Markets Are Whispering Bottom, Yield Curve Inversion Likely Through

STRATEGY: S&P 500 fell > 6% below its 200D and closed > 200D = 31 times since WWII = bullish signal
US is the “best house” in a bad neighborhood
As markets complete 1Q2022, it has been a bloody and treacherous 90 days. The macro environment has become decidedly hostile, with visibility on outcomes only emerging 3-6 months from now. Meaning, markets are still facing the same headwinds for the few weeks. These are apparent but let me recap:

• inflationary pressures are building
• current wave is commodity driven and amplified by Russia-Ukraine war
• Geopolitical risks remain high given the risk of Russia-Ukraine war expanding
• interest rates have risen, raising concerns of excess leverage
• Fed has gone into “full hawk” mode
• China is dealing with a major COVID-19 wave and threatens further supply chain issues
• yield curve has inverted

So, it is obvious that the macro environment is uncertain. Contrary to consensus views, FSInsight had warned of a treacherous 1H2022 in our 2022 outlook (published in December 2021), but this is actually tracking slightly worse than we expected.

Yet, in the face of this, the S&P 500 is down only 5% YTD. This is impressive resilience, especially after declining more than 16% peak to trough (intraday) at the worst. At the nadir, the S&P 500 was discounting a 66% probability of a recession, so the key question from here is whether the US avoids a recession:

• bears will say, the slide YTD is just the start and worst yet to come <– easier case to make However, as we have highlighted in our recent notes, we believe the S&P 500 has been “whispering” bottom for some time. And with 1Q2022 behind us, we now assign a > 88% probability that the bottom for 2022 is in. Yup, we think the lows for the year have been made:
• we think lows for 2022 are in with > 88% probability
• we still see stocks in a “jagged” recovery in 1H2022
• full risk-on coming in 2H2022
• S&P 500 can exceed 5,100 before year-end

• key is avoiding a US recession <– we believe this is the highest probability

KEY REVERSAL: S&P 500 fell > 6% below its 200D and closed > 200D = 31 times since WWII = bullish signal
As our clients know, our investment process does not look solely at macro, but is reliant equally on quantitative (Adam Gould) and technical signals (Mark Newton). And recently, significant signal is generated by quantitative signals. – most recently, the S&P 500 was 8% below its 200D moving average on 2/24 (day of invasion)
– and closed above the 200D on 3/22, about 1-month later

…> 90% probability the low is in for 2022
This is actually a bullish signal. Take a look at the table below

• this has happened 31 times since WWII
• 15 times when US not in recession at time of signal (ala Thursday)
• 14 of 15 times, S&P 500 higher 6M later, median return 10%
• 15 of 15 times, S&P 500 higher 12M later, median return 17%

• even if there is a recession eventually underway
• 12M median return (n=16) 18%

So, this recovery in equities to close above 200D generates quite a lot of positive signal.

TIME TO PANIC? 3 reasons we think stocks are still “whispering” bottom
In any era, and in most market historical timeframes, this curve inversion would indeed be a signal to get cautious. After all, this is the economic Dim Mak. But at the same time, we see 3 reasons to ameliorate our concern:

• “real” interest rate curve is still in normal slope
• in 2006 and 2019, when nominal curve inverted, “real” curve also deeply inverted
• variant development vs other curve inversions
• inflation curves are in deep backwardation (spot far higher than future inflation)
• implies market seeing “episodic” inflation
• leading indicators like Cass Freight Index, port backup volumes, car inventories rolling

• “real” cost of 10-year money is still negative
• supportive of risk assets, as real borrowing costs essentially “free”
• what asset benefits from negative “real” rates? equities
• argues P/E can expand

In short, the 3 reasons above seem to be supporting the rationale for why stocks are still “whispering” bottom. I am not trying to dismiss the economic risks — those are real. And the future is uncertain.

In this note, we explain why we believe stocks are still able to rise despite these very challenging macro headwinds. Just an apology in advance. This is a longer form analysis note. But the breakdown of why inflation backwardation matters is difficult to explain in short form.

COUNTERPOINT: BUT, we think inflation “Backwardation” is messing up the yield curve
But we think the inversion of the yield curve is due to inflation “backwardation” — meaning, the “real” yield curve did not invert. This requires some explanation:

• the nominal interest rate, or yield on a bond
• has two components

• “real” cost of money
• inflation rate

Therefore, at any point on the term structure, aka yield curve, there are two parts to the interest rate.

• Our view is that the “real” rate needs to invert to be a recession signal
• if the “inflation forecast” is the reason for the inversion (backwardation of inflation)
• this arguably is not a signal

…the “real” yield curve is still positively sloped = not economic Dim Mak
The simplest way to see the market-based “real” yield is using the TIPS market. These are inflation-protected bonds and measures the market’s expectation for the “real” return of any US gov’t bond, based on term structure and the prevailing interest rate for those bonds. The curves below were created by our data science team, led by tireless Ken, using the TIPS (Treasury Inflation Protected Securities) at varying maturities:

• the current “real” yield curve is normally shaped
• in 2006, the “real” curve was sharply inverted coincident with nominal curve inversion
• in 2019, the “real” curve was sharply inverted coincident with nominal curve inversion

In other words, the “real” cost of money tightened in the shorter term (shorter maturities) in 2006 and 2019. And these tightenings of credit conditions also contributed to a recession.

