>>ALFONSO PECCATIELLO: Welcome to the Real Vision Daily Briefing. It's-- what day is it? Thursday, February 3rd, 2022. This is Alf speaking from the Netherlands, author of The Macro Compass and contributor to Real Vision. And today, I have the honor to have with me a guy that only few people can understand, the one and only exquisite Michael Gayed, who is the CIO and portfolio manager of Toroso Investments. Michael, how are you doing?
>>MICHAEL GAYED: I'm definitely not atrocious, so I appreciate all that.
>>ALFONSO PECCATIELLO: Welcome here. And so, today is a pretty interesting move day in markets. We have the NASDAQ being completely slaughtered after few companies have released pretty bleak outlooks on earnings over there. And I know that you have some opinion on some of these names here, and in high beta tech stocks, so we will call those. We also have the ECB today, European Central Bank, coming out with quite an interesting press conference. Michael, shall we maybe start from the move that we're seeing in the stock market? It's pretty atrocious what's going on, especially in certain sectors, what's your take there?
>>MICHAEL GAYED: Well, it's funny, you said you couldn't remember what day it was because it seems like Groundhog Day is every day, even though it was just yesterday. The same kind of market action is persisting. So, I keep making this point that we have not really seen risk-off just yet. As much as January was pretty harsh for most risk seeking investors, the reality is, and I know you've talked about this as well in your own research, it did not have the ear markers of what a classic risk-off environment is.
>>And when I say risk-off, what I'm really talking about are dynamics in terms of volatility not only changing, but in terms of certain intermarket relationships manifesting in a particular way. Typically, when you're in a real risk-off scenario, credit spreads widen. And why is that? If you were to overlay credit spreads against the VIX, you'll see pretty much a one for one relationship. Because when you have volatility in equities, there becomes a repricing of default risk premiums, so high yield becomes higher yield in that a period.
>>Instead, what we saw in January was not credit spreads widening, but I'd argue more of a shift in the entire bond market, largely on this realization that inflation is here to stay. And if that's the case, then we could still see a bigger decline yet to come, just as everybody seems to think that the decline may already be over.
>>ALFONSO PECCATIELLO: Yeah. And interestingly, you mentioned, Michael, credit spreads, something we've been discussing here for a while already. And wasn't it interesting that Powell during the press conference was asked multiple times about financial conditions? And he said he was not impressed. And one of the reasons that he said he was not impressed is because financial conditions were threatening his dual mandate.
>>But if you look at the components within the financial condition index, credit spreads were the ones that were holding their ground the best. You didn't have much widening in junk credit spreads. I just pulled up a chart to show how these credit spreads in in the low rated portion of corporate bonds have actually widened pretty aggressively. They seemed to have broken out of the range that they kept for a while. What does this tell you, Michael, are you are you really worried and does it have cross-asset implication as you were saying before?
>>MICHAEL GAYED: I think it's possible. First of all, the time to worry about credit spreads is when they're very narrow, because just like volatility, it's very mean reverting, these waves of narrowing and widening. And it's interesting, because spreads tend to stay narrow when inflation is high, because the idea is that junk debt issuers end up having to pay back their debt with dollars that are worth less.
>>So, there's a link between inflation expectations and spread movement, which might explain why some of what we've seen in January was not the classic risk-off in terms of spreads widening and blowing out to the same degree as beta sold off. Now, having said that, if the central banks around the world are as serious as they seem to be to try to counter inflation, we know that it's very hard for them to thread the needle when so much of the system is so levered in a way that I would argue that they risk potentially a deleveraging deflationary pulse in their hiking of rates.
>>And that may ultimately be because the stock market itself keeps going down. You and I were talking briefly before about this notion that the stock market is no longer just a leading indicator of the economy, but rather a driver of it through the wealth effect. And if you go with that narrative, and that idea, well, then it seems to make sense that the way to break inflation is to break the stock market.
>>ALFONSO PECCATIELLO: Well, such a powerful statement, Michael. So, what you basically just said, if I can try to get my angle into that as well, I wrote an article at The Macro Compass, it's called The Macro Endgame, and talks about the fact that we have been basically leaving the wealth illusion effect. What we do is we basically lever up the private sector or the public sector or both at cheaper and cheaper borrowing costs. But while for the public sector, these borrowing costs are only risk-free real interest rates at the end of the day, for the private sector, you have to overlay credit spreads too.
>>And so, on some point, these junk companies find themselves with the rising real interest rates, that's what's happening today because central banks are trying to fight inflation, they want to lower inflation expectations, they push up nominal yields, so risk free real interest rates go up, but also credit spreads now start to widen. So, the aggregate refinancing costs in real terms for these junk companies goes up. And as you said before, well, that actually has a domino effect as well on the risk premia. And so, if you break down this risk premia, you basically deliver via stock market losses, the private sector.
>>this is not the, I will say, the most gentle way of deleveraging and bringing back things to a more, let's say controlled level when it comes to aggregate demand. But is there any other way that you think central banks could try to engineer a gentle tightening of some sort?
