Firebreak

1706 words - a 5 minute read.

The plate throwing, table tossing, cross asset market action continues to pingpong across the Atlantic as US /EU bank fears continue to burn like wildfires, leading to sharp falls in rates that coupled with weakness in energy prices signal markets are prepping for recession.

The fear used to be that the Fed would overtighten and force the US economy into recession in order to get inflation down to its 2% target. As we wrote in last week’s Musings  we think that battle has been fought and won by the forces arguing for a higher target, though we note BofA’s FMS suggests that 65% of those polled disagree with us – only 65%?

That brings us to today’s title: Firebreak, which is defined as a strip of land where the combustible fuel has been removed to either contain an ongoing fire or control a prescribed burn. Thanks to brother Kev who shared some pics of a controlled burn he led back in the home state, thus sparking the idea (no pun intended). Over the past few weeks it’s become clear that the ZIRP and WFH winners, namely the tech sector and its finance arms (SVB etc.) can’t handle higher rates.

This got us thinking about how the Fed has been on a mission to slow inflation as fears grew that it would tighten until unemployment rose & the economy tumbled into recession. Notwithstanding tech, which over hired massively during the Covid years & has been laying folks off by the thousands, it strikes us that SVB’s early demise could act as a firebreak to those fears, stopping the Fed from raising rates more and thus protecting the US economy from further tightening.

The bulk of the US economy remains in decent shape (consumption, services, housing, manufacturing) as we have argued since last summer when we began writing about our Middle Path between high inflation and deep recession. We remain on that path and we believe the US, European and global economy do as well.

The immediate, day to day, action seems chaotic with smoke swirling and heat rising as screens turn red then green then red again day after day. Yet, equities continue to hold in for the most part with the SPY still up for the year, fighting to hold its 200DS level & well above the key support from the December lows (3783), XLF fighting to hold its key support level from the March 2020 highs ($30-31) & EUFN (European banks) holding well above its 200DS level ($16.8). Within equity it will be important to see financials stabilize in order for broad markets to do the same.

The big action has been in rates which are tumbling one day to the next with the US 2 yr. rallying 120 bps in the past month to 3.6% down from 5% at the start of the month. The 10 yr. UST is at 3.3%, leaving the 2/10 inverted yield curve is at its most narrow in some time – now just 30 bps or so vs well north of 100 just a few weeks ago.

The MOVE index, which measure UST volatility, recently reached levels last seen in 2008 at 200; at 150 today, it needs to stabilize (100-120) so equity can follow. Credit has been well behaved outside of the financial sector suggesting the broad economy and ability to access capital both remain intact. The equity volatility index, the VIX, has been much more contained, sitting in the mid 20s, as the explosion of zero day options and $5T in MMFs (new high) cool demand for protection. We are watching both closely to assess the path to near term stability.

Commodities have been along for the ride, taking their cue from bonds & selling off, especially in the energy space with WTI oil down sharply though holding above the important $65 level. Energy and Material sectors have fewer stocks above their 50dmav than even financials!

Notwithstanding renewed bank fears in Europe we don’t believe the issues on either side of the Atlantic are systemic and should not automatically lead to recession unless they get much worse or are sustained for many months. While folks freak about tighter lending standards, net liquidity is surging. Much as lower rates lead to Tech OP in the equity space they also lead to better mortgage demand in the real economy space, thus serving as dual stabilizer.

Away from all the financial market drama, the other segments of the US economy seem to be doing better. Housing, for example, has clearly bottomed with both new and existing home sales climbing for several months in a row as low inventories and falling rates lead to declining mortgage rates and an almost immediate pickup in applications.

We have heard tons about how digital bank runs are a menace but the opposite is also true – one can now lock in a low mortgage rate when rates fall almost as quickly. To wit, Redfin’s mortgage lending company locked a rate on more loans on March 10th than it did any other day YTD. Here’s a March 17th quote from the Mortgage Bankers Assoc (MBA): "Both purchase and refinance applications increased for the third week in a row as borrowers took the opportunity to act” as rates plummeted.

