S&P Breaks June Lows in the Afternoon and Recovers into Close, Dow at 2022 Low
After many conversations with clients since the Sept FOMC (9/21), our overarching takeaways are the following:
- Fed sole focus is quashing inflation and
- In a way to make sure inflation is “deader than dead”
- How this is measured is not entirely clear
- Investors have lost faith in economists’ models/projections on inflation
- Fed similarly has little confidence in models and wants to see “tangible results”
- Because of known and variable lags, plus market impatience
- This is read to mean Fed will push the US into a recession
- Hence, risk assets sell off, and yield curves invert
There are “greenshoots”
Stocks have been caught in a painful downtrend for most of 2022 as the Fed is fighting the war on inflation. But we think there are other paths to beating inflation beyond creating a deep recession (which Fed is willing to move towards). In this commentary, we highlight a few perspectives:
- While markets viewed Fed commentary as drastically more hawkish, Fed funds futures only increased by a single hike for 2023.
- Granted, this could worsen if inflation data worsens, the key is that inflation trends remain the primary driver
- One of his more notable comments (Powell) is the lack of progress on 3M, 6M, and 12M inflation
- We looked at the 1970-1982 battle on inflation, and an interesting data point is Volcker ended the war on inflation when headline CPI 3M annualized fell to 2.5% (cycle low)
- In the 2022 context, this level will be seen in 2023 — does this mean this could be an important metric?
- More importantly, Fed funds will exceed 6M annualized inflation sometime in the next 4 weeks — monetary rates cross into truly restrictive territory now
- Costco and FedEx recent comments talk of significant disinflation
- Since 1948, whenever ISM “% reporting lower prices” exceeds 10%, PPI has tanked
- The most recent figure was 27%, well above the 70-year average of 10%
- The latest Manheim Used Car index shows used car prices now falling at a -50% annualized rate
- Yup, goods inflation is looking “transitory”
- Fed focus is cooling inflation in labor markets and cooling services (sticky) primary of these being housing
RESTRICTIVE RATES: Fed funds becoming restrictive vs CPI (6M) this month
We have heard many investors say monetary policy is too low because “CPI is 8% but Fed Funds is only 3.25%”
- but this is misleading
- investors should consider forward CPI and forward rates
- not “backwards looking” YoY CPI
- the better perspective is to look at 6M annualized CPI versus Fed Funds
- this is arguably a better measure of forward cost of money
- using swaps markets, we see that Fed funds will soon exceed forward CPI
- this crossover is expected to be in the next 4 weeks
- peak restrictive rates is December 2022
- hence, we believe further impacts of tighter monetary policy will soon be felt
- Risk reward growing poor for shorts with Equity indices nearing June lows. Meaningful oversold bounce likely starting first week of October
- Multiple back-to-back hugely negative Advance/Decline readings provides some initial evidence of downside capitulation
- Crude oil’s rollover likely extends to mid-70s before an intermediate-term low in October
- Reiterating unfavorable view on the U.S. equities. I released my next potential downside target range of 3200-3000 earlier this week. Be defensive, protect, and remain patient for better buying opportunity that is still in front of us.
- Forward profit expectations are still too high and more negative earnings revisions are still to come. The next several weeks will likely see several high-profile negative profit preannouncements before the 3Q22 earnings season begins in mid-October.
- The Fed has effectively removed all doubt about its inflation fighting commitment and hopes of an early Dovish Pivot. Tighter policy, weakening job market, and slowing economic growth are inevitable. At some point, Chair Powell and Company will make an important shift away from hawkishness, but for now, follow rule #1 — DO NOT FIGHT THE FED.
- Despite some potential short-term relative risk, my work still prefers Growth over Cyclicality, which has considerable downside to their forward outlooks.
- Stocks are continuing to move in tandem, presenting a difficult environment for stock picking which should continue for the near-term, at least. Pairwise correlations continue to rise, while idiosyncratic risk (the share of movement of the typical stock attributable to stock-specific drivers) was falling for the past few months, only turning up slightly in the past week. This is important for long only’s and long-short funds as it is more difficult for them to pick winners and beat the market when stocks are moving in tandem.
- The Reddit-based sentiment indicator for the market remains in the middle of the range, which doesn’t offer a meaningful short-term signal at the moment. Sentiment among Redditors was in bearish territory most recently on 1-Sep, after which the market rallied nearly 5% in the subsequent week.
