The Ivory Hill RiskSIGNAL is still red (since January) and we are still sitting on roughly 85% cash. Since we moved to 60%-70% cash in January, roughly $12 TRILLION in U.S. stock market value has evaporated.
The S&P 500 just finished its third consecutive quarter of losses, a worrisome streak last witnessed during the 2008–2009 Great Financial Crisis. The S&P 500 ended its worst month since March 2020 with a loss of 1.51% on Friday. For the month, it dropped 9.3%, while the Nasdaq fell 10.5%.
I think this bear market is just getting started and yet the Fed and policymakers still don't comprehend the new threats that are hurtling toward us right now. Think about what current Treasury Secretary and former Fed Chair Janet Yellen said last week, “I don’t see any erratic financial market conditions.”
I don’t see any erratic financial market conditions.
That statement is just as scary as it is sad. When I look at markets today and what is embedded in the underlying market conditions, I see something completely different than what Janet Yellen is seeing. These market conditions are worse than in 2000 and 2008.
The Fed has gone too far, way too fast on rate hikes because they are almost two years behind the eight ball on raising rates. This aggressive Fed behavior is driving volatility clustering. Volatility clustering refers to the tendency of large changes in asset prices to follow large changes and small changes in asset prices to follow small changes. This is important to know because it supplements our investment strategy that is focused on identifying early indicators of volatility. An example of this is, low-volatility months in the S&P 500 are usually months with higher performance. As volatility tends to cluster, a low volatility month in the present can signal a low volatility month with better performance in the future.
To simplify this:
If you have trending volatility to the downside, you have something you can invest in.
If you have clusters of volatility that explode significantly to the upside on a scale the world has never seen, you are going to have crashes.
The Fed has moved from being in control of volatility to creating volatility, and now we have cross-asset class volatility that is rising.
The MOVE index, which measures Treasury rate volatility, was over 160 last week. That is very close to competing with the pandemic high of 163. Today, the MOVE has moved back down to 141.
Whatever the Fed says now is irrelevant to the investment process. What matters is your account. What matters is protecting your hard-earned money. At this point in the cycle, no one should believe the Fed models.
The bond market has dropped significantly and still has more room to go, but bonds are beginning to look like they might be a good investment in the not-too-distant future. I realize that I have made this claim before, but the entire global financial system depends on US treasuries, so at some point they will bottom and stabilize. Keep calm; the bond market will return eventually, just not today.
I've been arguing for a long time that inflation isn't the true enemy of the economy right now. Credit and currency risk are. The $360 trillion in total global debt and the $31 trillion in U.S. federal debt are the root causes of the issue. When central banks lowered their benchmark rates to zero and even the longest-term debt only offered a yield of about 2%, no one had difficulty piling up debt when money was cheap.
That avalanche of debt is now proving difficult to service since inflation has predictably turned into a problem and central banks are aggressively hiking interest rates to confront it.
The majority of investors are ready to downplay the likelihood that something extremely catastrophic could occur since they feel comfortable believing that things aren't that bad. If you didn't think that the situation was not only growing worse but also dangerous, or if you thought that a true black swan event wouldn't occur, you need to be aware of what happened in the United Kingdom this past week.
All of it started with the ambitious new tax cuts proposed by the U.K.'s new prime minister, Liz Truss. This was a bad idea on its own in the current climate because it effectively reduces national tax revenues at a time when debt loads are already crushing, interest rates are surging, making it harder to pay the interest on existing debt, there could be an impending energy crisis, and inflation is expected to be around 10%.
Because the Truss proposal had no immediate plans to replace the money, the market rejected it as being financially reckless. At a time when monetary conditions were already quickly deteriorating, it was virtually endangering the U.K. economy by threatening it with increased debt and deficits. Let's not forget that the Bank of England (BOE) planned to drain liquidity from the market and run down its balance sheet around this time.
As a result, rates on U.K. government bonds increased and the value of the pound fell. If the harm had only affected retail and institutional investors, that would have been bad enough, but the U.K. pension market could have been a much, much bigger victim.