…fortunately, US financial conditions are still easy
The good news is that in 2022, we have not seen the severe tightening of financial conditions that presaged calamity in 2006 and 2019. As you can see, at the moment, US financial conditions are improving:

• this is dynamic
• so it can get worse at any time
• meaning, we can’t rule out financial conditions will worsen in the future

• as our team likes to say –> “the future is uncertain”

…inflation in backwardation is the real message of the inverted yield curve, in our view
To better illustrate the inflation component of interest rates, take a look at US yield curve below:

• the nominal rate is the line
• the composition at each maturity is shown below

• inflation is red columns
• “real” yield blue

• notice how the inflation expected is lower as maturities move outwards?

In other words, inflation is in backwardation. That means the “spot” inflation is above the forward rates. This is not a normal condition.

Inflation backwardation only started in 2022…
Inflation “backwardation” only started in 2022. In fact, take a look at the inflation curves for 2019, 2020 and now. We can see the evolution of inflation over time:

• in 2019 and 2020, inflation was seen at similar levels across time

• but in 2022, this went into “backwardation”
• meaning, markets see high inflation near-term and diminishing over time

This is an important consideration. After all:

• since nominal interest rates have two components
• “real” rate + inflation – if inflation is higher for a specific period of time

• nominal rates need to be higher
• otherwise, “real” rate is too low

To an extent, this is also why the Fed needs to raise short-term rates. Because short-term “real” rates are too negative.

…Is “episodic” inflation explaining the backwardation of inflation?
Our base case is that inflationary pressures are not as durable as market expectations seem to be pricing. Brian Rauscher, FSInsight’s Global Head of Portfolio Strategy, explains it best when he describes inflation issues as “episodic”:

• first wave was supply chain shortages
• second wave was “revenge spend”-fueled demand
• third wave is commodity parabolic surge further fueled by Ukraine war

This is illustrated below. And if this view tracks correctly, we should see inflationary pressures apex. That is: – inflationary pressures should cool

• leading indicators like Cass Freight Index, or port delays are rolling over
• labor markets are still tight, so this needs to ease
• employed to population ratio is only 59% –> historically this is a recession low, not a sign of a tight market
• greatest risk is that consumer expectations are anchored at higher inflation
• then Fed needs to be super aggressive

…Inflation curves did not “backwardate” in 2006 or 2019
One last point. In 2006 and 2019, at the date of the yield curve inversion:

• inflation curves were normal in contango
• upward sloping
• 2022 is in “backwardation”

So this is very different, in a concrete and measurable way, from 2006 and 2019.

STRATEGY: Stock market still “whispering” (deafening actually) BOTTOM…”real” interest rate is negative = supportive of risk assets
We have advised our clients that the current macro environment is indeed quite uncertain and dangerous. And those warning of economic risks from inflation, war, shortages, supply chains and even COVID-19, have credible and well-reasoned arguments. In fact, this is the reason our base case (from December 2021) was that 1H2022 would be treacherous.

But we also cannot ignore the continued “whispers” from the stock market that a major bottom is in place. This is not confirmed technically (see work by Mark Newton, Head of Technical Strategy) but is coming from multiple vectors:

• multiple quantitative signals such as successive +1% up days (see prior notes)
• “recession” positioning by institutional investors (see BofA FMS)
• “recession” sentiment by retail investors (AAII)
• stocks priced in “recession” with > 40% stocks down 20% from highs in March –> 9 of 9 times stocks higher in 12M (assuming no recession)

See the picture? Bears have conviction:

• bear case is more convincing and it is credible
• bears therefore have conviction
• but market acting like a major bottom

We are choosing to see the market message.

Another case for staying constructive is the fact that “real” interest rates are negative. Take a look at the “real” cost of money below:

• we highlight cost of 2Y and 10Y money
• nominal rate is the same at ~2.38%
• “real” rate is -2.53% and -0.62%

• 10-year money has a negative real rate
• if one can borrow money for less than inflation

• why wouldn’t one invest in “pro-inflation” assets?
• what is a pro-inflation asset class? EQUITIES!!!!

…History shows stocks do well when “real” rates are negative
History has shown this is the case. We have published this chart below multiple times in the past. This is looking at CPI and 10-yr treasury rates. Since 1880.

• 26% of the time, “real” rates are negative
• yup, far more common than most realize – it tends to be “episodic”
• 1906 to 1910 <– post-1907 bank runs– 1917 to 1928 <– Roaring 20s
• 1942 to 1958 <– Post-WWII economic boom

Hmmm… these are all periods of economic prosperity.

…Stocks staged parabolic gains during these negative “real” rate episodes
In fact, stocks did quite well during periods of negative real rates. Take a look below:

• S&P 500/ Dow 10-year rolling returns were strong during negative “real” rate periods
• 2022 is the start of another negative “real’ rate era

….Stocks go moon? Pamp it.

Figure: Themes in 2022 – “BEEF”

Per FSInsight

Figure: FSInsight Portfolio Strategy Summary – Relative to S&P 500

** Performance is calculated since strategy introduction, 1/10/2019