>>MICHAEL GAYED: Probably not, because the options are fairly few, among all the things that they can do. Couple of things on that, though. Keep in mind, if spreads do start to widen, it's going to happen in an aggressive way, it's going to happen at a point where smaller cap companies look like death. So, if you're looking at the Russell 2000, you look at the Russell 2000 growth as an example, for all this talk about how it's been a bull market, we have been in a bear market since February of last year, true period.
>>I don't care what anybody says about these large cap averages, the vast majority of stocks peaked in February of last year. Now, if small caps which are already pretty bombed out, if those companies now fundamentally have to deal with higher financing costs because spreads widen, if they stay wide, whenever that occurs, that's a real nasty setup for defaults in a large number of companies. There is a scenario where you can make an argument that you could have some real devastation in the real economy if financial conditions, which for the Fed really is spreads, start to blow out in an aggressive way.
>>The other complicating factor, I'm curious hearing your thoughts on these too, Alf, is we know that historically, when oil spikes, that tends to precede recessions. Last I checked, oil crossed above 90, I think, at some point today, and that's not really a spike. When I say spike, I'm talking about like 150 in a matter of weeks. But you know better than I do, there's a lot of people smarter than me who are making the argument that we're sleepwalking into an energy crisis. And that would complicate everything that central banks are trying to do this year.
>>ALFONSO PECCATIELLO: Yeah, that's very much true. Don't tell me about oil because I'm short. So, I'm bleeding big time. It's hurting. But yeah, it seems to be relentless. There is this this tailwind of the green transition effectively and drawing down inventories that generate structural tailwind for some of these commodities while we try to transact to a system that will demand a lot more consumption of these commodities while the capex or the production side of it seems not to be able to pick up, so the structural transition is there.
>>And if these tailwinds are really structural as you said, they have, of course, second round effects both on inflation itself and on inflation expectations. So, then for a central banker trying to tame these pressures, that's pretty tough. I tend to agree with you. I wanted to ask, Michael, your opinion about the stock market move. So, it's gathering a lot of interest to see this let's say large market cap weighted indices having these large intraday swings.
>>It's pretty wild at day. I think last week, we had the NASDAQ delivering the largest intraday recovery ever recorded over the last whatever, 50 years plus. So, you and I discussed before that you have this view of market internals telling you something here. So, can you elaborate on that?
>>MICHAEL GAYED: Yeah, I keep making this point that we're in a really nasty and tricky juncture. Because I do believe that there's an extreme tail event, some low probability, but high impact Black Swan-ish type of way that things could play out. The problem is it's not clear the direction. And I know that sounds strange, because typically, when people think about tail risks, they think about the downside. They think about the left tail, not the right tail.
>>So, here's the dilemma. To every storm, there's a magnitude to how bad the storm is and there's a duration and time. So, I go back to February of last year is when a lot of the stock market internally topped out. If you were to look at breadth charts, that's when breadth started deteriorating. You look at small caps, you look at emerging markets, you look at the speculative areas like Ark, that all topped in February, and it's been pretty unrelenting all the way throughout the entire past year.
>>So, on the one hand, the bears would argue that the generals are going to fall to the soldiers. The large caps, which had been holding up the averages will break down to everything else. That's your washout. That's your capitulation. But the other part of this is that because it's lasted for so long, maybe you have the exact opposite in an unbelievable way, meaning a huge relief rally in small caps, in emerging markets, in the Ark-type funds, strategies and underlying innovation type stocks, the areas which are very high price to sales.
>>They could still ultimately go lower. But it's always about the sequence of returns when it comes to trading and investing to some extent relative to your own behavioral responses. So, because of that, because I think the tails are so large on both ends, I was joking a little bit earlier that if I could, I would probably consider something like buying out of the money calls, and out of the money puts. Death on the extremes, because given the length of time these divergences have played out, it's going to probably resolve itself in a very violent way.
>>ALFONSO PECCATIELLO: That is a strategy that we call, well, you, I, whoever is professional involved in time straddles, long straddles, you basically paid two time premium, one to buy a call, one to buy a put, both very out of the money, so that effectively, you're betting on some volatility spike one way or another to profit. And if nothing happens in the meantime, you just end up losing money.
>>But if you're really convinced that you're going to break either up or down in a vicious way, being long straddles, that's the strategy that we just discussed, out of money call and out of money puts, seems to be the right thing. When talking about Ark and Tesla, let's say these very high beta components of some of the indices, and especially the high-tech stuff, I would like to get the audience to first listen to a clip that was-- to an interview, actually, that was recorded at Real Vision where Martin Leibowitz and Rob Arnott discussed the impact of low interest rates on the valuations of these high beta tech areas, and Rob had some interesting thoughts on that.
>>ROB ARNOTT: Yeah, it's interesting to me that people think that low interest rates should create higher valuation multiples. And again, there's so much narrative driving markets that is not supported by empirical data. If low rates would create an environment where equity valuation multiples should be high, well, what about the 1950s? 2% rates and an earnings yield of 10?
>>ALFONSO PECCATIELLO: Well, and the 1930s.
