Why Risk Appetite Is Back | Alfonso Peccatiello, Michael Kantrowitz, Andy Constan & Jack Farley

Episode Summary

Executive Summary: The discussion centered on the sharp mid-June rally in risk assets and whether it can last. Alfonso Pecatello argued the move was driven first by falling real yields after a less-hawkish Fed interpretation, then by a technical re-leveraging/vol-targeting squeeze as volatility fell. He and the others remained skeptical of the soft-landing narrative, citing deteriorating growth data, sticky inflation risks, QT, and rising issuance as headwinds for equities and cyclical FX.

Main Topics: Why markets rallied after mid-June (Priority: 5/5): Alfonso framed the rally as two legs: first, markets repriced down real yields after interpreting the July FOMC as a less-aggressive Fed; second, falling volatility triggered re-leveraging by vol-targeting, risk-parity, and underallocated managers. Growth-vs-inflation outlook and the soft-landing debate (Priority: 5/5): Speakers largely rejected the idea that the economy is headed for a clean soft landing. They pointed to weak forward indicators, deteriorating manufacturing surveys, and the risk that inflation remains sticky even as growth slows. Quantitative tightening, reserves, and issuance as market headwinds (Priority: 5/5): Andy Constant and Alf emphasized that QT, Treasury issuance, and shrinking bank reserves can pressure risk assets by forcing the private sector to absorb more duration and collateral while liquidity is withdrawn. Cyclical assets and FX leadership in the rally (Priority: 4/5): The second leg of the rally was led by cyclicals, small caps, European credit, industrials, transports, and commodity-linked FX such as AUD and BRL, which Alf interpreted as largely re-leveraging rather than a true macro growth reacceleration. Europe’s weaker macro backdrop and credit spread behavior (Priority: 4/5): Alf argued Europe had been weaker earlier than the U.S. because of energy shocks, more negative real incomes, and structural labor rigidities, helping explain why European high-yield spreads initially widened and then tightened sharply on the rally. Positioning and tactical trades (Priority: 4/5): Alf shared tactical expressions of his view: long JPY versus AUD and CAD, short Eurodollar, and interest in shorting equities again, especially more cyclical indices and European banks. Andy described his own bearish positioning via index puts. Earnings, housing, and lagging data risks (Priority: 4/5): Michael Kantrowitz and Andy Constant stressed that weak housing and PMI/NHB-type data will eventually flow through to earnings, making the current equity rally vulnerable even if reported earnings have not yet collapsed.

Key Arguments: The initial rally was driven by lower real yields after markets interpreted the Fed as less committed to continued aggressive tightening. A second, more technical rally leg came from volatility falling, which allowed vol-targeting, risk-parity, and de-grossed managers to add exposure back. The rally in cyclicals and commodity-linked FX is hard to justify on macro grounds because forward indicators still point to slowing growth. Europe looks especially weak due to energy costs, worse real-income compression, and tighter financing conditions for leveraged companies. QT matters because it shrinks reserves and forces the private sector to absorb more Treasury supply, reducing liquidity available for risk assets. Banks do not lend reserves, so QT is not a direct banking-lending channel, but it still affects system liquidity and risk appetite through balance-sheet mechanics. Bad news is only good news when it can plausibly force a Fed pivot; at current levels, weaker data is increasingly just bad news for earnings and markets. Housing is the key cyclical transmission mechanism that could validate or invalidate the soft-landing narrative. A strong equity rally can coexist with deteriorating fundamentals, but it becomes vulnerable once the re-leveraging flow exhausts. The Fed and ECB are unlikely to turn dovish quickly because inflation is still their binding constraint and they need convincing progress toward 2%.

Data Points: QQQ rally since mid-June: about 18% - Used to illustrate the magnitude of the rebound in risk assets after mid-June. S&P 500 rally from June lows: about 17% - Michael Kantrowitz cited this as evidence of a major bear-market rally. Front-end real yields: roughly 20-25 bps above neutral - Alf noted forward real yields in the U.S. remained mildly restrictive despite the rally. 2-year Treasury yield: around 3.20% - Used to show the front-end repricing after Fed speakers pushed back on the market’s dovish interpretation. Prior terminal rate pricing: about 4.0% - Compared with the earlier peak in the front-end yields and terminal-rate expectations. European high-yield spreads tightening: 140 bps in a month - Alf described this as an aggressive three-standard-deviation move. Russell 2000 move: up about 15% in a month - Cited as a leading cyclical winner in the rally. Home builders rally from lows: about 30% - An example of the rebound in cyclical/housing-sensitive equities. European junk borrowing costs: about 3.0% to 3.5% all-in - Alf highlighted how cheap borrowing had been for European high-yield companies in 2016-2020. Empire State Manufacturing survey: described as looking as bad as 2008 in subcomponents - Used to argue forward-looking growth indicators are deteriorating sharply. UST headline CPI monthly change: 0.0% (possibly slightly negative) - Discussed as reflecting a temporary energy-driven decline rather than a solved inflation problem. Energy prices in CPI: down 4.6% month over month - Explained as a key reason headline inflation printed so weakly. NHB housing index: 49 - Michael cited this as one of the weakest readings since 2007. Treasury issuance / QT timing: QT starting in September, about double prior pace - Andy argued this would be a significant upcoming headwind for assets. S&P earnings estimate for 2022: about 225 - Andy used this as the consensus earnings figure supporting his view on valuations. S&P earnings estimate for 2023: about 235 to 244 - Different data sources were referenced; Andy cited 235 from Yardeni, while another source showed 244. Oil one-year forward price: about 82 - Andy used this to argue headline inflation may remain restrained if oil futures are right. Current WTI price referenced: about 89 - Compared to one-year forward pricing to assess inflation expectations. Andy’s risk budget on puts: about 5% of AUM at risk - He said he had 2% AUM in Nasdaq puts, 2% in S&P puts, and 1% in Euro Stoxx puts. Potential equity downside scenario: roughly 3,800 S&P 500 - Andy suggested a 5-8% drawdown from the then-current level could still occur.

Pivotal Quotes: "The second part of the rally was a big gamma squeeze slash volatility targeting funds and risk parity funds and asset managers in general, which were pretty much under allocated to risk." — Alfonso Pecatello: Explaining the technical, non-fundamental drivers of the post-June equity surge. "If you’re a medium to long-term investor, what you’re looking at here is probably an allocation towards safer assets until there is very strong evidence that economic growth has bottomed." — Alfonso Pecatello: Summarizing his strategic view that bonds are preferable to cyclical equities. "I think the market’s prepared for a soft landing… and I don’t." — Andy Constant: Andy’s concise expression of his bearish disagreement with prevailing market optimism.

Implications: The panel’s message was defensive: rallies in cyclicals, small caps, and EM FX may be exhausted, while bonds and safer assets look better over 6-12 months. Listeners should watch QT, issuance, housing, and inflation persistence closely.