MAGGIE LAKE: Hello and welcome to the Real Vision Daily Briefing. It's Wednesday, January 5th, 2022. I'm Maggie Lake and here with me today is Darius Dale of 42Macro. Hi there, Darius.
DARIUS DALE: Maggie, what's up? Happy New Year. How are you?
MAGGIE LAKE: Same to you. I want to say Happy New Year, but it doesn't feel that way today, does it? We were just watching these markets fall apart right before we came on air. And there is a lot to unpack. The prospect of a more aggressive Federal Reserve really hitting markets late in the day in the minutes from their December meeting, FOMC committee members discuss reducing the balance sheet shortly after raising rates, whether they should do that or not as a way to ease back support for the economy.
And boy, the markets did not like the sound of that. And you rightly pointed out like when's the last time FOMC minutes move the market like this. It's been a long time, but that gives you a sense of what's happening. Just to wrap it up for those who may be out and away from their computer listening to this, US stocks lower across the board. They're still settling, but the selling accelerated into the close, which is something that you don't really want to see happen.
The Dow down almost 400 points, 1%. S&P down almost 2%. NASDAQ taking the brunt of it again with technology down 3.75%. The VIX up 18, the Russell down 3%. And you saw it in bond yields as well, the 10 Year up to 1.7. And those FOMC minutes, by the way, came on the heels of a hot ADP number which was swamped by that news, but private payrolls rose just over 800,000 in December. That was double expectations, so all of this really pointing to a different environment when it comes to the Fed. What would you make of it all, Darius?
DARIUS DALE: Well, that hashtag New Year New You, I think we got a New Year New Fed, and it's going to have market impact. This is something we've been talking about in this program ad nauseum for several months. And I think today, we got a preview of what the broader balance of 2022 will look like, if you think about a Federal Reserve that is no longer aiding and abetting, fiscal authority that is no longer dumping cash into the economy and comes with it a whole different set of asset allocation implications.
And unfortunately, I think investors are going to have to wake up to the fact that we were joking about this earlier, but the 2022 could be the year of the bumper sticker, the banner, the headline for 2022 could be the year where unrealized gains turn it to realized losses.
MAGGIE LAKE: Yeah. And that's true, [?] still good looking those amazing gains in their portfolio, but they're on paper right now. A lot of people are probably worried about that. We really haven't been in this environment, have we? We have been on this streak of equities outperforming, there is no alternative. Everyone piling in, even if you're feeling like things got toppy the last three years, if you tried to be more conservative, you got burned.
That was not working. Where does that leave us now both from a price action point of view, and psychologically as well?
DARIUS DALE: Well, I think the biggest issue, obviously, is the fact that what's happening sooner than investors really would hope for it, or certainly would have planned and/or positioned for that. If you think about what the minutes today apply to, effectively, they're willing to tie quantitative tightening and reduction in the Fed's balance sheet to the onset of interest rate hikes, the timing of liftoff, which is very much likely going to be March.
We've been saying this in our analysis. If you look at our forecasts for core PCE where they're likely to be at various intervals into those for SCPs, Fed meetings this year, we always thought March was a live meeting. And I think that the minutes today confirm that. Well, the minutes today surprised us. And to me, I think you have to give a golf clap to Jay Powell for giving us a Santa Claus rally, because he could have very easily had this conversation a few weeks ago in terms of the committee's willingness to have a very open and honest debate about quantitative tightening, and actually pulling that forward really into the early part of 2022.
But he obviously held off and didn't want to spook the markets at that particular interval, because they were already accelerating the tapering and getting investors set up for more than two rate hikes in 2022. It's all happening sooner. It's all happening faster. And that speed of the changes we talked about, in our research, I think we do some of the best research in the world on this, the speed of the change matters. The direction of travel matters, but almost sometimes as important as the speed of the change right now, policies changing in a very, very quick manner.
MAGGIE LAKE: And because you look at that so closely, I want to focus on what happened in some of the markets today. There's a lot of questions about whether this can be orderly, whether the economy can withstand this change, but let's drill down on what we saw. And again, because we saw that deterioration at the end of the day, we started to get a sense of this in the bond market before we saw it in stocks, didn't we?
We've had, for those of you who watch the bond market, and it's frankly, not all of us on a daily basis, most people are more glued to the equity part of their portfolio, because we've all been sitting in mostly equity.
DARIUS DALE: Nobody's long bonds, nobody long cash. It's been two consecutive years almost where you've done very poorly to have asset allocations into fixed income and asset allocations into cash. Obviously, high beta risk assets have been the place to be really since going back to the [?] or the pandemic, but sorry, they're going to kill you.
