March - In Like A Lion, Out Like A Lamb?

1855 words – a 5 minute read.

First off, Happy St Patrick’s Day to all the Irish out there – given Mom’s maiden name is Boyle you know I am celebrating! And hey we survived this week so that’s another reason to raise a glass.

Recent market action is just like the weather outside, which brings to mind the old proverb in the title. Research indicates the origin of the proverb goes back to astronomy and how Leo, the Lion constellation, rises in the East early this month while Aries, the Lamb constellation, sets in the West towards the end of the month. It was adapted for agricultural purposes to describe March’s transitional weather back in the 1700s with the first noted reference in 1732, almost 300 years ago.

I like old sayings or cliches because they have stood the test of time – much as we all hope our portfolios and investments are able to stand the test of time – even testing times like these.

I had the chance to opine in real time yesterday morning on Bloomberg’s The Open show https://www.bloomberg.com/news/videos/2023-03-16/-bloomberg-the-open-full-show-03-16-2023?sref=ftskAWJe (I come on at about the 8 minute mark). I always enjoy these hits because it forces one to think deeply about what one’s view is so that you can present it succinctly, in tv time. So, my process over the years basically entails writing my thoughts down before the show. To be forced to do so in such volatile times is very valuable.

The way I learned it at MS is to be ready to go with my POV & to know what I want to say even if the questions don’t take me there directly. Today, it is reusable for our Musings. So, what follows is the essence of my BTV notes updated to reflect the last 24 hours. The focus was on CS and the ECB rate decision.

CS has been the sick man of EU banking for years & thus its weakness is not a sign of systemic risk. Its now a $2 stock that is V oversold (ST RSI 17) with its bonds trading at distressed levels and its CDS at levels 3x that seen in 08 which gives one a very good sense of how far this bank has fallen. EU bank risk managers are well aware of this history suggesting little contagion risk.

EU banks are very well capitalized post the 2011-12 EU bank crisis and the need to prep for fallout from the Russian invasion of Ukraine suggests plenty of cash on hand. The same holds true for US banks which enjoy record cash reserves = to 200% of total nonperforming loans according to the FDIC with non current loans under $100B vs $400B in 08-9. Furthermore, LPL notes that cash = 14% of total bank assets vs 3% at start of GFC. In a panic none of this matters but putting things in context is key to understanding risk & reward.

It is worth noting that EUFN, the EU bank ETF, despite giving back all its YTD gains is still OPing XLF meaningfully and remains well north of its 200 dmav. It too is oversold with a ST RSI of 26. CS has less than a 1% weight in EUFN; in contrast its #1 weighted stock is HSBC (8%) which, according to FactSet, has a 12 month forward prospective dividend yield of close to 9%. We have not sold any EUFN from our TPW Advisory Global Multi Asset (GMA) model portfolio recently nor do we intend to. 

The news that the SNB will provide CS up to CHF 50 B which is = to 6% of Swiss GDP should throw a blanket over its problems much as the Fed’s Bank Term Funding Program (BTFP) is expected to provide up to a $2T liquidity blanket for the US banking system according to JPM. Note the SNB timing – news of its willingness to support CS came out at 3:30 EST on Wednesday to spook the shorts which worked wonders. Wednesday was the Ides of March – cycle lows?

We think the Fed and ECB can walk & chew gum at the same time. Thus, we expected the ECB to raise 50 bps (as it did) and the Fed to raise 25 bps next week to fight inflation while the massive liquidity provisions should limit the contagion fears rattling markets on both sides of the Atlantic.

Our key insight here is that the past week has laid to rest the idea that the Fed can raise rates until inflation falls to 2%. This course of action is off the table as the ZIRP winners need more time to recast themselves in this new high nominal growth rate environment. As such we believe the battle for a new inflation target, one brewing for months in academic and policy cycles, is over, and the higher target folks, say 3% in the US, have won the battle. This is crucial for investors to understand. We are in a new, global, high nominal growth world and are not going back to the low inflation, low rate world of the 2010-2020 period.

Where could panic go next? CRE fears are growing but its much slower moving. Credit is another area to watch closely. Midweek saw the first signs of pricing in recession risk when looking at Comm, especially energy & to a lesser extent copper. If our key insight noted above is correct, then Commodity weakness should be bought & FI strength sold.

