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Enemies Real and Imagined

Summary:
Today I want to share three things I think I know based on what Radiant, our platform for analyzing the prevalence of various narratives in markets, has been telling us. Then I want to share what I think I think about what that means. First, what I think I know. And no, I don’t think any of this is particularly earth-shattering or controversial. I think I know that the prevailing structure of central bank narratives is that the Fed can’t, shouldn’t and won’t move away from a dovish posture. Within financial news coverage of central bank activities and interest rate markets, our models determined that, after a brief flurry of begging for Fed intervention in early 2020, the dominant archetypal language in central bank coverage for most of 2020 was speculative inflation

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Enemies Real and Imagined

Today I want to share three things I think I know based on what Radiant, our platform for analyzing the prevalence of various narratives in markets, has been telling us. Then I want to share what I think I think about what that means.

First, what I think I know. And no, I don’t think any of this is particularly earth-shattering or controversial.

I think I know that the prevailing structure of central bank narratives is that the Fed can’t, shouldn’t and won’t move away from a dovish posture.

Within financial news coverage of central bank activities and interest rate markets, our models determined that, after a brief flurry of begging for Fed intervention in early 2020, the dominant archetypal language in central bank coverage for most of 2020 was speculative inflation language. Traditional media outlets, the sell side, the buy side and corporate earnings releases which discussed interest rates at all emphasized uncertainty and speculation about potential inflation that might result from aggressive intervention.

That shifted in late 2020 toward a narrative structure defined less by speculation about inflation and more by speculation about whether hawkish policy would be necessary or whether dovish policy would continue to be feasible. Our judgment was that common knowledge tilted away clearly from fears that banks would be forced to intervene in the direction of “inflation is transitory” in mid-April 2021. In other words, we think there’s a moderate but generally held belief among investors that other investors and the Fed are betting on transitory inflation. More importantly, we think significant missionary effort (i.e. effort to shape common knowledge) is being exerted to maintain this narrative.

Enemies Real and Imagined
Source: Epsilon Theory

I think I know that the most influential language being used to discuss US markets is less convinced that stocks are overvalued, with an emerging pole of those who believe policy and recovery have created pockets of attractive value. These are both features we think create an asymmetric bias toward more constructive / bullish responses to data.

Linguistic patterns consistent with attempts to create a narrative of the market as expensive or overvalued are still at high levels – apparently the “akshually valuations aren’t really historically high, it’s just a shift in market cap to sectors that should be more expensive” mafia haven’t gotten to everyone just yet. The density of these patterns in financial news, research, press releases and transcripts, however, has also been in a period of rapid descent. More importantly, that descent has taken place during period that has almost perfectly overlapped with the transition of the central bank narrative to the dovish “inflation is transitory” variety observed above.

Enemies Real and Imagined
Source: Epsilon Theory

In short, we observe that low-rates-longer-because-inflation-isn’t-really-a-thing stories are demonstrating a pretty strong pro-cyclical relationship with descriptions of how much “value” and “risk” are present in markets. We think, but can’t explicitly prove, despite how inherently sensible it is, that this relationship is causal. That is, we think that what everyone thinks everyone else thinks about dovish Fed policy is shaping how they characterize and describe the valuation and riskiness of their own portfolio positions. Accordingly, we tend to think that continued dovish rates and fed policy remains by far the most important market narrative, and the one most sensitive to change.

I think I know that outside of narratives of recovery, the emerging delta variant does not really represent a significant feature of US equity market narrative structure.

The network graph below presents US equity markets content from news outlets, blogs, press releases, sell side research and transcripts with broad distribution published between June 1 and July 16th – that is, ending just before the more serious attributions of market activity to the delta variant of COVID earlier this week. As usual, each dot/node represents an individual piece of content. Identical colors represent clusters of similar language, as do connecting lines and general proximity on the graph. Up, down, left and right have no meaning other than the “closeness” they otherwise impart. Bold-faced nodes represent those which are about, at least in part, the emerging variant and its risks. Washed out nodes represent those which are not.

In short, there’s a couple clusters off to the distant right of the graph that appear to be principally about these risks. There are some scattered nodes elsewhere. But the graphical representation here is consistent with what the underlying centrality calculations tell us: people are talking about this a little bit, but it isn’t informing or influencing the central discussions of positioning, risk, attractiveness, trade ideas or investment theses.

Enemies Real and Imagined
Source: Quid, Epsilon Theory

So here’s what I think I think:

I think that the primary contributor to the mid-July swoon (or ‘sell-off’ for those who don’t remember what an actual sell-off is) in risk assets was probably jitters about the first premise above. That is, I think most investors fear a hawkish Fed more than the delta variant. More importantly, I think most investors believe that’s what other investors fear.

I think that we reversed practically all of the damage when it became a sort of ‘common knowledge’ that the reason for the swoon was a change in the third premise. In other words, I think that the knee-jerk response by commentators ascribing soft markets to ‘fears about the delta variant’ rapidly built a wall of worry. In our cynical application of the term of art in markets, what we mean by wall of worry is a risk or series of risks that are specifically designed by narrative missionaries to be easily climbed. And once we’ve climbed whatever wall we are being told was what was keeping us back, well…get it? At any rate, because of the underlying narrative structure (or absence thereof) around COVID risks to markets, this would have been a particularly effective wall of worry for getting markets back on track.

What does that mean? I think for the time being that it means that we should expect the delta variant to be the bricks out of which additional walls of worry are built. I also think there’s a point where delta could become the real enemy to the markets, rather than an imaginary one conjured for an easy bounce-back win. After all, a narrative structure that isn’t focusing on something like this at all is inherently a complacent one. And no, I have no idea when or where that inflection point may be.

So whether it’s tradable or not (probably not), following this will still be a good news and research consumption training exercise. For the rest of July into August, keep a close eye on how missionaries describe the causes of any pull-backs. Look for simplistic explanations that don’t seem to match up with the common knowledge of what investors are most concerned about.

Then develop your own heuristics for identifying the construction of walls of worry in the world.


Rusty Guinn
Executive Vice President of Asset Management, Salient. Rusty Guinn is the executive vice president of asset management at Salient. He oversees Salient’s retail and institutional asset management business, including investment teams, products, and strategy. Rusty shares his perspective and experience as an investor on the Epsilon Theory website.

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