We all know the old adage—the four most dangerous words in investing are: It’s different this time. Today we argue that the five most dangerous words are: It isn’t different this time, states Jay Pelosky of TPW Advisory.
First a personal story. I recall using the dreaded "It's different" phrase way back near the beginning of my career. It was my first big Wall St job, working at Morgan Stanley Asset Mgmt. where I was assigned to develop, market, and manage a Brazil Fund—the Firm’s first such vehicle in Lat Am. This was in 1990-91 (yes, dating myself) and Brazil was a hyperinflationary basket case. So naturally, our marketing material argued that it was in fact different this time.
Well, we couldn’t raise any money (time to market and time to invest are often two different times) until we were funded by Julian Robertson of Tiger fame (RIP) rescuing the fund (and my career). Well, lo and behold that 1990-91 period was different; in fact, it was pretty close to the absolute USD low for Brazil’s Bovespa. So, the point is—I have form in this regard!
Seriously though, how can one argue that it’s not different this time? We are exiting a once 100 yr. a global pandemic, Europe is engaged in its first land war in over 70 years, the Fed has engineered its most aggressive rate hiking cycle in 40 years and China has just freed over a billion people from lockdown...of course, it’s different.
The trick lies in determining how this difference plays out in global cross-asset markets. That should be where one’s mind is. We argued in our 2023 outlook that the year will be one of gradual stability as 2022’s headwinds: inflation, rates, and Central Banks, become 2023’s tailwinds and financial market volatility declines.
As this stability manifests, we expect history to return to the investor toolkit as we enter a more normal cycle—what we expect to be a high nominal growth cycle led by a public–private funded global cap ex boom to deal with the Three Cs of Covid, Climate, and Conflict. For the skeptics, BofA notes that Q3 US cap-ex spending was up over 20% Y/Y. Our current historical focus is to see if the S&P can achieve the January trifecta we laid out in one of our more popular Musings: Welcome Mr. Bunny. So far, so good as this week’s little pullback actually helps work off an overbought condition, while leaving the SPY up over 1.5% MTD.
We have focused on the technical outlook for the markets, noting that technical analysts were increasingly positive with some calling a new bull market, including Walter Deemer, one of the most experienced US technicians, who highlighted a Break Away Momentum (BAM) signal last week. According to Deemer, this represents its 24th firing since 1949 with a 98% hit rate of up markets 12 months out with an average return of close to 20%. Given this week’s pullback he highlighted some work done around the GFC exit where he noted the history of these breakaway periods is such that they include pullbacks as deep as 4-5% over the first six weeks and three months following the signal.
It seems to us that the market in its collective wisdom knows and shows via price action what the individual fund manager has yet to accept. Technicians are bullish, fundamental folks are quiet. Here is a quote from another technical analyst we like a lot, John Kolovos of MRA Advisors: “Client sentiment is downright awful with a hard landing basically a foregone conclusion”. This ties in with the huge majorities expecting a recession, the Davos bear take and the majority of strategists polled by Bloomberg expecting EU equity to close 2023 BELOW current levels, etc. It’s been cool to be bearish. No longer.
This switch brings to mind another characteristic of the past few years—the speed at which things change. Regular readers might recall our focus on Covid Speed back in 2020 Climate Speed in 2021 or Analytical Speed last year. This year it seems like Narrative Speed is the one to focus on. The story is shifting so fast it's leaving many in the dust—note BofA’s most recent FMS reporting global investors are more than two sd below normal equity allocations. Many of the top IBs have been forced to rip up their 23 outlooks mere weeks after publishing them. Our forward focus and weekly Musings have been a huge help in avoiding those types of mistakes here at TPW Advisory.
Europe’s energy situation was the first such narrative shift at speed in this latest cycle. It got so extreme that we wrote a Musings titled Things I Don’t Understand with European equity exhibit one and the airline's stocks exhibit two. We could not understand how European risk asset prices were unchanged while European Nat gas prices had halved from their peak – BTW they have halved again since. For the airline stocks, it was passenger levels getting back to within sniffing distance of 2019 levels while the JETS ETF traded 30% below those 2019 levels. Stale narratives explain it of course. EUFN is up 34% since Musings and JETS are up 24% vs ACWI is up 13%.
