Fever Break

1,990 words – a 6 minute read.

After last week’s monthly where we wrote about the Turbocharging of the Tri Polar World, let’s dive back in to the day to day market stuff.

Not much has changed – yields are up, the USD is stronger with DXY breaking north of 100 as the Killer Bs – Brainard and Bullard - fire a twin salvo implying more hikes, higher rates and faster QT. At this point Bullard is a known factor but its impressive how he keeps ratcheting it up, now calling for 300 bp of hikes. Perhaps that explains why stocks sold off initially on his comments but ended the day up… in the price? 

Brainard, long considered a dove in Fed parlance, was a bit more of a surprise; her aggressive take on QT led some to say hmmm, sharply rising rates (fastest hike cycle since 1994) AND faster QT – that may be a cocktail too potent for stocks, especially Cyclical sectors. No real surprise then that Cyclicals have been weak with financials down sharply as BofA’s FMS shows financial fund outflows for the past 7 weeks in a row.

Guided by these policy makers, markets keep ratcheting up how many times the Fed will hike & how fast it will move to implement QT. After stabilizing at 6, 7 rate hikes in 2022 a month or so ago, the Russian invasion of Ukraine and subsequent food and energy price action have led to markets now pricing in roughly 11 hikes this year, suggesting several 50 bp hikes given there are only 6 more meetings in 2022. 

Thus, my earlier view of 2,3 rate hikes in 2022 is likely to be off given the invasion effects on food and energy prices though 11 also seems highly unlikely. I do note the Bloomberg consensus for YE US inflation is 6.2% and I will take the under big time. Recession calls for 2023 are starting to proliferate; Bloomberg notes that 48% of its respondents are now calling for a US recession in 2023. I will also take the under here. 

In fact, I think we are likely coming up to a fever break on this whole price spike, rate forecast spike, equity & bond vol spike process. Here’s why.

Over the next few months, we are likely to have some sort of ceasefire in Ukraine, perhaps as early as a month from now (May 9th, Russia’s WW2 Victory Day, is a crowd favorite). Time is not Putin’s friend – the latest example is Lukoil noting the rising risk of production shut ins as it has very little remaining storage. Once wells are shut in the cost, time and expertise needed to reopen is significant especially when every major oil field services company has ceased new work in Russia. 

Here is the well respected energy group Vortexa’s read: “As the first full month in the post-Ukraine-invasion era draws to an end, we highlight how much Russia struggles to place oil barrels, with clear cutbacks already visible in product exports. Things are unlikely to improve any time soon, and refinery run cuts are a reality while crude production shut-ins are imminent, if not already happening as well.”

Peak US inflation is also imminent as the base effects kick in. Next week’s March reading is likely to mark the peak. The Atlanta Fed sticky vs flexible inflation reading is worth a look in this regard. Its sticky inflation reading is up roughly 4.5% y/y which is high but not off the charts; its flexible inflation reading is over 18% y/y and it IS off the charts. Is it too far fetched to think the flexible components can come down as fast as they went up? 

Note that the Manheim used car price indicator has rolled over with March’s 3%+ decline the largest since Covid in Spring 2020. Its now flat to down over the past 3 months with its y/y rate of increase halving from Dec to March. There is also the most aggressive US fiscal contraction in recent memory ongoing with Bloomberg consensus forecasting a record drop from over 10% deficit last year to a 5% deficit in 2022.

The 2yr/FFR spread is well above 200 bps; during the rapid 1994 tightening cycle that was as steep as the spread got – we are already there before the Fed has raised rates 2x!  Much of the inflation – Fed reaction would seem to be priced into the rate structure – rather than investing according to the latest turn of the screw it might well be worth thinking about going the other way and preparing for a Fed response that is not as aggressive as is being priced in. 

Should this inflation, Fed response, rate reaction, fever break one could imagine some pretty rapid repricing of various parts of the commodity space, stocks and rate markets as a result.

Two years of constant pressures on supply chains and energy prices stemming from repeated Covid outbreaks as well as the Russian invasion has led to a sense that inflation can only go one way and the Fed will have to tighten to break things. Jet fuel prices for example are up over 130%, capping the upside for the JETS reopening trade even as EU departures hit a post Covid high. Such advances are of course unsustainable and tricky as we have seen with EU Nat gas prices of late (EU nat gas prices down 6 days in row, longest streak of year, off 9%).  Nonetheless, well respected former Fed folks are saying the Fed needs and wants investors to lose money and thus plans to force stock prices down. That seems feverish to me.

In contrast, Pantheon, a well regarded economics group, expects the sharp slowdown in housing activity coupled with “hefty” back to back declines in core inflation readings this month and next to cool off the fever, arguing that: “The private sector is under no aggregate financial pressure; solid growth is a better bet than recession. Spending is stronger than the confidence numbers suggest, because households are cash-rich. The rundown of savings accumulated during the pandemic has barely begun; it has a long, long way to go.”

