Feb 05, 2022
Federal Open Market Committee (FOMC) Chairman, Jay Powell, finally gave up on his hope that inflation pressures were transitory. At a hearing on November 30, 2021, Senate Banking Committee Ranking Member Pat Toomey posed this question to Chair Powell: How long does inflation have to run above your target before the Fed (Federal Reserve) decides, maybe it’s not so transitory? Powell gave some defensive explanation about the term transitory before saying, “I think it’s – it’s probably a good time to retire that word and try to explain more clearly what we mean.”
We take no joy in the chairman’s agony of having to explain why the Fed missed the mark on one of its two founding mandates: ensure price stability in the U.S. economy or simply put - keep inflation under check. Having to forecast many aspects of the global economy for a living, we are very sympathetic to the chairman’s plight. It is not an easy task, and we acknowledge it.
However, it is also true that the Fed employs just over 400 Ph.D. economists and gets close to a $6 Billion budget to help it achieve its goals. We are unaware of any organization, private or public, with those level of resources to conduct economic research and management. So, there is some validity to the criticism regarding the effectiveness of the Fed’s workings. Recall, that only about 15 years ago, it had also missed the biggest real estate bubble in U.S. history which led to the Global Financial Crisis (GFC). On the positive side though, the Fed did a remarkable job in supporting the economy during the Covid-19 crisis in early 2020. Without its forceful intervention, not only the U.S. economy, but the entire global economy would have collapsed.
We do not wish to get into the academic debate of whether the Fed needs to exist or not. We think that the Fed plays a vital role and hence needs to exist. Our concerns are for longer term and structural in nature. One of the most unfortunate consequences of the Fed’s involvement in financial markets of last 15 years has been the emergence of the idea of “Fed Put.” Simply stated, it means that the Fed is expected by market participants to bail out asset markets, equity markets primarily, whenever there is a notable decline. That idea has gained such acceptance that many investors seemingly assume it to be a matter of fact. While not similar, the Modern Monetary Theory (MMT) is principally derived from a comparable idea that government spending should only be constrained by inflation. In both cases, the argument is that the benefits of higher economic growth and lower unemployment outweigh the costs of higher inflation expectations and higher deficits. While we disagree, it is not hard to see why the Fed Put theory has gained such a wide following.
The chart below from the St. Louis Fed shows the extent of Fed’s involvement since the beginning of 2008. From less than $1 Trillion of assets on its balance sheet, the Fed now
holds just slightly less than $9 Trillion. That’s a nine fold increase in 14 years! Granted, the GFC and Covid-19 were tail events with such dire consequences that the Fed had to act in the manner that it did.
But now, inflation is putting a hard stop to its free-flowing monetary policies and, in fact, forcing it to go the other way. We hope for the sake of Fed’s long-term credibility that it does not deviate from its stated path of tightening monetary policy. At the same time, we also hope that they remain attentive to the other half of their mandate – full employment.
We have already witnessed the negative consequences of the Fed focusing only on the unemployment mandate. In the coming months, if the Fed focuses only on the inflation mandate, then other negative consequences will follow. The key, obviously, is to strike the right balance between price stability and unemployment to achieve the so-called “soft landing.” Maybe this time around the 400 Ph.D. economists at the Fed and its $6 Billion budget will deliver results that begins the process to relabel their previous low-quality results as… transitory!
Growth strategy
OppoQuest's GROWTH (GROW) strategy reversed course and underperformed its benchmark by -9.03% in the 2H21. Higher-beta Technology and Healthcare positions drove the underperformance as markets turned volatile after the Fed acknowledged it misread the persistent nature of inflation pressures. Also contributing to the downbeat sentiment was the emergence of the Delta variant of Covid-19 which was reportedly more contagious and more potent. More on it in our outlook section.
The top contributor this period was TradeWeb (TW), the online bond trading platform that presented continued evidence of market share gains versus its competitors. Interest rate volatility in the front end of the curve also helped overall volumes grow. While market share gains may moderate in the next few quarters, the roughly 12% share (per TradeWeb as of Mar’ 2021) of electronic bond trading offers immense growth opportunities for years to come.
ROKU had been the top performer over the last 18 months in our GROWTH strategy but turned negative this period as prospects for higher interest rates crushed high-beta, long duration assets. While we have talked at length about the fundamental case for ROKU, the sharp selloff did surprise us. To be fair, most high-beta stocks showed similar declines and so it is perhaps a case of guilt by association. Regardless of the reason, it was a big drag on the performance. We see a difficult environment for names like ROKU going forward but are willing to digest the volatility if the thesis remains intact.
