- Fixed Income Portfolio Manager
Hong Kong (香港), Individual
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“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” – Mark Twain
It is striking to me that a mere seven weeks ago, virtually everyone seemed sure that the financial system was healthy and that most US banks had plenty of capital. Obviously, the March 2023 failures of Silicon Valley Bank (SVB) and Credit Suisse have highlighted the potential risks of such market complacency.
In that vein, I’ve identified what I see right now as three entrenched macro assumptions that could well turn out to be wrong – ideas that, to paraphrase Mark Twain, “the market knows for sure that just ain’t so.”
1. The Fed will have a difficult time controlling US inflation
This widespread belief is a relatively new one. Prior to 2022, most economists would have said that the US Federal Reserve’s (Fed)’s biggest challenge was guarding against disinflation. These days, however, many doubt that the Fed will be able to bring inflation down to its 2% target anytime in the near future.
I agree with the long-term structural arguments for higher inflation resulting from deglobalization, but contrary to most observers, I believe the real problem over the next year could actually be that the Fed misses its inflation target to the downside. Certainly, the Treasury Inflation-Protected Securities (TIPS) market embraces this possibility, with forward-inflation expectations recently below the Fed’s 2% long-term target (as measured by the Personal Consumption Expenditures Price Index, the Fed’s preferred inflation gauge).
Why the disconnect between market consensus and my own view? Bank lending, which is the most high-powered form of money (and thus most closely related to money velocity), is likely to slow amid today’s tighter credit conditions following the turmoil in the US banking industry (Figure 1). If that proves correct, why wouldn’t we expect inflation to cool and even surprise meaningfully to the downside?
Figure 1
2. US corporate balance sheets are generally strong
Many investors believe the US corporate sector is quite healthy, with strong balance sheets, stable leverage ratios, ample interest coverage, and robust free cash flows. The latest data supports this belief, and many companies did use the low-rate environment of 2020 – 2021 to term out debt. However, much of the available free cash flow can be traced to a lack of capex investment over the past decade, plus companies holding off on further spending until inflation ebbs. Can companies continue to focus on debt-financed share buybacks in lieu of capex in a deglobalizing world of higher rates? Unlikely.
Most investors look at BBB- rated companies with roughly 3x leverage and net-debt-to-enterprise values of 33% and see no reason for concern. However, our research suggests that corporate profits could fall 15% – 25% during the next recession. If multiples were to contract similarly, then your typical BBB- company would start to look more like a BB- risk. For high-yield companies, this math would be even worse.
Normally, companies do not undergo stress from too-high interest payments or because they can’t roll over principal payments; more often, their net debt/enterprise values get so high that they find it easier to restructure the debt. Could ratings downgrades and economy-wide defaults surprise meaningfully to the upside? Perhaps.
3. Buy the US dollar when volatility spikes and stocks sell off
This is something the market has been lulled into believing, as the 15-year US dollar (USD) bull market may have ended in September 2022. The USD has historically tended to move in such long cycles, but often with little correlation to equity performance and market volatility. Past examples of USD underperformance despite financial market weakness include the 1970s, Black Monday (1987), the 1994 Fed hiking cycle, and the bursting of the tech bubble (2000).
Figure 2 shows the performance of developed market (DM) currencies and emerging market (EM) currencies during periods in which the S&P 500 Index suffered a drawdown of 15%+. Prior to the global financial crisis, in most cases, the USD actually underperformed other DM currencies in risk-off environments. EM currencies have a more mixed track record.
Figure 2
The USD has been curiously weak during and since the SVB fiasco. Maybe the pandemic-induced fiscal spending and debt-fueled asset bubbles are starting to catch up to the greenback.
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