Day Trip

1450 words – a 3 minute read.

Sometimes the best thing to do is to just step away. I hadn’t been to the beach all summer and time was running out, so I made the move and day tripped it out to one of my favorite spots, Fire Island, where I spent many a summer.

As such decisions usually do, it came with lots of rewards – smooth travel, fantastic weather, wonderful, cool ocean water, booming surf and near empty beach by the famous Fire Island lighthouse. The body surfing was transformative, the surgically repaired left knee held up fine & what’s not to love about a midafternoon nap on the beach?

A red fireball sunset as the ferry took me back to the mainland was Mother Nature’s reminder to come on back; the night was capped off by dinner with an old buddy at one of Long Island’s famous red sauce joints.

While I didn’t check the markets once I left the mainland, I did note on the way out that the commuter parking lots were quite full suggesting that Long Island got the back to the office memo – something that one can confirm just being in Manhattan these days with traffic back to normal and the post Labor Day buzz in the air.

What about markets, you say? Well, Tuesday’s CPI print was bad, not sure if it was 4% bad but it was a classic buy the rumor, sell the news on light volume event. After all, the S&P had been up the prior 4 days and the selloff, painful as it was for one day, took us back only to the levels of the prior week.

Stocks have continued to weaken and as I write the technical level of 3850 is the latest “line in the sand " as Fed Ex warns. The news/data flow continues to be very erratic, almost to the point of if you don’t like that data point, if it doesn’t fit your script, just wait and the next one will.

Bloomberg, for example, has both bullish and bearish China growth stories highlighted amongst its top 5 stories on the stocks section and that’s just one example among many. The data flow out of China suggests a gradual pick up in economic activity while the big Chengdu lockdown has already been eased after only two weeks in force. Property remains a laggard but we believe the Govt has drawn a line under it and completing the paid for but not yet built flats will be positive for growth. Nonetheless the story is the yuan breaking 7 to the USD reflecting the widest US – China rate differentials in over a decade and China stocks off 2% on back to back days.

It’s a similar story over in Europe where Dutch Nat Gas TTF prices are down roughly 45% from their recent peak and yet stories abound about deep recession ahead. Goldman Sachs, for example, expects gas prices to halve to roughly 100 by end of winter and then halve again as 2023 progresses. Record low unemployment & post Covid spending has buoyed European growth to date and while that may be ebbing, fiscal support and consumer support on the energy side together with an uber cheap Euro (over 40% undervalued according to OECD, Yen too) should provide support and limit any recession to the mild type. BTW, did you note how Pres. Xi dissed Pres. Putin at their meeting? Ouch.

Here in the US, the fear of continued high CPI prints and thus aggressive Fed response with more rate hikes leading to higher rates for longer is spooking the FI market and thus equities, especially on the growth side. We have been of the view that the Fed will raise 75 bps next week and that will be the end of the aggressive front loading which has sent the US rate structure on a hockey stick ride from front end to back, carrying mortgage rates along with it (300 bp mortgage rate rise in one year is largest since 1980-81).

That view has been called into question post Tuesday’s CPI; currently forward markets are pricing in two 50 bp hikes in Nov and December to get the Fed Funds rate to roughly 4 – 4.25% by YE. The end of front loading has been important to us as we believe it will signal the peak in the USD which, notwithstanding the aggressive rate back up, especially at the front end (2 yr. rates up 74 bps in past month), remains under its recent highs. 

This may be because rates are rising in Europe as well with the US – EU 2 yr. rate differential peaking over a month ago at roughly 277 bps and now fluctuating around 230bps with the 200dmav at 216. We expect the ECB will raise rates more than the Fed in 2023 and see the USD rollover as key to unlocking significant cross asset allocation shifts. 

It seems to be a battle between who has the cleaner shirt as neither the US nor the European economic story is clear or clean – with Europe cross asset valuation at rock bottom levels one has to wonder how much of its woes are in the price. We think quite a lot. Regarding the US, it’s worth noting that while real rates have risen sharply & financial conditions are the tightest since April 2020 the S&P remains roughly 6% above its mid June low.

There was an interesting Fintwit exercise  this week suggesting that if m/m US inflation levels remain at 0% or 0.1% then headline CPI would fall to under 4% by March 2023 as the big prints fall out of the y/y calculation. We have previously noted JPM’s view that US CPI will average 3% in the 2H of the year. 

This is an interesting exercise given that it suggests time is running out to be super bearish inflation, rates, stocks and super bullish USD, cash etc. as odds are rising that the FFR will be above PCE deflator by early next year. It’s also worth noting that while the 2/10 YC inversion gets all the play, the more trustworthy 3M/10 yr. spread remains positive by roughly 30 bps, leading the Cleveland Fed to suggest just a 27% chance of recession in the coming year. Goldman Sachs is at a 33% chance.

While seasonals are lousy at least for the next several weeks the always interesting BofA Fund Manager Survey (FMS) continues to suggest just absolute  peak levels of risk aversion. To wit: record low risk appetite – less than at the bottom in 2008 (we are in nothing like a 08 enrionement), record high cash allocations, record low equity allocations and the most crowded long USD position since “long Tech” in Nov 2020. 

On the plus side we note ARKK’s significant outperformance vs QQQs over the past month or so suggesting that the Innovation space has already bottomed as we have previously suggested. JPM makes the point that if any potential EPS downside is of the order of 10-15%, rather than 20-50%, then the current International equity P/E multiples of 9-11x, a discount to typical 13x, are showing meaningful enough compensation.

 Fed Ex’s EPS warning & massive options expiry set the stage for today’s action, but overall earnings revisions continue to be better than expected in both the US and EU. S&P 500 companies are still expected to post earnings growth of 3.7% for the third quarter, according to FactSet. While that would mark the slowest pace of growth since the third quarter of 2020 it remains positive. BofA notes its 3-month global earnings revisions ratio, which is running close to its long-run average level, translates into world EPS growth estimate of 7% in the next 12 months.

We remain of the view that the high nominal growth world we are in will be supportive of earnings and will buffer recession risk as will the global economy’s desynchronized nature with US and EU slowing but China accelerating (albeit slower than one would like). The same holds true on the monetary policy side as the PBOC continues to ease while the Fed & ECB tighten.

Earnings should take center stage in the coming weeks together with the 2023 outlook as we move closer to the end of the year – it’s also one of the best times for equities which are starved for good news - an awful lot of bad news has been priced in and positioned for... good news… not so much. 

Please note there will not be a Musings next Friday as I will be travelling. Back on the 30th with a deep dive Monthly.