The reflection trade is the Omicron trade

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Good morning. The minutes of last month’s meeting of the Federal Open Market Committee fell at. 14 yesterday afternoon, and they turned an uneven market, in the midst of an uneven growth-to-value shift, into an ugly mess. The minutes appear to have been more hawkish than expected. That’s not how they worked for Ethan and myself. However, this bit seems to have surprised people especially by setting a vague time frame around quantitative tightening:

Some participants also noted that it might be appropriate to start reducing the size of the Federal Reserve’s balance sheet relatively soon after raising the federal funds rate.

How much quantitative easing will mean something to the market and the economy is discussed, but regardless of your view on this, this wording (and the use of phrases as a “measured approach” in the following phrases) is in line with our view that the Fed has turned tactically but not strategically. This Fed will move, but move slowly unless inflation gets worse.

In any case, the perception of the Fed as more hawkish only adds fuel to the growth-to-value movement – but the increasingly relaxed consensus view of the pandemic’s long-term trajectory is the real driving force. More about this below. Send us an email: and

The reflection trade is the Omicron trade

The reflection trade – betting on faster growth and higher interest rates – is back. Maybe it will stay that way.

The narrative was somewhat muddy by a broad sale after the Fed minutes hit yesterday, but it remains intact. Since Monday’s close, technology-focused Nasdaq has lost 4.6 percent to 2 percent for the S&P 500. It is noteworthy that the sales pressure hardly bothered the Nasdaq banks index, which has risen 2.3 percent from Monday (banks are enjoying both higher growth and higher short-term interest rates).

The ratio between the Russell value index and the growth index has risen sharply in recent days:

There is logic here. As prices rise, we expect investors to favor stocks with current cash flows over those offering futures – the discount rate rises. If the stock markets work as they should, any semi-decent recovery should have this effect.

One way this shift is unfolding is like a wave of normality washing over markets that had become demented. Meme shares and crypto were thrashed on Wednesday. James Solloway, chief marketing strategist at SEI Investments, reminded us that the normality of the last decade has not been normal:

We believe that a rotation from the most expensive areas of the market, especially in the technology sector, is long awaited. We have had growth that beats value, really since 2010 or so, shortly after the stock market began to recover from the global financial crisis.

We had a hint that there was a rotation going on [in late 2020 as studies rolled out showing high vaccine efficacy], but it began to disappear after the Delta variant began to take hold. And investors largely went back to the tried and true and true.

In other words, the weak recovery from the last crisis caused a touch of growth in a market that was short on it. Now a false dawn in late 2020 and early 2021 may just be giving way to a bona fide recovery, based on new evidence that Omicron’s threat to the economy is less serious than Delta’s, and it’s increasingly popular perception that this latest variant may give way to a world where the virus is hopefully little more than a persistent nuisance.

In response to the tech sale, Qie Zhang, a fund manager at Abrdn, which specializes in technology and media, argued that investors need to distinguish between FAANG and non-profit technology. Where the long tail of tech consists of expansive growth bets, the FAANG stocks (and a few others like them) are companies that generate huge cash flows here and now. These may take a small hit, but are less likely to follow the market poorly.

However, all of this depends on Omicron’s medical facts. If it turns out worse than we expect, we may fall back into the old pattern. A more lethal Omega variant or other unforeseen medical relapse cannot be ruled out. The reflection trade is more precisely the Omicron trade. (Ethan Wu)

Procyclicality of private markets

The liquidity premium of private capital – how large it is, whether it exists at all – is important.

Many investors believe that we are in a world of low returns, which will make their return targets hard to hit (they are probably right). They allocate more to private markets to solve this problem. They hope that in return for tying up their money for many years, they will reap a liquidity premium, or that they have chosen a really clever private asset manager who will outperform, or that the optically stable return on private capital investment (they are not marked for the market ) will flatter their reported risk-adjusted performance. Most of them are probably hoping for a combination of all three.

The liquidity premium is closely linked to the simple notion that private asset managers – private equity and private debt funds – are long-term players. They take advantage of the cyclical fluctuations of the market instead of creeping in front of them, and they buy high and sell low. When times are tough, we are told private equity funds are putting their dry powder to work and, perhaps more importantly, can support their portfolio companies so they can invest through the cycle and avoid debt default.

There may well be some truth in this. But the latest quarterly review of the Bank for International Settlements contains a report that underpins a particular aspect of this story. Sirio Aramonte and Fernando Avalos argue that risk-taking in private markets is as pro-cyclical as in public markets:

While private markets offer long-term final investors, they appear as pro-cyclical as public markets. Capital distribution in [private markets] is positively correlated with stock market returns, ie. more transactions are carried out in bullish times. . .

. . . the sensitivity of private market investments to stock market returns is almost identical to the returns of leveraged loans and stock offerings;

Part of the explanation for this is very simple. In bullish times, discount rates are lower, driving up the present value of future profits. This is almost tautological. But there are some specific reasons for pro-cyclicality in the private market:

. . . some of these transactions require bridge financing or the issuance of high-yield bonds, which are in themselves pro-cyclical. . . More generally, leverage can contribute to pro-cyclicality. Fund managers can support more debt as their intrinsic value increases, thus expanding their balance sheets.

Here are scatter plots showing the relationship between the volume of different types of private market transactions and stock market returns:

The ratio is very similar to those between leveraged loans and IPO volumes and stock returns. These two markets are considered wildly pro-cyclical:

Private market fund managers buy when markets are high.

(Hat tips to Policy Tensor for pointing out the BIS report in a tweet).

A good read

On Adam Tooze’s fine Chartbook blog, a nice cool analysis of the heated debate over price controls in response to inflation.

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