Finding Some ‘Real Perspective’ in this Market Cycle

Is it possible to travel in two directions at the same time? Imagine walking to the restroom at the back of an airplane while in mid-flight. One would have, quite deliberately, been completing two missions at once, in completely opposite directions, and at very different speeds.

Economic cycles can display similar characteristics: there are longer demographic cycles that are in a downtrend today (further accelerated by Covid), which suggest lower levels of potential growth and a greater need for commercial efficiency to mitigate a shrinking workforce. Simultaneously, this very same need for efficiency is driving a rapid technological revolution that is in the midst of an uptrend (the CC: All economy, as we described previously), which is also accelerated by Covid. Balanced portfolios need to appreciate both of these cycles, among others, while navigating yet another cycle: the market cycle.

Indeed, the market cycle appears to be traveling at warp speed today. In less than 12 months, we have experienced a historic meltdown, a bottom carved out by fiscal and monetary policy action, and a full market recovery. But In the background of this hyper-speed activity, there appear to be some clear and distinct investment regimes evolving. We think we’ve passed through two regimes, are nearing the tail end of a third and are at the precipice of entering the fourth.

Regime 1: Covid gets priced by the market, illiquidity persists

No superlative does justice to the market carnage in March 2020. The S&P 500 experienced its fastest 30% drawdown in its history, leaving the Great Depression a distant second (it took twice as long then). What started as a social/humanitarian crisis threatened to become a full-blown credit crisis, as the uncertainty around future cash flow streams resulted in spread blowouts, inverted spread curves, and frozen capital markets. Investors sought liquidity by raising cash, in order to meet impending redemptions, as evidenced by record money market inflows. Yet, surprisingly perhaps, the cleanest indicators of an illiquid panic were to be found in the rates market – through a spike in real rates and collapse in inflation breakevens – suggesting a deflationary bust so severe that it required an immediate policy response.

Regime 2: Central bank steps in and provides liquidity

And what a policy response it was. Global liquidity increased by a staggering $7.5 trillion in 2020, setting a new record, as policymakers sought to force real rates down, and restore inflation expectations (spoiler alert: they succeeded at both). Our investment response at the time was to follow the Federal Reserve by buying both duration and high-quality assets. The spreads on offer in AAA securitized (auto loans at 400 basis points (bps); student loans at 600 bps) and yield pickups from moving one notch down in investment grade credit (100 bps to move from single A to BBB, for example), made it quite unnecessary for fixed income investors to reach much further down the capital stack in order to hit 4% to 5% yield targets. And returns very much reflected this wave of liquidity lifting all boats – almost all major asset class performed extremely well from April through July.