MAGGIE LAKE: Yeah, absolutely. Jump in anytime. That's right. We haven't been watching the bond market. But for those who do, especially in the macro world, we've seen big moves, and bond markets don't usually move super aggressively like that unless something's going on. And we saw it again this afternoon. That 10 Year creeped up again to 1.7%. And the 10 Year tends to be the benchmark for the US. Would you expect that yield to continue to move higher? What are you seeing when you look at that chart?
DARIUS DALE: Yeah. The short answer is yes in the short term, but the reality is it's not because of the reason you think. You go back to what happened in the bond market, this actually started happening last week in terms of the drawdowns we've seen really some pretty material drawdowns across the long end, long duration fixed income, not just in the Treasury market, but really abroad.
And in terms of our models, we started to pick up on a breakout in bond yields in Europe in particular, going back to last week, if you think about the German bund 10 Year. This week, we had the 10 Year gilt yield out of the UK, 10 Year [?] breakout, 10 Year JGB yield breakout. A couple weeks ago, we had the 10 Year Treasury yield breakout and then this week, we also have the 30 Year Treasury yield breakout.
We've had a lot of changes in our model in terms of our market nowcasting process that presaged a lot of this. To me, I think you really have to answer the question, which is, was this based on quantitative tightening in the bond market frontrunning that and the Fed minutes? I would tend to think part of what we're seeing, yes. But I think there's another solution and another answer to that question as well.
If you guys can pull up the charts, I did mention the 10 Year German boom chart having started to really break out in earnest in the last few weeks and it's now bullish from the perspective of our volatility adjusted momentum signal. But then when you decompose, looking underneath the hood of the equity market, we look at some of these ratios as an indicator of market risk. You think about starting with the high beta to low beta ratio, these are high beta stocks, stocks that tend to be more volatile well to the stocks that are more defensive and less volatile. and that ratio bottomed, putting up that chart, that ratio bottom has headed higher over the last couple of weeks.
The next chart, we showed the value to growth ratio, which bottomed even a few weeks before that, and then so now, it's actually gapping higher. And then lastly, you haven't really seen it yet in the small cap, mega cap ratio but the reality is some of these procyclical ratios are really starting to show up. And to me, we made this call going back in September, we're in the middle of the market correction, we made this call going back to October 2020, we're in the middle of the market correction.
And typically, what happens when you see procyclicality, when you see cyclicals leading, high beta, small caps, value leading in a correction, it's a harbinger for positive things on the other side of that, typically when rotations happen, and those rotations tend to occur when you have a positive economic development. Guess what could be the positive economic development? Well, it could be this thing called Omicron catalyzing herd immunity for not only the US economy but for the global economy and really ushering in what we think will be a shallow positive growth impulse to start the year.
That is the positive message in all this, but obviously, the negative message is that's going to be short lived if you take advantage of that. Because again, we're talking about, obviously a reduction in liquidity at some point this year. But what could potentially be a meaningful reduction of liquidity, if you think about the Fed's balance sheet being near almost $9 trillion, and they might actually be very uncomfortable with that just in terms of the size of it, where it is today relative to where it was at the start of the pandemic.
MAGGIE LAKE: So there is a, if I'm understanding it correctly, a very short term in this pain, a short term pocket of opportunity, but then as we look out further into what? End of Q1, beginning of Q2, you've got to do that trade and get out because then, there are even rougher waters around what's happening with the Fed. Is that correct?
DARIUS DALE: Yeah, that's exactly what we're saying. That's been our call all along. I think it's been hard to stick with the call at various intervals in this the second half of 2021. But we've always thought that the time for which investors should anticipate a meaningful rise in volatility, a meaningful widening in credit spreads, and ultimately some trending pain in their portfolios was late Q1, early Q2. A lot of stuff happens in late Q1, early Q2. If you think about, you're going to see a faster, it's likely according to our models, a sharper deceleration in growth starting around that timeframe. It's very likely to see a sharper deceleration inflation around that timeframe. And it's very likely that you see a meaningful reduction in liquidity starting around that timeframe.
And those dynamics should persist really all the way through 2022 and into 2023. It doesn't mean markets have to go down that entire time, eventually, they'll find the bottom and price it all in. But the reality is, I don't think we're anywhere near that bottom. If you think about the last few times we've come off the peak in the global growth cycle, which we're effectively arguing that we're near and pressing through, you've seen a roughly 30% decline in high beta stocks relative to their low beta counterparts in each of those intervals.
We've seen 75% to 85% decline in Bitcoin relative to Treasury bonds in each of those last three cycles. And these are market cycles that are tethered to the broader economic cycle. This is always a risk we thought was going to come to fruition in 2022. And I think we got a real meaningful preview today. That doesn't mean, again, I just want to be very clear about this, I do believe that in terms of our dispersion analysis and our ratio analysis looking at market internals, it's not suggestive that this is the main event.
