commercial loans will rise sharply in the next few years, and pressures for banks to hand out those loans will increase.
The Efficiency Bull Market: Bull markets are often led by new technologies. Last week, we discussed the potential impact of a natural-language AI search engine on the biggest tech companies in the world and virtually every marketing department in the globe. Already we have seen AI taking over some simpler jobs. A law firm already introduced an AI chatbot to write simple merger memos. It costs nothing and can produce something of quality, the quintessence of productivity improvement. The competition in the field is just beginning and we could see significant improvements in productivity over the next few years.
The EM Bull Market: Twenty years of globalisation have certainly benefitted the global economy and markets. Yet, the IMF now says that the trend has slowed down significantly (“Slowbalisation”). As India rises and contests China’s place at the heart of global supply chains, a new supply-chain race to attract western businesses could start, leading to significant investments in infrastructure.
The Private Bull Market: According to a 2019 report, the number of U.S. companies that are publicly held has declined by 50% since the late 1990s. 14 years of QE have left Private Equity funds with over $1.2 tn (ex-Real Estate) in cash. Companies have big incentives to go Private: more control and fewer reporting requirements. Private deals usually leave all major stakeholders very well off. But more companies going private means that the pool of investment money would chase a narrower set of opportunities, ultimately pushing prices up for all risk assets.
And the more we think, the more candidates we could uncover. Markets are currently focusing on a data-dependent Fed. Looking a little bit further, the debate should be about the nature of the next bull market. Identifying the right factors and positioning early could make a huge difference for returns going forward.