Kristal CIO Desk

This week’s US inflation data was the 3rd consecutive punch proving inflation is stickier than many have anticipated.

This CPI along with unemployment and wages has now led interest rates on US Treasuries to go wider and we stand atclose to 4.50% now from under 4.00% at the end of 2023. This makes long duration much more attractive and closer tolevels seen in Oct - Nov last year.
Markets are now pricing only 1 to 2 cuts this year and the Fed speak is likely to now reiterate the possibility of only 2cuts this year.
Our call on DM Eurozone rates (Germany, Austria) has been further validated given the recent moves where we are stillwithin 10bp on 10yr rates in Europe vs being more than 60bp wider in the US. Add to it bright chances of imminent ratecuts being prepared by the ECB this summer.
The rate volatility measured by MOVE index has also moved higher to 110 levels, up 20 points from the 90s not morethan 3 months ago. This makes callable interest rate products amongst the top picks to play the combination of widerrates and volatility increase.
Earnings season kicks off this week and is likely to give an insight into the strength of overall US equities. Higherearnings are likely to keep the markets supported in the near term though it may be increasingly difficult for equities tojustify a higher price-earnings multiple going forward.
There is an interesting comparison done by BoFA research comparing today’s markets to the environment witnessedin 1995, 2000, and 2007. The comparisons to 1999 and 2007 are particularly intriguing.
By late 1999, the global equity risk premium turned negative, implying investors regarded equities safer than bonds.Yet, as soon as growth momentum started to weaken, the equity rally came to an end, with the market dropping 50%over the next 3 years.
The attraction of the 2000 episode is the lesson of how quickly the growth and risk premia compression narrative canreverse, even as it becomes dangerous for investors to stay out of the market before the reversal takes place.
In 2007, the Fed raised the Fed funds rate by more than 400bps over two years up to mid-2006 in an attempt to coolthe housing market, but the US economy powered head, driven by the housing bubble, until late 2007.
Yield premia compression continued as the US high yield credit spread dropped to 250bps by May 2007, effectivelypricing a default rate of 0%. However, once the housing market began to deflate, a full-blown crisis began. The analogywith 2007 illustrates that strong cyclical conditions can cause risk premiums to compress even amid a persistence ofwell-founded macro worries.
The returns by the Nasdaq 100 index in 1998 were close to 85% and in 1999 were more than 101% before it all camecrashing down by more than 60% in 2000-02.

The billion-dollar question today is – are we in 1998 or 1999?

So while risks are being recognized by investors, the market positioning and chasing of returns can continue for a while.Given where VIX is, it may be prudent to take equity exposure via long optionality while capitalizing on the higher interestrate curve.

We expect Equities to continue the rally albeit moderate on the back of better results from businesses with high operatingleverage. We prefer taking incremental exposure to Equities with some downside hedges now being built in via longoptions play.

Kristal Advisors

May 2, 2024

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