Please don't ignore 6 key signals from last week... it was a "game changer" and supportive of YE rally

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Please don’t ignore the 6 key signals from last week

Most of 2022 has been a cascade of ever more troubling developments, from surging inflation, Russia-Ukraine war, Fed going full Volcker, China issues and multiple seismic crypto events (terra luna, 3 Arrows, Voyager Digital, and now FTX). And this has pushed interest rates higher, panicked policymakers and punished equities. Still, equities found some sort of footing on 10/13 (day of Sept CPI) and since risen 15%.

Last week was a “game changer” in our view, principally due to the far softer and repeatable Oct CPI but there were 6 signals generated last week. Each of these 6 are why we see a far different path forward for markets:

• Foremost is the positive Oct soft CPI (and repeatable) which showed a favorable break in 3 key inflationary areas: shelter/OER, medical care and goods (apparel and used cars). We expect this to be sufficient for Fed to slow pace of hikes, and possibly December 2022 may be the last hike.
• Second, bond volatility is collapsing (VXTLT or MOVE -8.31% ) and this is a point made repeatedly by one of macro clients (HA in NYC, who works at a major pod of macro HF). Similarly, Tony Pasquariello of Goldman Sachs notes bond volatility “is one asset that every other asset is priced off.” For perspective, TLT Vol (VXTLT) lows has marked every equity market high in 2022. The 8/12 low of 17 marked S&P 500 highs of 4,300.
• VXTLT has plunged from 33 to 21 in less than 15 sessions and we expect to fall to 15 or so. This collapse in volatility, in our view, would support S&P 500 surging to 4,400-4,500 before YE.
• Third, US yields saw a massive decline ranking in the bottom 1% largest downside moves in the past 50-years. Analysis by our data scientist, Matt Cerminaro, shows yield declines of this magnitude portend further declines in rates 6M and 12M forward. In other words, chances are rising the highs for the 2Y and 10Y yield are in further supportive of P/E multiple expansion.
• Fourth, USD (DXY) posted one its largest ever declines (6D) falling -5.8%, ranking it the 8th largest ever decline since 1970. As our data science team shows, USD historically lower 6M and 12M later. Increasingly looks like the top is in for USD as well. Several FX strategists are making similar comments including Deutsche Bank’s George Saravelos.
• Fifth, there is economic signal in the fact that Republicans fared poorly in 2022 midterm elections. While preliminary, it looks like Democrats will hold a majority in the Senate and Republicans have only a slim margin in the House. While many politicos call this an indictment of Trump, we think the bigger message is the economy is simply not bad enough for voters to kick out the Democrats. Inflation arguably is not bad enough that voters are blaming incumbents. Think about that. If inflation is “as bad as 1980s” I would have thought midterms would have been an incumbent massacre.
• Sixth, crypto had one of the tsunami of financial collapses ever (largest in dollar terms), with liquidations (to zero) of >300,000 accounts with leverage and the stranding of $10b or more in assets in FTX along with further contagion effects. Only Mt Gox hack was worse. Yet, the S&P 500 managed to post strong gains in the final two days of last week. This shows that investors are becoming more discerning, rather than “hit the sell button” on any bad news.

BOTTOM LINE: Case for a sustainable rally in equities is the strongest it has been in 2022

In our view, the case for owning equities is the strongest now than it has been in all of 2022. The reasons are cited above. But consider this additional perspective:

• Skeptics will say “growth is the problem now” and point to downside in EPS. But as we have written (see below), S&P 500 has historically bottomed 11-12 months before EPS troughs. So EPS is lagging.
• In 2020 and 2009, S&P 500 bottomed 12M and 10M before EPS bottomed. Since 1900, 13 of 16 major equity lows saw S&P 500 bottom before EPS. See table below.
• From 1982 to 1990, S&P 500 EPS only grew a cumulative 19% (or 2% per annum) but S&P 500 3X. Collapse in bond volatility (risk of higher rates) matters far more in our view
• If inflation is indeed slowing to a 3.5% annualized pace (0.2% to 0.3% per month, as we expect), this shows inflation is far less sticky than inflationistas have argued.
• While we have maintained that view “inflation not as sticky” (given the constellation of leading indicators), it is only now that we are seeing this in the “hard” data (CPI)
• Lastly, recency bias is keeping investors bearish. We have many clients telling us October CPI did “not change a thing. Inflation still too high and Fed will keep raising until something breaks”
• We still see a rally into YE

Post CPI: Fed likely to moderate hikes

We have previously written extensively about our post-CPI views. But the comments from JPMorgan Economics, about a Fed moving slower, is what we expect to increasingly hear.