>>ROB ARNOTT: Yeah, and for that matter, if rates of just under 2% are fine for US valuations to be at 38 times the 10 Year earnings, why in Japan and Europe were 10-year rates are essentially zero? Why did their valuation multiples come in 30%, 40% below ours instead of massively higher? That doesn't make sense.
>>ALFONSO PECCATIELLO: The interview is available on Real Vision for the Essential Plus and Pro tiers if you want to listen to what Rob was saying there. And further, the Japanese example where 10 Year interest rates have been basically at zero for a long while and together with the fact that therefore, real interest rates also were dropping while the valuations weren't picking up is interesting. But coming back to the Tesla and Ark story, whose valuations by the way, were very large too, Michael, we had a chat before, because you have a pretty interesting theory on the Tesla, Ark story and correlation back and forth. Do you want to help us understand what that is?
>>MICHAEL GAYED: Yeah. And really quick on that point that I think Arnott is 100% spot on, it goes back to this narrative of "don't fight the Fed". I always go back to what in the world does that even mean? Because I'm pretty sure if you fought the Fed by shorting small caps, which all those dollars are supposed to help, because they're most tied to the domestic economy, you would have won that battle. So, these narratives, I always rant on this on my Twitter on Lead Lag Report account, there's so many narratives that don't make sense if you just ask a few questions deeper and start tearing these apart.
>>Okay, now on this. Let's go back to, okay, we're in an environment where I think there's an extreme, let's play out the negative extreme for a moment. There's, I think, a really interesting structural dynamic here, which I keep teasing out. And I talk from the standpoint of somebody who runs funds, who knows how fund flows work, with my mutual fund, my ETFs, you see the tickers in the background here. But there's this really amazing phenomenon when it comes to Ark and when it comes to Cathie Wood, ARKK, where the enormous drawdown in performance is actually greater than the drawdown in assets under management in Ark.
>>Now, that's unusual because if you've been in the business, typically, assets follow performance. So, as something performs poorly, assets start getting sold, people start bombing out of the position. People have actually been buying into Ark, so they've had net inflows actually from the last I checked, a billion plus over the last year or so, despite performance looking terrible. Now, what if that reverses? What if you have capitulation in investor behavior, where people say, the hell with it, I'm not going to touch this thing anymore. I want out of Ark. Some real nasty selloff in the Ark fund.
>>Well, the largest position of a ARKK is Tesla. That's like, I think last I checked, around 8%. If Ark goes down because you have massive investor redemptions, you better believe there's going to be all kinds of domino effects on Tesla which has all kinds of domino effects on the broad market averages, which could result in broader massive deleveraging and potentially a global margin call. I know that sounds like a strange concept, but we live in a chaotic system where butterflies flapping their wings can create hurricanes. And given how much margin there is in the markets, it's not impossible to see something like that really create a nasty, nasty setup for the bulls.
>>ALFONSO PECCATIELLO: It is a pretty interesting theory. It is basically a reflexivity bias or a large fund attracting a lot of interest in owning a large cap stock that has an effect, has a butterfly effect basically on large cap indexes and therefore on the entire risk-taking appetite from market participants out there. So, basically, investors should be watching out for this market internals and this cross-asset correlation and sometimes even these reflexivity biases, right, Michael, that's what you're saying?
>>MICHAEL GAYED: Yeah. And it's also infesting, because you're even seeing with Meta Facebook and the effect that one company has on the broader "stock market". The classic argument in investing is you want to diversify to get rid of company specific idiosyncratic risks. Every company has idiosyncratic risks, so you diversify so they end up crossing each other out. Well, what happens when idiosyncratic risk exists in the large cap averages, because five or six stocks are about a quarter of the entire market cap of the S&P? You see days like today.
>>So, I really do believe that people are under estimating how much idiosyncratic risk they are having in a so-called diversified portfolio of 500 stocks.
>>ALFONSO PECCATIELLO: I have to agree with you. I always call the S&P 500 the S&P 5 for a very good reason. It's just part of the game. There are also ways to get exposure to the stock market that are not market cap weighted. There is also a very relatively liquid and low expense ratio equal weight ETF, as well, if you want to get exposure to, let's say, the beta of being exposed to the stock market, but it's of course, much more common for the indices which are market cap weighted.
>>Changing a bit the topic, Michael, today as well, we had a pretty important Central Bank meeting, actually two. One was Bank of England this morning, and the other one was the European Central Bank, and actually both gave a very similar hawkish outcome. So, Bank of England raised rates by 25 basis points, but there are nine people on the MPC, on the Monetary Policy Committee of the Bank of England, and four of these nine guys voted for a 50-basis-point hike. So, we were very close to getting the hawkish price of a 50-basis point hike.
>>And then you move to the European Central Bank, and they are known to be probably together with the Bank of Japan, the most dovish global central bank amongst developed markets. Today, Lagarde couldn't keep it. She went out and literally said that they will be working on the forward guidance going forward. And then we'll probably most likely remove the QE and taper it back to zero much faster than market expected, which gives as well a very decent chance the European Central Bank is going to hike rates this year. And