This is not to say that Pantheon has the answer but simply to note that there are other sides to the argument. There is very little sympathy for example for our POV that the ebbing of Covid will have a major, beneficial impact on global economic activity – perhaps more than Russia’s invasion, especially over time. US service sector activity is starting to give a hint of this; Covid’s ebb can be both growth supporting as well as inflation reducing thru better supply chain and labor conditions as the latest jobs report suggested.

It's worth contemplating what is priced into markets. For instance, Chinese equity is up since Shanghai went into lockdown – that’s a little surprising right? Policy response potential is likely supporting Chinese asset prices. Likewise, WTI oil prices are back below where they were on Feb 24th when Russia invaded Ukraine – that seems a bit odd as well doesn’t it? EU equity is above the invasion date levels and up 4 of the past 5 weeks. UST are in their worst bear market in almost 50 + years – suggesting a fair bit is priced into bonds. 

Why have stocks have held up as well as they have? One reason might be that analysts have increased their US EPS estimates for every quarter over the past month – notwithstanding Russia, energy – food spikes, Fed tightening etc. etc. Earnings season is coming up next – the single digit EPS estimates for US and EU seem quite easy to beat. The well respected Ed Yardeni just increased his 2022 S&P EPS estimate 6% to $240 from $225. We have noted many times that high nominal growth (we expect US and EU to have nominal growth of 6-8%) drives sales growth and earnings.

JPM points out that their analysis of positive global economic surprises and the level of ACWI suggests that ACWI is too low given the broad number of positive economic surprise. It further highlights that the bottoms up estimate for S&P Q1 EPS is 4% BELOW Q4 EPS which it notes is a very rare thing, having occurred only 6x in the past 34 years. MS recently highlighted that it expects Q1 US GDP to come in at roughly 2.8% suggesting that a decline in Q1 EPS Q/Q, as consensus suggests, is likely to be quite off the mark.

Kevin Muir, of Macro Tourist fame, has an interesting piece out arguing as we do, that perhaps markets have gone to fare in pricing in an inflation and rate scenario that is becoming less, not more, likely to occur. I like this quote in particular: “Jerome Powell’s Federal Reserve is way more hawkish in Wall Street’s mind than in reality.” He notes that oil is down from over $130 to under $100 and expects a sharp reversal of the recent OP of defensives over Cyclicals coupled with a weaker USD and non US outperformance… from your lips Kevin. 

He also points out the dichotomy of a market that believes the Fed will be the most aggressive in 30 years while also being very pessimistic about the economy. Is there a chance for the Fed to thread the needle? Kevin thinks so & so do we.

It’s just like a fever to have temps spike and then the fever breaks and one awakens as if from a dream. This is not a dream (it may be a simulation but that for another Musings) but I do think its well worth thinking through the potential for this price spike, rate hike fever to break and how it would impact the multi asset world. 

Much depends on how much has already been priced in – it seems clear from this vantage point that quite a lot has indeed been priced in. Real yields have rallied back towards positive while inflation break evens have come in - suggesting inflation expectations may be ebbing. An interesting Fed meeting minutes indicator done by the US FI group suggests we have reached Maximum Hawkishness – something I have been looking for over the past several months. 

So to put it all together – a ceasefire is likely in the months ahead, as is inflation’s peak, while we have reached Max Hawk even as markets have priced in an ever more aggressive Fed rate hiking path. More proactive China policy support is imminent while earnings estimates are likely too low for a high nominal growth rate world.

We recently updated our two Model portfolios: our Global Multi Asset (GMA) model and our TPW 20, 100% thematic Model. We made few changes in either given that the GMA rode thru the Q1 “Golden Age of Asset Allocation” volatility relatively well while the hi beta TPW 20 struggled a bit as is to be expected. We remain constructive towards the thematic – disruptive tech space.

We remain long equity, prefer non US including Europe, China and Brazil, deeply underweight bonds (though if we were traders we would be thinking about getting long) and remaining OW commodities. We added to our commodity producer position slightly as we see the slimmed down and profit focused nature of these companies likely to assure continued rivers of cash at anywhere near current primary product prices. 

Let’s end on a high note: TD Ameritrade’s Investor Movement Indicator, a retail investor sentiment indicator, has been down 4 months in a row thru March – this has occurred only 4 x in the past decade and the following 3M and 6M were both sharply positive, up 7% and 11% respectively.

We wrote last week how Tesla has become a Tri Polar World company – check out this drone video to see what we mean.

For those interested in our TPW thesis please check out this hour long, deep dive video with the good folks at OHM Research.

Please note no Musings next week due to travel.