• what matters is how the Fed responds to data
• this soft Oct CPI points to a Fed likely to move slower

BOND VOL: Bond volatility is collapsing and that is good for stocks

As we noted above, bond volatility has collapsed. But notice the inverse relationship between bond vol (VXTLT) and S&P 500 (SPY 1.36% ).

• in fact, the August highs for S&P 500 at 4,300 were seen when VXTLT was at its lows
• we see VXTLT falling below 15 soon (already down from 33 to 21) and this should fuel a rise in S&P 500 towards 4,400-4,500

Many tactically focused market strategists are seeing this. As noted by Tony below, bond volatility is what other assets are priced off of.

YIELDS: Plunge in 2Y and 10Y is signal

Similarly, we believe there is a lot of signal in the plunge in 2Y and 10Y yields. The bond market was closed on Friday (Veteran’s day) but we suspect yields would have further moved down last week.

In fact, as “tireless Ken,” our head of Data Science, highlights, these moves in yields across the structures are historic:

• 1D change in yields is among the 1% most downward ever

And history shows there is follow through. 10Y yields tend to see further declines after such a dramatic 1D move.

USD: USD might have peaked...

The same message is seen in USD. USD has been relentless in 2022. But it looks like it might have peaked:

• 6D decline in USD is one of the largest ever declines and exceeds that seen in March 2020
• USD decline is a support for EPS as strong USD was a headwind
• history shows USD likely sees further declines 6M and 12M ahead
• this is supportive of equities

And FX strategists are also seeing significance in this USD move. Take a look at comments from George Saravelos of DB.

And our team shows this move in USD likely portends further declines in USD ahead.

EPS: Reminder, S&P 500 bottoms 11-12 months before EPS bottoms

We have highlighted this previously, but keep in mind, that equities bottom BEFORE EPS.

• so while many cite “growth challenges” in 2023
• equities have priced much of this in already
• of 16 major market lows since 1900, equities bottomed ahead of EPS in 13 of 16 instances.

P/E: Collapse in risk premia if inflation is defeated

Finally, on EPS growth. If inflation is falling and vanquished. We expect to see a collapse in equity risk premia — that is, P/E will surge:

• inflation is the largest single risk to equities
• if inflation is vanquished, this will be a 2-3 generation defeat of inflation and means a major tail risk is gone
• hence, we expect P/E to surge
• from 1982 to 1990, EPS only grew a cumulative 19% but multiples surged as inflation was defeated

Rally should exceed the “June false dawn pivot”

As far as market implications, we think the case for a strong rally into YE has been strengthened:

• Foremost, Fed no longer has its “back to the wall” on inflation as October CPI beat looks repeatable and therefore the case for a pause after December is stronger. This counters the hawkish rhetoric of Powell post-FOMC but he did not have October CPI in hand.
• For most of 2022, Fed has not been able to point to measurable progress on containing inflation but a significant constellation of leading indicators showed deflation/soft inflation was in the pipeline. October CPI is the first month the “hard” data syncs with the “soft” data.
• Softening inflationary pressures strengthen the case for a “soft landing,” counter to the consensus narrative that Fed is spiraling economy to a hard landing. Core inflation running at 3.5% annualized (above) will not require Fed to bang out +75bp and arguably 4.5% Fed funds would be very tight.
• A Fed shifting from “higher in a hurry” to “predictable but possibly longer” is far better for risk assets. Fed has acknowledged serious and unknown lags in monetary policy and with inflation improving, Fed can gain some measure of patience.
• While some bears say the Fed doesn’t want equities to go up, this is an oversimplification. Fed just was in a hurry to slow things down in 2022. Stocks are far more complex than bonds which are arguably two variable assets (inflation and future Fed funds).
• Stocks are acting like “beach balls under water” because P/E averages 19X when 10Y between 3.5% to 5.5% — true since 1871. Thus, those arguing P/E should be 15X or less are just plain ignoring history.
• The “false dawn June pivot” rally lasted 23 trading days and saw S&P 500 rise +16%
• We believe this “Fed pause” rally should last closer to 50 days and push S&P 500 +25% higher. Thus, we think S&P 500 should surpass the 200D average of 4,100 and given possibility of another weak Dec CPI could see a move well beyond that. Why wouldn’t 4,400-4,500-plus be a possibility?
• Recall, in 1982, following the final low in August 1982, the S&P 500 reached a new all-time high within 4 months, erasing entire 27-month bear market. That was a vertical rally. Vertical.

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