Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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The equity bounce as mean reversion kicks in
Peter Garnry
Chief Investment Strategist
Summary: Equities are rallying as many of the moves from the past two trading sessions are reversing. There is a sense that the market has survived a shell shock, but it is important to note that financial conditions are now the tightest since early October suggesting equities should be weaker. But yesterday and today, short-term flows are dominating the market and everyone should be careful of being too quick to draw conclusions. It could in fact be Bear Stearns all over again. In today's equity note we also talk about small cap stocks and the private equity industry as segments that could come under pressure from higher financial conditions.
Is it Bear Stearns all over again?
Following yesterday’s chaotic flows across many markets, with the most historic moves observed in the US 2-year yield and Fed Funds futures pricing the direction of future Fed rate decisions, we are observing a relief rally today. Equities are higher, several US financial institutions are up in pre-market, bonds are lower, interbank funding stress is coming down (see FRA-OIS spread below), VIX is coming down and the VIX forward curve is less inverted, and the USD is stronger. There is a sense today that the financial system suffered a shell shock but ultimately survived.
While risk is bouncing back it is worth noting that US financial conditions are not rebounding to the same degree. US financial conditions are as tight as back in early October, so all things being equal the S&P 500 Index should be lower reflecting these tighter conditions. The fact that US equities are not reacting to the tighter financial conditions are either 1) short-term flows and trading are dominating the price action which is today betting on mean reversion, or 2) that equity investors are betting that financial conditions will quickly loosen again. Our view is that this event did happen without longer lasting effects in the system and changing market behaviour.
The downfall of Bear Stearns certainly comes to mind observing the markets response. It all started with two failed Bear Stearns credit hedge funds failing due to losing 90% of their value in July 2007. The market got initially spooked but carried on to new highs. The problems came back and on 14 March 2008, exactly 15 years ago, after initially been given a loan from the US government the investment bank was taken over by JPMorgan Chase. The market initially celebrated by the swift rescue and solution to the problem with equities rally over the next two months. Eventually the problems snowballed into a systemic risk that ended with the Great Financial Crisis.
With tighter financial conditions and the US February inflation report showing that the US services core inflation remains at 7.3% annualised our view is that investors should consider their exposure to small caps. This segment has a higher debt leverage to operating income compared to S&P 500 and it is have a lower EBITDA margin meaning that smaller companies have less pricing power amid inflation. The higher debt leverage also means that tighter financial conditions will hit smaller companies more.
Private equity leverage on the rise
Listed private equity firms have been hit hard during the SVB Financial fallout as all pockets of the financial system got repriced lower. It is clear that the venture capital system experienced a dramatic blow and it will just reinforce dynamics that were already taken place, that venture capital funding is drying up. This will force venture capital firms to restrict the new lower funding flows to their best and largest positions. The long tail of venture capital backed companies will have to do it alone to a larger degree which means cutting costs. Overall, the discount rate for venture capital firms has also gone up which means demands of faster profitability by the companies they invest into. All this points to a less aggressive startup ecosystem for the time being and less investments.
The private equity industry has a less uncertain funding situation as many of the private equity owned companies are cash flow positive and thus the sources of funding are more diversified for private equity firms. But many private equity funds have moved into real estate investments, alternatives such as renewable energy projects, private direct loans competing with banks, their own venture capital investments, and generally been part of a cycle of higher equity valuations on private companies. In many ways private equity firms are a secondary or shadow banking system. The leverage among private equity firms has risen substantially the past year so that the asset-to-equity ratio is ~3x compared to ~2.1x before the pandemic and ~1.8x in 2013.
Blackstone has recently experienced significant redemptions in its real estate fund outstripping the fund’s limits on redemptions. Private equity funds come with different lockup provisions and thus we cannot generalise, but if investors suddenly began questioning the asset values of private assets or simply redeemed capital from funds with less strict redemption limits then these funds could put downward pressure on the industry. The total assets in the S&P Listed Private Equity Index are $1.3trn and according to McKinsey the global total asset under management was $9.8trn in 2021. Latest Market Insights
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