Fed Faces Reality
1429 words – a 4 minute read.
“One and all got to face reality now” is a line from Natural Mystic, one of Bob Marley’s best tunes. Notwithstanding stocks doing what they do in the most seasonally weak period of the year, the main point of the recent cross asset fireworks is this: The Fed is more in line with reality than at any point since Covid struck more than 3 ½ years ago. That is unabashedly a good thing for risk assets.
I was on BTV’s The Open show this morning and so as usual what follows is taken directly from my prep notes. The focus was on risks to the market (no surprise given the past few days) with tons of talk about UAW strike and Govt shutdown risk.
We pushed back and highlighted what we at TPW Advisory see as the main points of the post Fed decision; first, that as suggested on The Open several weeks ago the Fed doubled its 2023 GDP estimate & raised its 2024 GDP estimate to well above consensus at 1.5%. It cut its peak EUR to 4.1% and suggested inflation would return to its 2% target in 2026 thus validating the higher for longer crowd of which we have been charter members since we laid out our Middle Path thesis over a year ago.https://www.bloomberg.com/news/videos/2023-09-11/fed-will-double-2023-gdp-forecast-tpw-s-pelosky-says?sref=ftskAWJe
In our view the Fed put a stake in the idea that we will return to the 2010-19 period of low inflation, low growth, very low rates. We agree. The Fed also took recession off the table and validated the soft landing scenario in return for halving the # of expected rate cuts next year. This is a GREAT trade for risk asset investors – no recession in return for a few less rate cuts which since recession is unlikely no one needs? We’ll take that trade all day long.
The bond market upheaval demonstrates the depth of its belief in the recession argument – one that never really took hold in the equity space given the lack of confirmation by either the credit markets or forward EPS estimates. So yes, stocks did sell off the past few days leading to the most oversold condition of the year according to Bespoke while pushing Barchart’s Fear and Greed index into fear territory levels last seen in March. Remember March – SVB failures, Credit Suisse implosion etc.… we are far from that today and thus opportunity knocks.
As we see it (and yes, often we see it differently than the crowd), as we see it, the Fed is now more in sync with the global cross asset space than at any point since Covid struck. It has now validated the cross asset landscape:
Validating the bond bear market – TLT has now completely roundtripped the post GFC bull market and is back to 2011 levels. We have been deeply UW USTs in our Global Multi Asset (GMA) model portfolio for the past two years and remain so;
Validating the Commodity bull market which has GSG up 18% or so over the past three months – no recession signal here;
Validating the inflection upward of global earnings revisions which provide key support for global equities;
And confirming the credit market which has never supported the recession argument thus HYG ( or in our case HYGH) outperforming AGG by a considerable margin YTD.
So what does all this mean for the search for stability we wrote about last week which we believe will unlock the $1T in reward money sitting in MMF?
Well, it suggests that the stability we seek is coming into view, validating the benign VIX and MOVE readings. We’ll let others obsess over the dot plot (“dot plot don’t mean squat” was my BTV quote) while we focus on our four signposts along the road to stability.
First, continued disinflation in the US and Europe. We expect disinflation to accelerate in Europe with very easy Y/Y comps in the coming months – its possible that the ECB may jump the queue and cut rates before the Fed. US consumer inflation expectations at multi year lows, EU inflation may hit 3% Y/Y by YE.
The DM rate hiking cycle is tired – EM rate cutting cycle is wired. We are focused on the forward looking rate Cutting cycle, led by EM & now underway with Brazil cutting again just this week Note EM FX (CEW) has OPed the Euro & Yen versus the USD since the USD bottom in mid July.
Second, the global manufacturing recovery we expect as inventory destocking shifts into inventory restocking on a global basis – new orders vs inventories are inflecting upwards across the globe according to BofA while JPM reminds us that history suggests buying stocks with an ISM Manuf PMI under 50 but rising is a good idea (where we are today). Expect US ISM Manuf PMI over 50 by YE.
Third, continued inflection upward of forward looking earnings revisions, something validated by the Fed’s new economic forecasts and which should provide equity support amidst all the gnashing of teeth, wailing and tearing of hair one sees all around. BofA’s global revision indicator at best levels since Spring 2022. Note Q3 E season up next.
Fourth, the traction gained by the drips and drabs of China policy support which augmented by very easy Q4 Y/Y comps (recall Q4 22 was the depth of the Covid clock downs – seems like a century ago but was only last yr) should lead to a more positive take on China. JPM notes its China business cycle indicator is back in Recovery mode for the 1st time since March & just raised its Q3 and Q4 GDP estimates.
China equity (FXI) is OPing the SPY over the past month… what will China equity do once the data flips? Here’s a hint – zero, zilch, nada, none of those surveyed in BofA’s latest FMS expected higher growth in China – zero! BofA goes on to note China growth expectations are back to lockdown lows.
Obviously, there are some potential flies in the ointment – UAW strikes, Govt Shutdown etc. We expect the UAW strike to be settled in the coming weeks as there is plenty of money to go around and the automakers cant afford to fall further behind in the EV race. Same with Govt shutdown – Congress under Far Right Republican control is a clown show but history suggests shutdowns are short and not meaningful – we don’t expect this to be any different.
No, the real question for us resides in the path forward for the USD and rates and whether they are both breaking out into new uptrends which, if so, that will make it tough for risk assets to move meaningfully higher into YE as we expect. Yet, for all the noise the 2 yr. UST is up only 5 bps over the past month and the 10 yr. is up 11 bps.
DXY remains in its recent range at 105 & change not validating a new and higher $/rate range. The Euro for example has fallen for 9 weeks in a row – its longest losing streak since inception! USD weakness would support Commodities, EM equity and risk assets in general.
Higher for longer doesn’t have to mean rates much higher than they are currently – note the 10 yr. real rate of 2% is the highest since the GFC. It just means as we go back to the top that rate cuts will be fewer than envisioned a week ago (market was pricing in YE 2024 FFR at 4.4%, now its 5.1%).
So, taking it all in, we remain constructive on risk assets, OW equity with focus on EM especially China, deeply UW FI, with a focus on US & EM credit as EM leads the new rate cutting cycle and OW Commodities including energy, industrial and precious metals. JPM notes Europe’s recent sell off has left it trading at a record 28% sector neutral discount to the US (cheapest in 23 years) while its banks (EUFN) sell at more than double the normal forward PE discount to US banks.
If the above is of interest and you want to learn more join us next Wed the 27th at 2:30 EST as friends of TPW Advisory, Winston Capital, host us for an hour long discussion. Register here: : https://shorturl.at/nzAHS
Enjoy the last day of summer and GO Duke as the Blue Devils seek to go 4-0 vs UConn in the run up to next Saturday’s prime time match up with Notre Dame for which I shall be in attendance!