I didn't think it was possible, but I returned from my New York trip even more bullish. I hosted a breakfast with long short managers, a dinner with a younger group of CIOs and portfolio managers, and met one on one with various investors. 

The macro conversation hovered around rates volatility which remains elevated, the contraction in money supply as measured by M2, and the senior loan officer survey. The undertone was decidedly bearish. 

M2 contracted on a year over year basis for the first time in December. And now we've seen contraction continue for five straight months. 

The popular macro view since the Great Recession has been that this has been a liquidity driven rally—a result of central bank balance sheet expansion. And now with balance sheets shrinking, the contraction in money supply, and the coming increase in the treasury general account, only bad things can happen.

I never liked the chart that showed the S&P 500 going up into the right just the same as the central bank balance sheets. A more relevant chart is to plot the S&P 500 with earnings, which shows the same picture and is a much better explanatory variable. 

In fact, the statistical links between measures of the money supply and other key macroeconomic variables like growth and inflation have weakened since the late 1980s. We shouldn't be surprised to see M2 and GDP growing in different directions much of the time. 

It’s important to remember that even with money supply contracting, there’s still a whole lot of cash sitting around in America’s financial system. At nearly $21 trillion, M2 is still more than $5 trillion dollars higher than pre-pandemic levels, offering an adequate level of liquidity. 

But of course, a deeply inverted Treasury yield curve signals that the Fed has over tightened and now we’ve also got the ongoing tightening and credit conditions in the banking sector. It is surprising to many how narrow high yield credit spreads are given this dynamic. The macro concern is that a default cycle will soon begin. 

I’m less worried based on reasons outlined in our recent work. Interest rate sensitivity in the US economy is historically low. 

Bond default rates for all us corporates are 2 percent. And for speculative grade it is 3 percent. There’s a declining share of fallen angels in the high yield index.  

Default rates for auto loans and credit cards are moving higher, but remain within the long term average. The New York Fed’s Q1 Household Debt & Credit report showed debt delinquency rates are up from their lows, but only 2.6 percent of outstanding debt was in some stage of delinquency, that’s 2.1 percentage points lower than last quarter of 2019.

The credit spread between the high yield corporate bond composite and the 10-year US Treasury sits at 450 basis points down from 600 basis points last July. It isn’t spiking higher as it did during previous credit crunches. In 2001. It reached 1000 basis points in 2008, 2000 basis points, and in 2011 2016 and 2020, it reached 800 basis points. 

The senior loan officer survey by itself does not foretell a recession. We need to see default rates going higher, unemployment tick up, and the Fed respond to a crisis by cutting rates—none of which we expect. 

What interested me most in the macro conversation was the discussion around bond volatility, which has stayed in an elevated range relative to equity volatility which continues to trend lower. There is no clear explanation for the dislocation. Although issues with the market microstructure and option trading activity certainly have something to do with it. 

The move index nearly hit 200 on March 16, following Silicon Valley Bank’s failure. It is now at around 132, which is making the cost of funding more expensive and slowing down new issuance. So I think this is a key indicator to follow going forward. 

A break below 120 will be constructive. Credit markets will start functioning properly again and more deals will get done. We just had the busiest week of the year for investment grade corporate bond deals.

An important question, then, is what will cause rate volatility to go down? 

We have some clarity on inflation, which has been falling for 10 straight months, we believe the Fed is done hiking, but perhaps a clear pause at the next meeting will alleviate concerns. Or perhaps we need to get through the debt ceiling and economic data needs to prove that a recession is not imminent.

Moving onto the equity discussion, the bottom-up message from company reports has been far more bullish than the high frequency data. Going into earnings season, analysts were expecting a nearly 7 percent year-over-year drop in earnings per share for S&P 500 companies. The decline so far is only 2 percent. 

Profit margins declined by much less than feared in the first quarter, which was the primary bearish thesis behind the sharp earnings decline this year. But the nominal picture is still too strong, with 7 percent growth. Last year was all about pricing power and now we’re seeing costs declining. The S&P 500 margins are back at pre-covid levels.  

Now the concern is lack of breadth. While the S&P is up 9 percent year-to-date, it’s one of the narrowest rallies on recent record. So it can’t be real, right? Without the big tech names the market is flat or slightly down. 

I think this ignores the fact that lots of industries that don’t include any of the largest eight names are up more than 20 percent since the October low. Semis and homebuilders are among the best performing sectors, each up 50 percent. We’re just in phase now where large cap growth is outperforming. That is not uncommon. 

And if one of the portfolio managers I met is right, who thinks the street is going to keep missing earnings numbers for Big Tech by as much as 20 percent as they focus on capital discipline, then this outperformance can persist.  

More interesting to me than the lack of breadth is the lack of participation. Equity funds have seen outflows for seven straight months, including $24 billion through the first three weeks of May. Retail investors have reduced positions and institutional investors are favoring cash. The total combined put open interest for major equity ETFs is at the highest levels ever. 

This is with the S&P 500 index trading at a 18x forward PE. And if we strip out the largest eight names (who trade on almost 26x in aggregate, with Tesla back well above 50), it falls to 16.5x. That looks interesting to me with a secular AI tailwind. 

There was a lot of excitement around AI which could not have arrived at a better time. There are frustrated bears all around and now everyone has a new story to tell, from VCs to hedge funds and company CEOs. We’ll be exploring the AI theme more in the community soon. 

I really enjoyed the conversation around credit. One of the guests at the dinner said he trades “toxic waste” which I found funny. He’s looked closely at the CRE market and spots an opportunity in commercial mortgage back securities. 

While office is anywhere from 20-30 percent of a CMBS securitization—not all office is worthless—and the remaining 70-80 percent of CRE that backs a CMBS (retail, industrial, multifamily, hotel) generally have stable demand drivers. 

CMBS is backed by 10-year loans, and 70 percent of the securitization is rated AAA which remain near 10-year wides. The pricing execution that a CMBS securitization issuer gets on the AAA can drive the pricing of the underlying loan spread to CMBS loan borrowers. 

The current persistent rate volatility has reduced demand for long duration fixed rate paper from real money buyers, compounded by the stressed CRE asset class, which is feeding into the negative narrative of lack of available financing for commercial real estate borrowers from the CMBS market.  

But if rate volatility declines, the resulting stabilization of spreads can in turn allow desks to quote loans at tighter spreads allowing for more refinancings. The refinancing market picking up will result in more borrowers accessing capital, which can bring relief to a sector that is not as stressed as headlines suggest. He said, “you only need the narrative to go from awful to bad to make money at current levels.”

From a credit lens, he was not so worried about the economy. He didn’t think that we’re on the cusp of a recession either.

Perhaps the strangest aspect of my conversations is that many VC and fundamental long/short managers who never found much use of macro analysis or market timing as an input have now become obsessed with both. 

I’m reminded of historian Cyril Parkinson, who coined a thing called Parkinson’s Law of Triviality. It states: “The amount of attention a problem gets is the inverse of its importance.” Given everyone’s attention is on macro—the Fed, inflation, politics—maybe it matters less?

I was left wondering on my trip, why is everyone so bearish? Why is there so much pessimism? 

While listening to a Tim Ferriss podcast with Seth Godin, the answer struck me. Godin, sixty one, said:

Boomers have driven our culture since the day I was born. That when we were draft age that was when the draft really mattered. And when we listened to rock and roll that’s when music really mattered. And when people needed to make money for their family that’s when Wall Street really mattered. And now boomers are dying. And so we’re living in a culture that there’s an overhang of all these people with loud voices talking about the end of the world. Because it’s the end of their world. But it’s not the end of the world.

I think that explains it.