Lines In The Sand

1571 words – a 4 minute read.

Lines in the sand feels about right – a line one won’t cross, or as the Grateful Dead sang in their classic tune “Fire on the Mountain”, a point beyond which one really won’t go. The origin story traces back nearly 200 years to the fight at the Alamo so it’s fitting that the Horns are 20 point dogs to Bama in tomorrow’s big game, the biggest display of lack of faith since the 70s according to my UT buddy.

It strikes me that there are all sorts of lines in the sand these days – interest rate lines (how bout the end of ZIRP in Europe – worth celebrating no?), commodity spike lines (Dutch Nat gas down 40% from its high – who knew the Russian shut in of NS1 would be bullish?), policy lines (EU to cap energy prices and support consumers, China’s $30B bailout package draws a line under its property sector woes).

There are also lines in wartime. Note the Ukraine advance and its potential to cut off Russia’s resupply lines. Keep the name Kupyansk in mind – it is a key transport/resupply/logistics hub for Russian forces. The conflict has stretched on longer than we anticipated but the battle lines are shifting in Ukraine’s favor, drawing more Western support.

There are lines in the sand throughout the cross asset markets as well. We have long written about the utility of technical analysis in the current ahistorical period; is it a surprise that the S&P bounced right off the 61.8% Fibonacci retracement line? What about those inflation breakeven lines – US 5 year at 2.45%, down from 3.6% last March and right in line with the 10 yr. average of roughly 2% - speaks well to that Fed credibility concern one reads so much about.

We remain focused on our 3 key TPW questions for the 2ndH: the pace of US inflation decline, the path of Europe’s energy prices and the smoothness of China’s exit from Covid and growth recovery. We see progress on all fronts and anticipate it to continue. As noted, Dutch Nat gas prices are down dramatically since we noted the prospect for a “massive crash” and there is plenty of room for them to fall further. Europe is coming together to support its energy markets and its consumers in an integrated fashion reinforcing the value of the EU in the Tri Polar World and throwing a spotlight on the UK travails as it goes it alone courtesy of Brexit.

The ECB followed the Fed’s playbook and raised 75 bps, its biggest rate hike in 20 years and signaled more to come. European financial assets responded well with the Euro stabilizing and stocks rising with even bank stocks catching a bid. For years the worry was negative rates and how could banks make money – now rates are positive again and heading higher, supporting the Euro, banks & capping inflation.

 Just as Jackson Hole’s real message wasn’t more pain but rather the end of the low growth environment and the coming acceptance of a high nominal growth world the main message from the ECB isn’t that more rate hikes are coming but rather that growth will be ok, forecasting over 3% growth this year and roughly 1% next. Given that virtually the entire investment universe is convinced Europe is already in recession this is quite the divide. Note the consensus calls for 1.6% GDP growth this year.

China has drawn a line under its property sector as the PBOC cuts rates and the Govt steps up to ensure housing gets built. We have noted the disconnect between headlines and market action with China HY bonds rallying in the face of all the negativity. Note August Services PMI came in BTE @ 55 while August car sales rose 28% y/y, led by EV sales up over 100% y/y. We expect further policy measures to come post Pres. Xi crossing the political line and receiving an unprecedented  3rd term.

The recession belief exists in the US as well – this conviction that we are already in recession or if not we soon will be. We remain of the “Middle Path” view expecting inflation to decline faster than most while growth stabilizes as inflation comes down, real incomes go up and consumption remains robust. JPM’s call for US inflation to average 3% in the 2ndH of the year seems right to us as does its call for global inflation to fall to 5% from 10% in 1st H.

As gasoline prices plummet day after day after day – now 85 days to be exact and food prices follow while used car prices shrink and supply chains unsnarl next week’s US inflation reading should be supportive of the inflation rolling over view, allowing the Fed to raise 75 bps one more time & capping the front loading exercise.

Importantly we believe that will also be it for the USD just as headline after headline references King Dollar and the wrecking ball. Rate differentials are shrinking, technicals are stretched, JPM notes extreme bullish momentum, fundamentals are lousy as the US current account blows past 5% of GDP, valuations are wild – OECD sees the Euro as 40% undervalued on its PPP basis. The Yen at 144 is going to foster big profits for Japan Inc which has built a 117 rate into its 3/23 FYE calculations.

So what to do with all these lines? Well, create more right? That’s we did this week as we held our model portfolio review where among other things, we look at the technicals for every position. This exercise led to today’s title because there was such a distinction between the negative headlines and what BofA calls “appalling market sentiment” and what we saw in our two model portfolios – our Global Multi Asset (GMA) and our TPW 20 thematic model.

Notwithstanding all the horrible stories about inflation, recession, EM risk etc. etc. what showed up in our review was how the best performing ETFs were from the Commodity and EM spaces. Now if things were as bad as one reads it is unlikely that these two groups would be leaders but of the GMA’s top 5 performers over the latest period (roughly the past month) three were Commodity and two were EM related including our URNM Climate position and KHYB our Asian HY position. Extending it out further, eight of the top 10 positions were either Commodity or EM related.

Did you see Dr. Copper up over 5% this week as storage inventories fall to 8 month lows – probably nothing. How about Brazil’s inflation peaking back in April at over 12% coming down to roughly 9% in August with the SELIC rate close to 14%; EM CB’s are close to the end of their rate hiking cycle having started well ahead of the Fed.

That’s reality – not opinion, fact not fiction. We often say we like to let Mr. Market tell us – this is exactly what we mean. So given the line between portfolio reality and the drumbeat of negativity – I mean just this week there must be 3 or 4 well respected sell side folks talking about 20% declines this month or by the end of October – what should one do?  

Well, we have decided to lean in (remember that phrase) and add to areas showing relative strength like EM which we added to last month and Climate/energy which we just added to this week. Our thought is that if things go our way then these areas will be where others come in first and if things don’t go our way then the relative strength should be a support.

We did the same in our TPW 20 model where Climate now represents the single biggest segment at a full 40% of the model. JPM had some VG work out this week making the case for US energy stocks noting “across all sectors Energy is seeing by far the largest improvement in its ranking across all key styles / factors simultaneously. This makes it the most favorable sector based on various Quant models”.

September is the worst month for US equity on a seasonal basis and then the calendar turns more positive for risk taking… lets see how it plays out. This market moves fast – maybe we have had the September pullback in August. Last week there was a huge amount of institutional put buying – $8B worth, 3x that bought in the depths of the GFC according to All Star Charts - suggesting great fear and perhaps great opportunity.

We expect the August inflation print to come in soft and the Fed to hike 75 bps which will mark  the end of the front loading which should lead to USD weakness.  In turn, this should start investors thinking about EM, growth and about the global cap ex boom that is unfolding as Govts and corporates seek to deal with Covid, Climate and Conflict.

I made several of these points on Bloomberg   earlier this week, including the strategic case for Europe – 28 straight weeks of fund outflows, trading at 11.5x forward PE vs 17x for the US, more E upgrades than downgrades, rock bottom FX etc. etc. I am on from the top to about minute 25 or so. Enjoy.

One line in the sand that should never be forgotten, 9/11… the 21st anniversary of that day falls on Sunday… never forget.