European equity continues to look the best of the major regions with EZU well north of its 200dmav vs the SPY which is fighting to hold above its 200D support level (3930) as we go to print. EZU remains up roughly 4% YTD vs SPY up 2-3%. Lost in all the hoopla around the ECB rate decision are its updated forecasts which included a higher 2023 GDP forecast to around 1% and a lower inflation forecast down to slightly north of 5% with inflation forecast close to 3% by YE 2024.

After raising rates 25 bps next week, we expect the Fed to go on hold as inflation continues to decline. We agree on the 5% terminal rate but do not expect the rate cuts the market is now pricing in given our long held Middle Path, no recession view. February’s inflation print (remember that) shows inflation continuing to moderate; Moody’s Mark Zandi forecasts inflation close to 3% by YE & expects a patient Fed to allow inflation to moderate while averting an economic downturn. Bespoke forecasts US inflation at 4% by June and notes that will be well below FFR.

When banks are failing and the sky seems to be falling in with bond market volatility back to 2008 levels its important to bound the risks. GS helped out by forecasting a .3% hit to 1.2% for Q4 GDP as a result of reduced lending by the smaller banks that have large amounts of uninsured deposits. MS chipped in by raising its Q1 GDP forecast to roughly 2% on the back of this week’s retail sales data.

That’s good news for risk assets including US equity which has held in extremely well given the huge onslaught of bad news - it remains well above the 3745 SPY level most technical analysts point to as an important support level. Bears have to be wondering what is needed to crack this equity market. Falling rates help drive an internal rotation to Growth and Tech which are performing much better than the broad market. The Qs are up over 15% YTD! The sustainability of tech OP is a major question underlying recent equity action.

The equity selling pressure seems to be approaching exhaustion. Going into this week AAII investor sentiment was already at record bearish levels while Lipper reported 9 straight weeks of equity outflows - the longest run in 7 years.  Fin Twit reports 5 day eq put/call ratio broke above 0.8 earlier this week; this has occurred 18x in past 10 yrs. and 3 months later SPY +6% in 17/18; 6 months later, SPY + 10% w 13/15 up. In addition, Citi’s US Earnings Revision Index has turned up, calling the earnings driven equity collapse bear narrative into further question.

We continue to see USD weakness as key and note that ROW is holding in better bc it does not have the VC, Crypto, bank nexus seen here in the US. The sharp fall in US rates has led to USD weakness back to the 103-104 level (DXY). As the US stabilizes as we expect the ROW can continue to move ahead. Beyond the stock & bond markets, the St Louis Fed Financial stress index remains very well behaved, lower US rates help housing (XHB remains in VG shape) while Bloomberg’s Financial Conditions index has tightened, doing the Fed’s job for it. Credit while widening somewhat has held in very well given the media onslaught.

The risk asset upside that stems from the Fed being done with rate hikes far exceeds the risk that we are approaching any kind of systemic bank crisis on either side of the Atlantic. Translation: Fed finished = USD finished = ROW OP. The past week has demonstrated beyond any doubt that for the Fed to try and bring inflation straight down to 2% would be an economic disaster.

Unless one has either a death wish or a supercomputer sitting on ones hands makes the most sense here given how wildly things are swinging around. We are big believers in how fast things have sped up - but the past week, especially in bank stocks and USTs (MOVE at 173 – highest since GFC) has been truly exceptional. We wrote Narrative Speed six weeks ago & described the avalanche effect; the SVB collapse reflects exactly that.

As part of our monthly model updating process we added to areas of strength late last week and remain happy to hold them in the robotics, Fintech & semiconductor spaces as well as adding to Mexico as the world’s best nearshoring play. All but Mexico are up from when we bought them. LT investors can look to the commodity space.

Our big picture view remains that much as we have moved through the Covid period, we are moving through the inflation period. As we do so investors will start to focus forward (as we are) and note the desynchronized nature of the global economy with China’s economic expansion picking up steam. As the Fed goes on hold we expect a rate cutting cycle to begin, led by EM central banks. This rate cutting cycle, coupled with a China led Asian economic expansion and a global cap ex boom unfolding as Industrial Policy returns to the US and expands in Europe sets the stage for a new, high nominal growth cycle for the global economy in the years ahead. We continue to expect a flattish SPY this year & 10-20% USD upside in non US DM and select EM equity.

Happy St. Patrick’s – please drink responsibly!