Digestion Time
1551 words – a 4 minute read.
Given those of us in the US just celebrated July 4th with its obligatory cook out and fireworks display, digestion time makes sense as a title even if one isn’t talking about Joey Chestnut taking top dog out at Coney Island. No, what we are talking about is the normal, healthy, cross asset market behavior of digesting big moves. https://www.usatoday.com/story/sports/2023/07/04/nathans-hot-dog-eating-contest-2023-results/70381518007/
There have been big moves a plenty in the 1st H of the year with Nasdaq having one of its best 1st Half’s ever, Japan & Brazil both gaining nearly 20% last Q while several of our favored Cyclical sectors enjoyed double digit gains last month. Elsewhere, Global Sov bond yields have risen back to levels last seen in 2008 while record breaking Mexican Peso strength & Yen weakness finally reversed a bit. Here’s one for the books – Brent crude oil has now declined for four quarters in a row, the longest such stretch in 35 years! We like energy for the 2ndH.
The Yen is interesting; Marc Chandler notes that by the OECD’s PPP measure it is close to 50% undervalued vs the USD, as is the Euro. This compares to the roughly 25% undervaluation levels that prompted the famous 1985 Plaza Accord. Given our view of the imminent end of YCC, shorting the Yen seems like a picking up pennies in front of the steamroller trade. We note DXY failed to follow rates higher yesterday.
We appreciate the digestive period as it allows us to see who is weak and whose strong, perhaps step up in some areas we missed and prep for the 2H. We don’t see big downside risk and continue to think equity dips are for buying.
In macro land, we continue to focus on the rotations & transitions we have been writing about here and here. We covered this in great depth in our latest Monthly: The Great In Between where we highlighted five major transitions including the shift from rate hikes to rate cuts, the consequent shift from a myopic focus on monetary policy to fiscal policy and the cycle shift from recession fears to early cycle global recovery. Let’s unpack these a bit before turning to the markets.
We remain of the view that the Fed is done raising rates or at least very close to being done. This week’s sharp bond selloff puts the AGG back at pre SVB levels & is just the latest slap in the recessionistas’ face. We remain in the higher for longer camp and see Global Govt bond yields at 2008 levels as a feature not a bug. One additional hike is already priced in and most assume it will occur later this month. While this is feasible, we think it unlikely given that June’s Y/Y headline inflation number should be well under 4% while rental price weakness suggests rents will go a long way to capping 2H inflation.
We may be wrong and perhaps the Fed will raise one more time but the bigger point – that we are close to the end of DM rate hikes (ECB may hike 2 more times but PPIs are now in deflation territory) stands. The corollary is that we are also closer to the beginning of an EM led rate cutting cycle. We have noted that the PBOC is already cutting and expect several of the Lat Am countries, namely Brazil and Chile, to cut rates this quarter and Mexico next. See Chart 15 in the monthly which highlights how EM inflation is already close to 2%.
As we shift our attention from monetary to fiscal policy, we start to see why Pres. Biden has decided to run on Bidenomics given the roughly $500B in private sector announcements along the EV and semiconductor supply chains as the impact of the Infrastructure Act, the IRA and the Chips Act start to be felt. Construction of US manufacturing facilities continues to surge; up 1% in May from April, putting it up an eye-popping 76.3% from a year earlier.
This is a key issue given the main question we have is whether manufacturing will catch UP to Services or will Services catch DOWN to manufacturing? We expect the former in the US due in large part to the New Industrial Policy & believe US Manuf PMIs are bottoming, noting that the new orders to inventory ratio is at its highest since Feb 2022. We worry more about Europe & China. This helps put Europe’s 2% equity market decline yesterday, the biggest in 4 months, into context.
We expect the investment process unfolding across the US will run for years. The same holds true for Europe with its Fit for 55 and Green Industrial New Deal funding which we highlighted in the Monthly as well. We remain with our 2H of the 1990s analogue for the US and extend it to the globe given the global nature of the fight against the 3Cs of Covid, Climate & Conflict.
We expect China to also move in this direction following this month’s Politburo meeting. China is shifting from export and investment led growth to domestic demand led growth and needs to stimulate consumption from a populace that is still somewhat shell shocked by Zero Covid and the continued weakness of the property sector. Asia leads the early cycle global economic recovery with China still likely to grow roughly 5% (more than double US & EU) while Japan goes from strength to strength as it exits deflation and likely exits YCC as well in the coming months.
This sets up the two additional transitions we highlighted in the Monthly. The shift from bear market fears to equity rotation and from the US to the ROW. Both stocks and bonds have been busy pricing out recession risk with bonds leading by pricing out the likelihood of multiple rate cuts later this yr.; stocks have followed more recently with June seeing Cyclical sectors like Transports (IYT) and Homebuilders (XHB) return roughly 10%. For all the talk about how the market advance is just a handful of big tech names the Tech sector actually UPed the S&P last month while Industrials & Materials had double digit gains & Defensives trailed badly.
We continue to focus our attention on the Non US equity markets as well believing we are at the early stages of a global shift in leadership away from the US to the ROW. After UPing in the 2H of last year, the US is OPing ACWX ytd though several of our key markets, namely Japan, Mexico and Brazil have all performed in line or better than the S&P. We expect this to continue & our mantra remains: Fed on hold = USD weakness = ROW equity OP and Commodity upside.
The latter has yet to occur with both energy and industrial metals being weak. Oil in particular has had a rough ytd; we remain of the view that inventory destocking has more than offset decent demand growth as rising rates and the Covid effect reduce the desire to hold inventories. This sets the stage for sharp upside price action at some point – we envision this to come once the global economic recovery we foresee is more fully embraced, perhaps signaled by US Manuf PMIs breaking back above 50.
Q2 earnings season is upon us after a pretty heavy data period replete with head fakes (ADP) and booty shakes (the end of the 14 month run of BTE jobs reports – longest this century). We remain focused forward & are interested to hear what companies say regarding the 2H outlook and early read into 2024. We are especially focused on the conversation around pricing power and whether the great price adjustment that coincided with the Covid period is over.
We updated our two model portfolios this week, our Global Multi Asset (GMA) and our TPW 20 Thematic model, once again reviewing the technical positions across both models and broad indices. We found very few oversold conditions unlike a few months ago. Somewhat surprisingly we also found very few overbought condition – mainly in housing and transports, no surprise there given the sharp June run up. Most are well above their 200 dmav with both models having only four positions under their 200dmav, a sharp & welcome change from several months ago that should stand the models in good stead in the current digestion phase.
In this digestive environment we want to maintain the barbell positioning we discussed in the monthly: the US and non US equity barbell noted above together with the US Big Tech and Cyclical barbell we highlight in Chart 2 in the Monthly. We also note our FI barbell with HYGH & EMLC; we were pleased to note that EMLC was the best performing US listed FI ETF YTD with HYGH not too far behind. We continue to abhor UST and DM Sovereign exposure given our economic recovery view. Our cross asset barbell with Digital (AI related) on the one side and Physical (Commodities) on the other has been a tilted tale for sure with ARKF and other digital vehicles up sharply while XLE and AMLP have been disappointing to say the least. We expect a better 2H for the physical world.