In July 2007, just before the global financial crisis (GFC) struck, then Citigroup CEO Chuck Prince famously said: ‘As long as the music is playing, you’ve got to get up and dance! We’re still dancing’.

After a brutal 2022, many investors are being lured back onto the dance floor by the siren song of Fomo.

Now, as I am all too aware, one of the dangers of dancing is making a fool of yourself. And later in 2023 investors may come to the fateful realisation that they are suspended in mid-air and due for a fall.

What will cause it? The adrenaline buzz is going to wear off.

Persistently buoyant consumer spending and another pulse of aggregate demand have resulted from a fortuitous combination of Chinese re-opening and monetary easing, quantitative easing from the Bank of Japan, a mild European winter, falling commodity prices and accumulated lockdown savings.

While we expected economic resilience coming into 2023, we must confess some surprise at how far markets have risen. The bit we didn’t see coming was the rip-roaring return of risk appetite.

We are living in an echo bubble of 2021. Daily retail flows into equities have surged to new all time highs, trumping the meme-stock bull run. The CNN Fear & Greed barometer has more than doubled from a year ago and is now teetering on the edge of ‘extreme greed’.

Short sellers have been forced to close. One day options – pure gambling – have proliferated. Tesla is up by 60% year-to-date, while bitcoin gained 45% in the first 40 trading days of 2023 – annualise that!

Yet the many crosscurrents roiling markets make high conviction dangerous.

The peak in rates and the speed of quantitative tightening are uncertain. How sticky will inflation prove? How long are the ‘long and variable’ lags of monetary policy? Is the inverted yield curve sending its first ever false signal of recession?

Russia’s spring offensive is gearing up. Hard economic data remains strong, but forward-looking surveys remain recessionary.

Five months ago, Citigroup said UK inflation would hit 18%; last week, it forecast inflation back at 2% by autumn. We’ve gone from hard landing to soft landing, to no landing.

The big danger is to get caught up in the chop, latching onto each data point as proof of a new trend. Risk on! Risk off! Re-opening! Pivot!

In a world of volatile inflation and economic growth, we need to practice patient opportunism, step back and wait until things settle down. Equity markets have delivered a year’s worth of returns in just nine weeks.

When will the music stop?

As I noted above, many investors have returned to the dance floor just when the music may be about to stop. But they don’t need to take that risk. While the outlook is muddled, one thing is clear: risk premiums are very low.

First, consider a crude proxy for the equity risk premium (ERP) – the earnings yield on US equities versus the yield offered on cash. Both are 5%. Why bother taking on the vicissitudes of the economic and market uncertainties for zero additional return?

On most measures, the ERP is the lowest it has been since at least 2007 (just before the GFC). This is a stark reminder that stocks are down from the 2021 highs because interest rates are up, not because the ERP has widened or because earnings have fallen – both of which we believe are yet to come. For investors seeking to take equity risk, the ERPs in Japan, the UK and Europe look relatively attractive.

The brokers tell us that credit is the hottest trade of the year. Flows are strong – the yield pigs are out snuffling for truffles, with 5-6% available on reasonable credits. The problem? It’s base rates doing all the work, while credit spreads remain tight. Astonishingly, the investment grade credit index now yields less than cash.

Again, it poses the question: why venture further out along the risk curve? It looks like the credit risk premium is actually negative. Analysts will say this is because the yield curve is inverted (the short end is higher than the long end). But inverted yield curves usually indicate a coming recession, which isn’t good for credit. That isn’t much to hang your hat on.

Low risk premiums would be surmountable if corporates were about to deliver great profits, but we have concerns here too. Earnings estimates are coming down but still appear optimistic, pricing in a flat 2023 and then double-digit growth for 2024.

What’s the shape of the potential earnings recession? We have experienced an earnings bubble, with real earnings and margins well above long-term trends.

One man’s inflation is another man’s pricing power. During the pandemic, companies took the opportunity to price aggressively. Margins, which were already near all-time highs, went ballistic. But, if covid disruption and inflation is going away, surely that pricing power will also disappear.

An earnings bear market would be brutal even if they just returned to trend. Furthermore, these problems could be exacerbated by macro factors such as higher energy costs, supply chain re-shoring, wages, labour hoarding and the energy transition. Perhaps earnings will be more vulnerable than many think. 

The eye of the storm

So what’s my point? We are in the eye of the storm. The job of bear market rallies is to suck investors back in. For a decade, cash has been a dirty word. Now, it should be a key allocation.

Let us take lessons from the dotcom bubble. During its bear market from 2000-2003, the Nasdaq had some significant rallies. A 44% surge in late 2001 just set the scene for the final 45% capitulation in what was a 73% peak to trough fall.

Importantly, between 1999 and 2003, the Fed Funds Rate rose from 5.25 to 6.5% at the peak of the bubble before ending at 1%. The Fed eased all the way through the bear market. Even this failed to support equities: investors’ risk appetite had changed.

Today – for now – investors are still reflexively anchored to risk taking, and central banks are a world away from easing. Risk premiums compensate investors for the things that might go wrong.

Counterintuitively, they are lower today than at the start of the bear market. The second act of the bear market is coming. Later in 2023, the music will stop.

Duncan MacInnes, investment director, Ruffer Investment Company

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