Supply chains have fully unsnarled with retail facing companies from Nike to Lululemon noting that inventories are finally under control. Here’s the WSJ: “The Federal Reserve Bank of New York’s Global Supply Chain Pressure Index for February was -.26, down from 0.94 in January to bring the measure below the historical average for the first time since August 2018”.

Reshoring and nearshoring activity levels continue to rise driven in a large part by the need to lock in climate related opportunities. Here’s a quote you might have missed – from a leading Volkswagen officer: “There’s never been a better time to build a factory in America”. Given our TPW 20 thematic model and belief that Climate is the single biggest global macro theme of the decade we believe this is a game changer.

In the Americas, our Tri Polar World’s third main region alongside Asia and Europe, climate related investment activity is truly becoming regional in scope. From new battery investment in Canada to the new US Battery Belt replacing the old Rust Belt & on down to Mexico where EV production facilities are being put in place to benefit from the IRA’s build in N America provisions its happening. Economic activity in Mexico has started the year off strongly, up 4.4% y/y in January vs 3% forecast. Industrial Policy has returned to the US, something investors have yet to fully appreciate given all their fire fighting duties.

Europe is doing much the same to ensure its capacity to be a Climate player while sustaining its shift away from dependence on Russian energy. Industrial Policy is not the bad word in Europe that it has been in the US but Europe too is spending heavily across both public and private sectors to ensure it is in the game. Germany just raised its GDP growth forecast for this year and next, now expecting to avoid recession.

Asia, as noted, lies in a different position, with no real inflation fears (subdued in China, welcomed in Japan), quite limited rate volatility and decent stock market performance. China’s PBOC just cut it’s bank reserve requirement ratio - quite the juxtaposition from Fed & ECB rate hikes. Meanwhile, GS just raised its 2023 China GDP target to 6% while MS argues that China/HK stocks have only been cheaper 3x in the past 20 years – 1999, 2008 and last October.

We continue to expect Asia to lead a desynchronized global economy into a new growth cycle, supported by EM central bank rate cuts as the Fed goes on an extended hold and underpinned by the global cap ex boom to meet the needs raised by Covid, Climate & Conflict.

We do expect the Fed to go on hold post this week’s 25 bp hike & expect inflation to decline markedly in the next few months (Bespoke sees Y/Y inflation in the 2s by June) given easy Y/Y comps while falling shelter prices should sustain declining inflation in the 2H of the year.  We believe March’s inflation # could signal a change in investor attitude to risk & note “well anchored” inflation expectations & a 2% 10 yr. inflation breakeven – the lowest in over two years!

We do not expect to see the rate cuts priced in the futures markets given our view that the US is unlikely to enter a recession as concerns over credit scarcity & their equivalence to rate hikes are overblown. We expect bank credit to continue to track NGDP as it has since 2016 according to Bloomberg’s Conor Sen. We’ll give the last word to Dr. Ed Yardeni: "During 1st week March, loans & leases at the banks totaled $12.1trn, consisting of $6.5trn at large domestic banks, $4.5trn at small domestic banks. All at record highs. There is no credit crunch."

We expect continued USD weakness which should provide support to non US equity and the Commodity complex. StoneX tells us, for example, that spec traders net long position on oil futures contracts is now at 5 year lows. We continue to watch key technical levels to assess short term vol from long term trend change.

While it is tough to remain medium term constructive amidst the day to day market swings it strikes us that it must also be tough for those dyed in the wool bears who must be wondering what is going to crack the equity markets. With BofA reporting investor sentiment is approaching levels seen at the lows of the past 20 years, we think we would be more worried if we were bearish given how well equities have held in as the Fed goes on hold, China’s growth recovery accelerates and housing and the US consumer remain in good shape.

Here’s a quote to consider: “Protected by my dignity, I search for reality”. Any guesses as to the author?

No Musings next week as I will be on the road. TGIF!