The fastest narrative shift of all has been China’s shift off Zero Covid which was originally seen as a move driven by weakness and has only recently come to be viewed as part of a pragmatic and aggressive shift to growth. A shift encompassing all phases—social with the end of Zero Covid, economic with the end of the regulatory crackdown on Big Tech and the removal of the three red line property focus, and diplomatic with the end of Wolf Warrior diplomacy. This last was made concrete with this week’s meeting between Vice Premier Liu He and US Treasury Secretary Yellen which concluded with an agreement to have the Secretary visit Beijing.
As we noted at the time there is no better single signal that the world economy will not go into recession than to have China go for growth. Two points to keep in mind here – one, China is doing so because it must in order to maintain the social contract between the people and the party, and second that China has the tools to do so with plenty of room to cut rates (no inflation pressure) and expand fiscal stimulus. The key is that China recognizes the tie in between growth, domestic consumption, and property.
So, while US and European growth may be ebbing China is likely to grow at close to double its 2022 pace of 3%; the global economy is desynchronized. MS just raised its 2023 China GDP estimate to 5.7%. Furthermore, we expect EM Central Banks to lead the way to a global rate CUTTING cycle this year—one that is likely to get well underway once the Fed pauses which we expect it to do post a 25 bp hike next month. In fact, EM Central Banks have already begun the journey with Malaysia’s CB deciding to pause this week rather than hike rates further as expected.
The Fed pause should lead to continued USD weakness as capital exits the US to the ROW - reversing the decade-long flow that pushed up US asset prices and valuations to levels that now look unappealing versus the ROW. We expect the ROW to grow faster, and it is cheaper, under-owned, less tech-heavy, more cyclical, etc., etc. It’s different this time.
Our view of a flattish SPY in 2023 coupled with a weak USD sets the stage for non-US equity OP. We think we are in the first inning here—perhaps even pregame. This is a key call for TPW Advisory: we are at the very beginning of a multi-year period of non-US equity Outperformance led by a combo of DM and EM equity markets. We have been making this case for the past several months, building off a positive and quite contrarian outlook on European equity and more recently developing an OW position in EM equity, a position we added to in our most recent Model update. We see four drivers to EM equity OP: China’s dash for growth, Fed pause, USD weakness and an EM rate cut cycle—this after a record year of redemptions from EM equity funds.
Importantly for our Global Multi-Asset (GMA) Model Portfolio, the non-US equity markets continue to lead the way with China up double digits and Europe up well north of 5% MTD. While flows are starting to become noticeable – Krane Shares highlights that foreign inflows to mainland China equity YTD exceed that of all of 2022—it represents just the beginning. European flows, for example, are just beginning to reverse what BofA’s fund Manager Survey notes were 47 straight weeks of outflows.
As noted previously our non-US OW extends to both EM and DM, Europe and Japan, Asia and Lat Am. We are most keen on Asia and expect Japan to be a surprise performer. Japan confirms for us the global regime shift to a high nominal growth path we noted above—it has worked for decades to generate inflation and today it has 4% inflation—the highest since 1982! It is different this time.
We expect Japan to exit its YCC over the course of the year and contrary to most, we focus on the domestic impact of a bond bear market. We expect that to lead to significant domestic investor flows back to equity as the daughters of the famed Mrs. Watanabe step up and buy stocks. Japan households hold roughly 50% of their financial assets in cash/deposits = to roughly $8T vs 13% in the US and account for roughly 16% of shareholders vs close to 25% in the US. There is potential for massive domestic reallocation into stocks. KKR noted recently that Japan's equity is among the cheapest assets in the world relative to its 20 yr. history, denominated in a cheap currency, in a part of the world that will lead the next growth cycle and particularly exposed to the return of the Chinese tourist. What’s not to love?
There is little that says It’s different this time more than non-US equity OP. These are decade-long trends that are reversing—that reversal is in its infancy. Investors should worry less about the history and embrace the changes that are taking place everywhere one looks.