From a Position of Deep Discomfort
- sebastienpautrot
- 20 hours ago
- 4 min read
07 April 2025
A key element of our process is to capitalise on situations where market pricing has de-coupled from fundamentals or the emotional sources of volatility. The challenge in this episode is that the correction was not an emotional overreaction. Put another way, there is a genuine fundamental shock to global growth and trade. That is a critical distinction. If there is legitimate and lasting damage to global growth, trade and corporate earnings, the drawdown could be much deeper.
The additional element at play is convexity and leverage. We have discussed this through the lens of the “reverse feedback loop” and the Soros boom-bust framework (that the Treasury Secretary understands intimately). One of the key issues earlier this year was the starting point. While valuation often doesn’t matter on a shorter time horizon, it is often pivotal in these moments. The S&P500 started the year at 23 times forward earnings. While the difference between the earnings yield and the 10-year Treasury yield (a proxy for the equity risk premium) was negative 0.6%. Stated differently, risk compensation was extremely poor at the start of 2025. From a macro point of view, the economy started with a positive output gap (or close to full employment).
As we also noted at the start of the year, there was considerable crowding in consensus beliefs and positions. The US, global indices and investor portfolios were very concentrated in mega-cap technology stocks. The prevailing bias was very long and, in many cases, levered long “American Exceptionalism.” From our perch, the valuation starting point and the extreme crowding in positions and beliefs are just as important as the fundamental impact of the Administration’s policy agenda in explaining the current market correction.
In these moments we often discover the “hidden leverage” or as Uncle Warren would say, the naked swimmers. A few observers have noted that this might be America’s “Liz Truss” moment. The damage to the UK markets in the 2023 episode was via the gilts (sovereign bonds) and the currency. In the US, so far, the damage has mostly been via equities. Markets only stabilised by full course policy reversal. The unexpected or (not so) hidden leverage that emerged was the LDI (liability driven investment) funds that were forced to sell gilts. In that episode, the Bank of England effectively had to bail out pension funds and allow an orderly resolution of risk.
The challenge in the current episode is that a policy reversal or adjustment is unlikely. Indeed, through chaos, the Trump Administration is delivering on campaign pledges. Our sense is that Trump’s primary goal was to achieve $500 billion in revenue and the current policy arguably achieves this objective. It is worse than the worst-case scenario and we agree that the formula is dubious but that’s probably because they solved for a given revenue target. As we have noted for some time, the policy agenda needs to be viewed through the lens of the Art of the Deal: this is a starting point for negotiation (escalate to de-escalate). Put another way, don’t take these tariffs for granted but also don’t use them as endpoints.
From that vantage point, Trump is likely to maintain a brutally hard line in the near term leading to a deeply uncomfortable start to the week. But if markets start grinding to a halt due to counterparty and other solvency risks, then the Federal Reserve and the Administration will have no choice but to inject liquidity and reverse course. While it is way too early to understand how this episode will impact growth, what we do know is that there is probably a genuine fundamental shock to confidence. As we have noted, that was already evident before last Thursday. The context for the credit markets is that spreads are still below the long-term average (like the lack of risk compensation in equities). In a major recession, high yield bond spreads rise to over 1000 basis points or more (chart 1).
Chart 1
The best investments are made from a position of deep discomfort. The drawdown in the S&P500 global risk proxy is now -17% from peak. The drawdown is much greater in markets and sectors sensitive to global growth. The good news is that there has been a material, rapid and emotional liquidation in risk assets. The bad news is that the valuation starting point was among the most expensive and most crowded in history. Tactically, there is hope. The relative strength index on the S&P500 is at 23%. That is comparable to the trough in 2020, 2022 and 2008. Many other sentiment and tactical indicators are equally extreme which suggests that the liquidation is well advanced. On Friday, investors also started to liquidate gold and other defensive equities to meet margin requirements.
Our equity exposure in this region trades below 10 times earnings (even adjusted for a growth shock). We also hold a large proportion in money market available to deploy into the current liquidation phase. However, we appreciate that the current episode is a genuine shock to global growth, trade, and corporate earnings. Put another way, the warranted equity and credit risk premium has increased. In the near term, the credit risk premium is most under-priced.
Comments