- Looking at the composite factors that make up the stock rating model, momentum has continued to show strong performance. After a historically poor July, the momentum factor has earned +3.5% since the start of August, while the market is down over 6% during that span.
- FOMC raised rates by 75bps, as expected. At the post-meeting press conference, Powell towed a thin line between hawks and doves, reiterating his commitment to data-driven decisions and 2% inflation, while mentioning a future slowing in the pace of rate hikes once “appropriate”
- A continuing resolution (CR) must be passed by October 1st to avoid a government shutdown. This could be a headline risk between now and then.
- Democrats need 60 Senate votes to pass the stopgap budget measure, meaning 10 Republicans will need to vote yes, assuming all 50 Democrats approve the CR. The Manchin energy proposal remains a key hurdle to passing the CR in time.
- The CPI print and subsequent Fed actions have led to an increase in correlations between crypto and equities.
- We note that October (next week) has been a historically bullish month for crypto. Relative strength in crypto compared to equities could signal a tactical bottom.
- Despite a partial reversion of the ETH/BTC relative value trade, governance tokens for liquid staking providers have held up quite well, and we would expect them to continue to do so as staking adoption continues into year-end.
Wall Street Debrief — Weekly Roundup
- The S&P 500 closed at 3,693.23 after breaching the June 16th lows intraday. The VIX spiked to above $32 but settled just under $30.
- Markets were roiled by a hawkish FOMC meeting and mounting economic fears. The UK's new tax cuts spooked bondholders in Europe as well.
- Recession fears are rising and the USD reached new highs today as European currencies plummeted.
“Mama said there’ll be days like this, There’ll be days like this Mama said.”- The Shirelles
The Dow and the S&P 500 were down about 5% for the week. The June 16th lows were breached intraday for the S&P 500. Chances of recession are going up, according to JP Morgan. They are about at a coin flip over the next year and 74% over two years. Also, more market commentators are starting to raise the specter that the Fed may over-tighten. The Fed’s Summary of Economic Projections (SEP), also called the dot plot—but this week, you can call them the dots of doom. All components of the DJIA were negative for the week. The VIX spiked to its highest levels in months and settled just under 30. We ended up closing about 25 points above the June lows for the S&P 500, but the Dow closed at its lowest level in 2022.
There is a character in Greek mythology called Sisyphus. The Gods punished him with the fate of rolling a boulder up a hill for all of eternity, then watching it roll down and starting again. Tasks or professions with a similar quality of being impossible to complete and repetitive are sometimes called Sisyphean tasks. If you haven’t realized it yet, markets and the pursuit of gains through them meet the definition pretty well. It's hot, then it's cold. You're on top, then you're deep in the red. Indeed, the first book on markets ever written by a Dutch trader named Joseph de la Vega introduces markets to his readers with this same mythological allusion.
Philosopher: And what kind of business is this about which I have often heard people talk but which I neither understand nor have made efforts to comprehend? And I have found no book that deals with the subject and makes apprehension easier.
Shareholder: I really must say you are an ignorant person, friend Greybeard, if you know nothing of this enigmatic business [stocks] which is at once the fairest and most deceitful in Europe, the noblest and the most infamous in the world, the finest and the most vulgar on earth. It is a quintessence of academic learning and a paragon of fraudulence; it is a touchstone for the intelligent and a tombstone for the audacious, a treasury of usefulness and a source of disaster, and finally, a counterpart of Sisyphus who never rests as also of Ixion who is chained to a wheel that turns perpetually.
-Confusion of Confusions, Joseph de la Vega, 1688
So when you look at the screen on a day like today and start cursing yourself, remember that markets have perplexed people for hundreds of years and hopefully will for hundreds more. Days like today and the ebb from bull to bear market and back again are like the rolling of Sisyphus’s rock. We have multiple methods of looking at markets to produce research that helps one navigate the inevitable ebbs and flows of the market. After the hot CPI report this month, our team advised that tactical weakness was highly likely going into October. Markets face a persistently hawkish Fed that appears dead-set on keeping rates restrictive for longer. Equities had benefited from There is No Alternative (TINA), but with rates moving so high, that previously existing source of price support is increasingly precarious. Fixed income, which has had a historically bad year, looks more attractive relative to equities. The 10-yr settled at 3.687%.