In order to fully comprehend why the pension market is such a crucial component of the British economy, it is vital to note a few key facts. First, the market for retirement plans in the United Kingdom differs from that in the United States. In the U.S., the defined benefit plan that supported the retirement of so many employees in past generations has mostly vanished and has been replaced by the defined contribution plan, like the 401(k). In the United Kingdom, 28% of employees still have access to defined benefit plans.
Employers and the government are now responsible for paying for future benefits that are anticipated. Sovereign bonds, which have seen their rates rise and values plummet over the past several weeks, are one of the most common investments in U.K. pension systems, just like Social Security is in the United States. And the pension exposure is rather considerable.
"Long-dated bonds represent around two-thirds of Britain’s roughly £1.5 trillion ($1.6 trillion) in so-called liability driven investment funds, which are largely leveraged and often use gilts as collateral to raise cash." - Elliot Smith, CNBC
Gilts are bonds that are issued by the British government and generally considered low-risk equivalent to the U.S. Treasury securities.
You can start to understand why the U.K. pension market was so vulnerable to interest rate risk when you combine "£1.5 trillion" and "leveraged." Beginning the year at about 1%, the 10-year British bond. Its yield has increased gradually and consistently to roughly 3% as of a couple of weeks ago. That is a significant change in obligations, but if it happens gradually enough, it is at least manageable.
The 10-year yield shot up from 3% to as high as 4.5% in a week after the U.K. government revealed its intentions to lower taxes by heavily borrowing. That's a lot more challenging to control. Since conditions changed so quickly and a large portion of this exposure was leveraged, it led to margin calls, which are something that happen to everyone who becomes overleveraged.
The market was near to imploding entirely unless the BOE intervened, which it did since the credit market was drying up and these pension plans lacked the funds on hand to raise equity levels.
Did this isolated event have the potential to get EXTREMELY bad if the BOE did not intervene? 100% yes.
Where does the British economy stand now if we take a step back and assume this situation is resolved for the time being? More significantly, could this have a global impact?
Let's be clear about one thing: The bond market continues to be quite vulnerable. The United Kingdom's problems are far from solved.
Currently, just like in the US, the UK is tightening monetary conditions in an effort to control inflation, while the UK government is relaxing regulations in an effort to prevent the collapse of the bond market and the economy. Can either side of this tug of war succeed in achieving their objectives? It has roughly the same chance of happening as the Fed successfully executing a soft landing. That's hard to see how it doesn't at least hinder the BOE's goal of getting inflation under control, but if the government's goal is to just avoid an implosion in the bond market, it may very well consider that a big win. A forthcoming recession is likely to last for several quarters, according to the U.K. That timescale won't be shortened by their latest actions.
Less attention was paid to the BOE's decision that it would postpone its planned Gilt sales until the end of October and keep the 2-week window for buying long-term bonds open. I don't think the BOE will resume bond sales, at least not this cycle. I can't wrap my brain around how they can tighten again so soon after an economic bubble almost burst. I think that the BOE's bond-buying initiative will end up resembling the Bank of Japan's in many ways. In other words, instead of just one major developed economy, yield curve control is now taking place in two.
The greatest risk in this situation might be that. I have always believed that the emerging markets would be where a sovereign debt crisis would start first. What if established markets are where it actually begins? Is this a one-off occurrence or is there a larger problem? Is this just a symptom pointing to a bigger problem?
If so, nothing else might matter right now.
I do think we are going to start seeing the narrative change from less about inflation to more about deflation. The Fed is panicking and they will overshoot inflation by raising rates too quickly. I would not be surprised to see more of a run for the sidelines than what we have seen over the past few weeks.
This chart shows the 200 week moving average of the S&P 500. We are approaching a key resistance level only breached in 2001, 2008, and 2020. Hopefully it provides some support here but highly unlikely.
The VIX is in the kill zone and hovering around 30. We need to see this blow out to at least 45.
While credit spreads are back on their upward trajectory we still need to see them blow out as well.
We very well could be sitting in this position for a while now so patience is key.
We are going to sit on our pile of cash and take small nibbles at macro opportunities until the Ivory Hill RiskSIGNAL tells us where the bottom is.
And remember – the one fact pertaining to all conditions is that they will change.
Feel free to reach out to me and use me as a sounding board.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President