On that last chart we have showing the dispersion analysis, this is something we track on a daily basis at 42Macro, which I call this on a daily basis at 42Macro, by the way. These are all charts from our morning note this morning. You look at, what we're tracking is the month-over-month Sharpe ratio across 50 US equity sectors and style factors. And one reason we track it that way is we want to observe changes in the composition in the upper quintile relative to the lower quintile.
And one thing that's really caught my attention of late is the fact that we've started to shift back towards procyclicality in the upper quintile. And now you have four sectors, or four style factors represented in that upper quintile, you think about least shorted value, least shorted high debt value, and now you have least shorted high beta. Investors are starting to tiptoe back into cyclicals in the more safer categories, not in most shorted high beta stocks trying to YOLO it.
But they're certainly seeing that. And the reason I bring this up again, is because when you see that reemergence of procyclicality in the upper quintile in a market decline, it typically is a harbinger of a real positive move higher. Again, the last few times this happened during the market decline was September of 2021 and October of 2020, so be aware of that.
MAGGIE LAKE: When you're talking about those sectors, what would they look like for someone who's listening to it, for the average person listening to it, what kind of industries or stocks are they?
DARIUS DALE: If you think about where the value trade is generally concentrated, it's generally concentrated in the heavy stuff that hurts when you drop it on your foot. It's the materials, industrials, obviously, financials tend to be that way as well. It's been financials been value my entire career for a variety of different reasons.
That tends to be-- what's happened in the QE era is because we had so much financial compression or repression that the secular low or the high quality compounders, as they call them in Boston, those types of stocks have really gotten a real valuation premium in so much that the traditional bond proxies like utilities, consumer staples, REITs, healthcare, those types of stocks have also gotten a valuation premium. If you want to slice and dice value versus growth that way, or high value stocks versus low value stocks, that's a really easy way to do it from an industry perspective.
MAGGIE LAKE: Which is super helpful. We have a question from Goncalo on The Exchange and it's pretty technical. In your conversation with Cem in RV, for those who didn't watch it, that's on the platform, you guys talk about a good strategy right now is stock replacement to bet on fat tails. Is this because volatility will be higher this year and the right bet is to get exposed to a melt up or melt down, but not a normal market? Could you explain the rationale and maybe explain a little bit of technicals as well if you could, Darius, for those who didn't see that interview.
DARIUS DALE: Yeah, absolutely. You guys are [?] about like 5% of Cem Karsan when I reply, so just be aware of that. Cem's one of the world's best at what he does, and I'm only going to pretend to be in for a few minutes here. But I think my interpretation of what Cem was discussing in the terms of stock replacement is the fact that vol is really low now but, it's expected to widen and widen materially in those forecasts and I do share a lot of the same views in terms of the market risk dynamics we'll see this year.
Because vols slow down and you're expecting large tail risk moves, the reality is if you want to stay long, it's a lot smarter and carries much better to be long a call spread as opposed to being long the actual underlying. Being long the underlying just exposes you to that leptokurtic tailrisk in terms of maybe you melt up let's say the S&P touches 5000 then goes back to 3500 in a straight line. That's the risk you want to avoid. And you can mitigate that downside, that volatility to your portfolio by just simply stock replacing it with a call spread.
MAGGIE LAKE: Okay, that makes sense. And from what you just said a moment ago, it sounds like we could be in a situation where it's not going to be this straight line down either. The way it was, we did really see that rally after rally on the way up, it sounds like it's going to be volatile, and it's going to bounce around, because you just said that you may see that value, but then you're going to get into that really tricky part of next year where the Fed is going to be implementing some of this stuff if it comes to it. It sounds like it's going to be a lot of volatility.
DARIUS DALE: Yeah. Look, I very much try to, I lean perma bull just because I started in this business in the spring of 2009 and obviously, it's been straight right up since then. Just in terms of my own market experience, I tend not to bet against asset markets and the ingenuity that we have in this economy and in the society. But I think it's very easy.
And I think I've seen a lot of investors get this at this point, I think it's very easy to paint a secular bearish outlook for the market. And the reason I say that is twofold. One, we're coming from a really asymmetrically high level of growth, not just in the US economy, but also in the global economy. If you think about, obviously, growing at about 5% to 6% real here in the US, expectations for 2022 are somewhere around just shy of 4%, which is almost a double of where the trend growth rate is.
You're talking about we could have multiple years, either we're going to have a very sharp slowdown back towards or through trend, or we're going to have a multiyear deceleration whereby the Fed put struck significantly lower as a function of the inflation pressure we're going to have in the economy over the next few years. We're going to have this multi, potentially multiyear very sharp slowdown in economic activity, whereby the Fed can't just bail out the market.
Actually, now their main objective at this point, in our opinion, is fighting inflation in line with the Biden administration trying to salvage whatever political capital they have into the midterm elections.
MAGGIE LAKE: And addressing the real pain that's being felt on Main Street for people who for any wage gain they're getting is being eaten away by inflation, which the Fed is surely seeing. I