The Ambiguity Effect

Summary

• Introduction to the Ambiguity Effect.
• “Make Duration Great Again”?
• Equities: More pain ahead?

Pgiam/iStock via Getty Images

“On the road from the City of Skepticism, I had to pass through the Valley of Ambiguity.” - Adam Smith

While we continue to watch the “domino effect” playing out in the crypto universe as a result of “Deceptology” leading to a “Minsky moment” for the sector, when it came to selecting our title analogy, we reminded ourselves of the “Ambiguity Effect” given the indecisive gyrations in financial markets. The “Ambiguity Effect” is a cognitive bias where decision making is affected by a lack of information, or "ambiguity". The effect implies that people tend to select options for which the probability of a favorable outcome is known, over an option for which the probability of a favorable outcome is unknown. The effect was first described by Daniel Ellsberg in 1961. As such, a risk-averse investor might tend to put their money into "safe" investments such as government bonds and bank deposits, as opposed to more volatile investments such as stocks and funds. Even though the stock market is likely to provide a significantly higher return over time, the investor might prefer the "safe" investment in which the return is known, instead of the less predictable stock market in which the return is not known. The famous “known unknowns” of Donald Rumsfeld but we ramble again:

The Unknown As we know, There are known knowns. There are things we know we know. We also know there are known unknowns. That is to say, we know there are some things we do not know. But there are also unknown unknowns, the ones we don't know we don't know. — Donald Rumsfeld, Feb. 12, 2002, Department of Defense news briefing

We already know that macro is slowing and that the synchronized recovery from the COVID crisis has morphed into a synchronized slowdown on the back of rising inflation and energy woes. As such we feel the rally seen in credit markets will not last, and thus we would use this bounce higher to reduce risk and “buy” credit protection in that context. 2022 has marked the return of "cash" in your allocation toolbox and it should be used more extensively as such.

In this conversation, we would like to look at what the “Ambiguity Effect” means in terms of “asset allocation”. Is finally the long end of the US yield curve enticing from a positioning point of view? Is more pain ahead for “equities”?

• “Make Duration Great Again”?

We are probably entering a period of time when “cash is becoming king again”. Sure, High Yield has shown bouts of strong performance during recent times as shown in the retracement of European High Yield synthetic CDS 5 year index Itraxx Crossover now down to 466 from the recent high of 650:

Itraxx Crossover (Bloomberg)

• Graph source Bloomberg

But, being underweight “high beta” is we think indeed a good recommendation at this stage of the credit cycle, given as we have pointed out in our previous conversation in relation to the Fed’s latest quarterly Senior Loan Officer Opinion Survey (SLOOs) showed that financial conditions are tightening. As a reminder, the most predictive variable for default rates remains credit availability and if credit availability is “waning” then you want to reduce your “allocation” to “high beta” in general and the CCCs bucket in particular when it comes to US High Yield:

US High Yield YTD (Macronomics - KOYFIN)

• Graph source Macronomics – KOYFIN

Since the beginning of the year, we have seen divergence rising between ratings buckets in US High Yield since May of this year. 2021 was an anomaly given the outperformance of US CCCs over BBs and Bs due to the exposure of CCCs to the Energy sector.

Overall, global CDS 5 years YTD indices have continued to tighten, but at a much slower pace since our last conversation:

Global CDS (Macronomics - Datagrapple.com)

• Graph source Datagrapple.com

We have seen a tightening in various CDS indices and regions since our last conversation (from 414 bps to 411 for US High Yield vs 318 bps to 317 bps in European names).

As we indicated in our previous conversation the rally in credit markets was depending entirely on bond volatility receding as per below YTD MOVE index:

MOVE Index (Macronomics - TradingView)

• Graph source Macronomics – TradingViews

With “Bond volatility” falling it is much more supportive of credit markets in general and US Investment Grade in particular on the “long end”, as well as quality wise for higher rated issuers:

US IG YTD (Macronomics - KOYFIN)

• Graph source Macronomics - KOYFIN

For instance, US High Grade (Investment Grade) 15+ years has considerably “rallied” from -33.25 YTD in our previous conversation to -27.73% YTD.

There is indeed more room for “outperformance” of Investment Grade relative to High Yield when one looks at the two most liquid ETFs LQD for US Investment Grade and HYG for US High Yield:

ETF HYG and LQD YTD (Macronomics - TradingView)

• Graph source Macronomics - TradingView

During 2022, rising bond volatility “convexity” has been hammering US Investment Grade.

