Equity Market Sell-off--Looking For Babies...


Here is piece I put out earlier in the week to my clients. The main idea of the piece is for investors to focus on the remaining and much more attractive asymmetries (even more attractive after the sell-off) remaining in the market and not on the question of the valuation of the broader US equity market. In my framework, these strategies are consistent with a view that rates are header higher--higher rates seems to be the culprit most investors are looking at for generating the sell-off. Yes, I would position for higher rates but at the same I would buy regional US banks and European equities.  Higher rates on the margin should actually provide a tailwind for regional bank ROTE growth. Tax reform will also provide an offset to higher rates for regional bank through higher after-tax earnings, since they have been paying pretty close to the 35% corporate rate. Add to this upside, the potential boost to valuations of regionals from financial reform. This reform could drive price-to-tangible book back up to historically levels (almost double from current levels) by allowing banks to grow earnings through higher margin lending and by allowing them to releverage back up to historical levels. Part of this view on the benign impact of higher rates is that normalization of rates come gradually. Most importantly that inflation does not spin out of control, which could trigger a much more aggressive Fed. So in contrast to a number of investors and commentators that are still fighting the last war, I find it hard to believe that the inflation going back to levels of the 70-90s is a real threat. Demographics have reduced that threat substantially and created another more likely threat of deflation, just look at Europe and Japan.  European equities look compelling even with the potential valuation issues about US equities because they have largely missed the US equity rally. This should give them somewhat of a buffer to the downside, and give them cheap asymmetry to the upside from continuation of normalization of economic growth both in Europe and the rest of the world. Additional convexity to the upside will come from the repricing of southern European banks as the growth turns off the NPL cycle which has been a brutal headwind to after-tax profit growth despite earnings growth.