The apparent catalyst this week was the FOMC meeting on Tuesday and Wednesday. Jay Powell didn’t give investors a whole lot to be happy about. The dots showed a higher terminal rate than the market expected. The SEP also showed that the Fed expects and intends for growth to moderate significantly. Other things in the background also soured sentiment. Ukrainian forces have recently had breathtaking offensive gains against their Russian adversaries. Vladimir Putin was reprimanded at a Central Asian summit by the Indian and Chinese heads of state for his invasion of Ukraine. Predictably, he lashed out in the face of humiliating setbacks, ordered the mobilization of 300,000 reservists, organized sham referendums to annex the eastern territories, and made veiled nuclear threats. He is rumored to have lost his trust in the military and is now micro-managing the campaign.
The Energy sector, one of the only places to hide so far in 2022, was slammed and was down 7% at close . Materials, also a relative respite, were down sharply, suggesting concerns about demand are mounting after Powell’s address. Energy is now at levels only seen before Russia's February invasion. On Thursday, the Japanese government intervened to support the yen for the first time since the late 1990s. South Korea is also deploying reserves liberally to shore up the won.
The UN met this week, and President Biden spoke about the importance of upholding the UN Charter by not allowing Russia’s invasion to be successful. While some may fret about the economic consequences of an ongoing conflict in Ukraine, it’s important to remember that sometimes these efforts have a very profound and positive effect on the future when the rule of law and self-determination are allowed, with the help of the world, to prevail against tyranny, oppression and economic despair. The United Nations deployed forces 72 years ago to help the beleaguered government of the Republic of Korea push back an onslaught from a similar unprovoked invasion.
There is perhaps no more stark example of the power of a free way of life, the kind of country where markets flourish and citizens prosper, versus totalitarianism, isolation, and jingoism, as the two sides of the 38th parallel. On one side, you have South Korea, a flourishing democracy that is a lynchpin of the global economy and a technological leader. On the other side is North Korea, a veritable hell where freedom of expression is banned; poverty is incomprehensible, and the shameless regime routinely uses torture and violence against its oppressed citizens. Imagine the cost had the United Nations not acted. Imagine how different the world be without the resolve shown by Korean and UN forces. War is always horrific and tragic, but wars of self-preservation are necessary, and the support given by the West is being put to good use by our Ukrainian allies.
The Fed decision roiled European markets, and many have reached new lows. European currencies are reaching multi-decade lows versus the dollar. The new UK government released a significant wave of tax cuts. The pound and UK bonds both were pummeled. Investors are concerned about the stimulative impact of this policy when inflation is running at multi-decade highs. These concerns are compounded by the generous energy subsidies the UK recently announced, estimated to cost around 60 billion pounds. The UK’s new Prime Minister is pursuing classic supply-side economic policies associated most closely with former President Ronald Reagan. Some critics believed the policies were naïve and would result in the pound sterling getting below parity against a persistently strong US dollar. It will be an interesting real-world experiment in economic philosophy and we’ll keep you updated on progress. Companies with more than 50% of their revenues outside of the US in the S&P 500 had earnings growth about a third as high as the average last quarter.
There have been a string of downgrades across the economy. Morgan Stanley cut expectations for AMD. Others cut Micron. Goldman Sachs also cut a number of stocks and their target for the overall index. The effect of Fed tightening was once compared to an old hotel shower by Larry Summers, who was Treasury Secretary and almost became a Fed Chairman himself. The idea is that there’s a lag between the actual hikes and the effect they have on the economy, similar to when you turn the handle and expect hot water to come, but there’s a delay. Then suddenly, it’s too hot, and you’ve scalded yourself. If you take the Fed at Powell’s word from his September process, it seems like the water’s about to get pretty scalding. Many market participants were trying to get out of the shower today to avoid getting burned. The Fed has turned the knob to hot, saying they will keep it there for some time.
Survey: 104.5 Prior: 103.2
This is a monthly survey of consumer expectations on various items like spending and inflation.
Survey: 215k Prior: 213k
The initial jobless claims are reported by the Department of Commerce and measure how many applications for unemployment insurance have been received over the past week.
Survey: 4.4% Prior: 4.4%
The Core PCE measures inflation without food and energy. It is one of the Fed’s preferred gauges to assess inflation.