Sawtooth

1160 words – a 4 minute read.

Sawtooth: shaped like the teeth of a saw; a sawtooth wave ramps upward and then sharply drops. That seems like a pretty apt description of current cross asset market action - from stocks to bonds, fx to commodities.  

Sawtooth was the word I hit upon when thinking at breakfast about what to write today. Obviously the big focus is the US CPI print which came in slightly above consensus as goods inflation hands off to service inflation. Importantly, Pantheon Macro reports that at 6%y/y, core inflation hit a four month low - sawtooth. For all the talk about it being highest inflation print in 40 years, when I looked at a chart of inflation stretching back to that time point what stood out was how quickly inflation rolled over once it peaked, falling all the way back to 2.5%.

A sawtooth market is a frustrating market and that is clearly the case today. Waiting for inflation to peak and roll over have proven to be like waiting for Godot. This month it was food, fuel and rent – no real surprises though the double digit jump in airfares for the 2nd month in a row, 3 month annualized at 376%, really struck me for two reason. One, the price of jet fuel has fallen 40% + since its early April peak and two, the performance of the JETS ETF has been less than stellar, roughly flat since early March.

There remains a rationale for expecting inflation to soften – partly driven by the likelihood that huge price increases like airline fares are not sustainable, coupled with supply chain easing, the softening of the labor market, the peak in AHE & the sharp drop in housing. As an inflation bull, it has been a frustrating and painful wait.

And yet for all the focus on inflation, Univ. of Michigan consumer price expectations have been relatively stable since March, at roughly 5% for the coming yr. and hovering around 3% over a 5/10 year outlook period since January. Consumer confidence just hit record lows yet consumer spending remains robust – watch what they do, not what they say. Importantly, inflation expectations have yet to become unmoored, though one has to acknowledge the risk of such occurring if inflation does not soften in the coming months.

Inflation is also an issue in Europe, where the ECB has made plain it plans to join the rate hiking parade in coming months. Much like the Fed it will be following the market – 2 yr. German bond yields have risen160bps since March, to the highest levels in over a decade. One area stands out as not having much inflation – China. It reported May inflation at roughly 2%, flat on the year and down M/M with producer prices halving from its recent peak. Obviously the Zero Covid policy inspired lockdowns could well have something to do with this lack of pricing pressure.

Yet, it also suggests more policy room to maneuver; to date, China’s policy response has been muted something we have expressed our frustration with in prior Musings. While policy remains small bore it is worth noting that May’s aggregate financing data showed a significant increase, up three fold from April’s number and 30% ahead of estimates. Chinese equity has been strong of late, led by tech (KWEB) up roughly 60% off its March low – widely OPing the Qs which is up less than 5%.

As we have commented many times, (monthly link) there are pockets of relative strength developing in the cross asset markets. One such area includes the non US equity space. To wit, amidst yesterday’s sharp selloff, StoneX reported that among equity ETFs with inflows 7 of the 9 were either global (ACWI) or non US, split between EAFE and EM. We remain OW non US equity in our Global Multi Asset (GMA) model portfolio.

We have also been adding to our US credit position over the past few months and here too we noted an interesting point, namely that much as the IPO market has closed with proceeds down 90% y/y, US HY issuance is also down roughly the same with BofA noting that a 6 week moving av peaked in April 21 at $13B of issuance and has collapsed all the way down to the current number at $1.7B. We remain UW bonds and prefer Credit to Sovereign.

We remain focused on the thematic space as well via the TPW 20, our 100% thematic model portfolio. Climate related ETFs continue to be the relative outperformers here while we watch to see if ARKK and other representative instruments can continue the bottoming process. Emblematic of the space, CATL, China & the world’s largest EV battery maker, has seen its PE decline back to 2019 levels.

JPM reports that the YOLO investors are done - noting that call option flow is back to Dec 2019 levels, suggesting we are closer to the end of selling rather than the beginning. It makes sense to us that the innovation space – first into the bear market back in the Winter 0f 2021 - would be among the first to bottom. ARKK, the poster child for the space, has also OPed the Qs of late, up roughly 15-20% off its recent low.

I noted an interesting comment from BofA regarding how the market panic won’t abate until the policy makers panic. I am not sure I agree, having thought that the market panic was at odds with a policy process that seems pretty well thought out and which market participants outside the daily sawtooth action seem to agree with, referring here to the relatively stable inflation expectations and breakevens.

We continue to see a “middle path” between ever higher inflation and recession as the most likely way forward. Our view remains that US or European recession is unlikely over the next 12 months absent a Fed panic; currently not a single US state is in recessionary conditions even though recent polling shows a majority of Americans believe the US is already in recession. Recent US polling shows near record gaps between individual situation satisfaction (very good) and how people see the national situation (very bad). Not sure what that means but it’s worth musing over.

The Fed appears on autopilot to raise rates 50 bps each in the June and July meetings. Absent recession, US 2022 EPS estimates should remain relatively stable, having risen by 3% since January. Notwithstanding all the recession angst, LPL reports that the percentage of downward US EPS revisions has fallen over the past three months. Avoid recession, maintain earnings, continue the “sawtooth” bottoming process & avert another down leg in risk assets.

The Fall is likely to be the period when the Fed looks to reassess, should inflation decline and the labor and housing markets soften.

As we enter the Summer of 2022, the Fall seems a long way off.