As such we do think that the long end in US Investment Grade is enticing from a carry and roll-down perspective. As Oaktree puts it:

“Rising recession risk may make investment grade debt attractive on a relative basis: Investment grade debt is likely to outperform high yield bonds if widening yield spreads, not rising Treasury yields, are the primary drivers of performance in the credit markets.” - Oaktree

On a side note, synthetic exposure through credit indices such as Itraxx Main Europe 5 year and CDX IG for the lucky few of you benefiting from an ISDA agreement provide sufficient liquidity to “sidestep” any Investment Grade “liquidity concerns” (not as bad is crypto land… joke aside). The US equivalent to the European CDS investment Grade index, namely the CDX, does not include banks as a reminder. The Itraxx Main Europe 5 years index is therefore a good "macro" hedge instrument for investment grade exposure to more turmoil in Europe next year. If indeed we are back into a "macro" world when it comes to "trading" then, using the right "macro" instruments such as synthetic credit indices and options on credit indices might provide “mitigation” to heightened volatility over the course of 2023.

One way on playing the “Make Convexity Great Again” game is via ETF ZROZ (PIMCO 25+ Year Zero Coupon US Treasury Index ETF) which is extremely sensitive to rates move (ETF ZROZ performance YTD):

ETF ZROZ YTD (Macronomics - TradingView)

• Graph source: Macronomics – TradingView

If we look at the chart for ETF ZROZ since 2010, we can see view it as a “tactical” tool which can be very useful to “play” a change in the Fed “narrative”:

ETF ZROZ over time (Macronomics - TradingView)

• Graph source Macronomics - TradingView

We hinted a "put-call parity" strategy early 2014, e.g. long Gold/long US Treasuries as we argued in our conversation "The Departed":

"If the policy compass is spinning and there’s no way to predict how central banks will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds goes up." - Macronomics

We believe that in 2023, both strategies should work well from an “Ambiguity Effect” perspective (Gold versus ETF ZROZ, 1 month performance):

ETF ZROZ vs Gold (Macronomics - TradingView)

• Graph source Macronomics – TradingView

Another way to express this “put-call parity” strategy which is “highly sensitive and volatile" can be seen below in the one month chart displaying ETF ZROZ and Junior Gold Miners ETF GDXJ:

ETF ZROZ vs ETF GDXJ 1 month (Macornomics - TradingView)

• Graph source Macronomics – TradingView

As per our previous conversation given that Mack The Knife’s rampage (US dollar + Real Yields) has receded (DXY and US Yields), we continue to be more positive on gold in general and gold miners in particular:

Gold and Gold Miners 1 month (Macronomics - TradingView)

• Graph source: Macronomics – TradingView

If ETF ZROZ is a high beta “convexity” play, then again ETF GDXJ is as well somewhat similar in terms of “asset behavior”. Of course, both of them are highly “volatile” instruments to say the least, so “trade accordingly”.

• Equities: More pain ahead?

For a more severe equity sell-off to materialize you need three deteriorating factors:

1. Corporate balance sheet leverage,
2. Credit availability,
3. Earnings revisions.

In our last conversation we pointed out that credit availability was becoming more scarce as indicated by the most recent Fed quarterly Senior Loan Officer Opinion survey (SLOOs). As such credit availability is one of the factor which will weight on equities (and not only US High Yield) for weaker corporate balance sheet:

Banks tightening (Bloomberg - Twitter)

• Graph source Bloomberg

When it comes to corporate balance sheet leverage, as such it is higher than during the Great Financial Crisis (GFC) as displayed in the below chart from Goldman Sachs (h/t Mike Zaccardi, CFA, CMT on Twitter):

US Corporate leverage (Mike Zaccardi - GS - Twitter)

• Graph source Goldman Sachs – Mike Zaccardi - Twitter

Overall, net leverage for the median Investment Grade and High Yield -rated US-domiciled non-financial corporations has moved further down this year but remain nonetheless historically high, at similar levels than during the Dotcom crisis. Something to monitor and keep in mind.

As far as earnings revisions are concerned, all S&P 500 sectors recorded a downward revision to fiscal 2023 EPS growth forecasts over the past month, but technology's fall was most profound:

Earnings revisions (Bloomberg - Twitter)

Moderating expectations (Bloomberg - Twitter)

Analysts giving up (Bloomberg - Twitter)

• Graph source Bloomberg

Earnings are highly correlated to PMIs. Weaker PMIs indicates weaker earnings going forward as indicated by Michael Kantro from Piper Sandler:

ISM and S&P 500 (Michael Sandro - Piper Sandler - Twitter)

• Graph source Michael Sandler – Piper Sandler – Twitter

Therefore, one should favor US bonds over equities. US Equities still look expensive amid Wall Street's 'timid approach' to earnings revisions, says Morgan Stanley. Maybe it is just a case of “Ambiguity Effect” for Wall Street analysts? We wonder…

“It is in middles that extremes clash, where ambiguity restlessly rules.” John Updike

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.