Moderate Strategy
OppoQuest's Moderate strategy (MODR) also underperformed although the margin was much lower at -2.72% compared to the GROWTH strategy. Individual names drove the performance with no sector recording outsized gains or losses. Similar to GROWTH, TradeWeb (TW) was the top contributor in the MODERATE strategy as well. We have already discussed TW in the GROWTH section and so will avoid repetition here.
PayPal (PYPL) was the top detractor in the MOERATE strategy as the stock declined notably after the company reportedly showed interest in buying Pinterest for ~$40 billion. Despite the company’s denial a few weeks later, the damage to management’s credibility had already been done. While we found the whole episode to be a clear negative for the stock, it did not break our thesis on PYPL. At worst, we think the company’s premium valuation may suffer a bit. But that is likely to be more than offset by the growth opportunities in digital payments category globally.
Conservative Strategy
OppoQuest’s CONSERVATIVE strategy (CNSR) was the only strategy to have outperformed in the 2H21 although the margin was almost negligible. Semiconductors, low-beta tech, and Transports contributed positively while oil services, fintech, and reopening stocks contributed negatively. As a reminder, this strategy only invests thru Exchange Traded Products (ETPs) and Closed End Funds (CEFs).
Invesco PHLX Semiconductor Fund (SOXQ) was the top positive contributor for this strategy as the fund rose by around 20% in the half. As second tier, high-beta tech came under pressure, established and proven areas of Tech found solid support. Semiconductors within that area turned out to be the biggest beneficiary.
The largest performance detractor was SPDR Oil Services position, XES. With West Texas Intermediate (WTI) crude oil prices unchanged for the period after surging ~55% in 1H21, oil services equities lost ground. Participants clearly have very low confidence in oil prices staying elevated and hence every rise is seen as the “last” opportunity to sell. We do agree that oil equities have a limited runway but don’t think oil prices have seen the highs for this cycle. U.S. and OPEC producers are showing remarkable production discipline which should keep supporting higher oil prices. Higher production is the only factor that can reverse this trend because demand seems to be getting quickly back to the prepandemic levels of $100 million barrels per day.
Outlook
For the first time since the Covid-19 crisis, markets are beginning to price in rate hikes. The 2Y Treasury note yield, which is the most sensitive Treasury coupon security to Fed Funds rate, jumped 47 bps to 0.72% during 2H21. While FOMC members haven’t given any firm guidance on a neutral Fed Funds rate, we think it will likely end up between 2.5 to 3% given that the Fed’s preferred inflation rate is 2%. Quite a way from where we are currently.
Equity markets’ response to rising rates at the short end thus far has been exactly on expected lines. Second-tier, high-beta Tech stocks have sold off aggressively even as stable, high-quality Tech stocks continue to move higher. Another factor that needs mentioning here is the emergence of Delta variant of Covid-19 virus. Although initial reports had indicated that it was more contagious and more potent, we have not seen authorities react in panic. In fact, many have taken a surprisingly practical approach and are implementing more subdued measures to combat it compared to 2020. It keeps our conviction in the reopening trade intact.
We remain constructive on the overall market even as we continue to view the Tech sector as vulnerable to higher interest rate expectations. On the other hand, higher rates and steeper curve should provide a powerful catalyst to financials in general and Banks in particular. We have sizeable exposure to financials and would likely use any upward moves to start monetizing those positions.
As telegraphed in our last update, we have indeed increased our risk exposure in this Tech selloff at a measured pace. From almost 40% in cash in all strategies, we are now down to ~ 25% in cash except for the CONSERVATIVE strategy where we are just over 35% in cash. Most of our buying has been concentrated in the Tech and Communications sectors although Transports also received higher allocations. Moving forward, we expect to keep adding to the Tech sector if we get lower valuations. We also intend to keep selling cyclical areas like commodities and Energy.
Barring any unforeseen situation, markets should move fairly in line with the trajectory of inflation numbers. Our current expectation is that inflation will moderate in second half of 2022 on the back of rising supply, reduced demand, and easier year over year comparisons. Of course, it is a long timeframe and therefore susceptible to revisions. But our strategies are designed to capture the upside over long term and hence we usually project conditions 12 months out.
Our crystal ball for February 2023 is looking pretty good.
For OPPOQUEST
PARESH JAIN
Founder & Portfolio Manager