Temperature Check

1450 words – a 4 minute read.

The temperature has been on my mind lately and I doubt I am alone. Returning from two weeks in the cool air of the Catskills to the 95 degree blast furnace that is NYC in August was quite an adjustment. When the temps fell to the mid 80s a few days later, it felt cold, like it was the mid 70s… my inner temperature gauge was all messed up.

It strikes me that investors’ temperature gauge is also all messed up. From the vicious June swoon to the sweet July bounce and on to the double barreled July jobs and inflation reports its been a wild ride of fear and panic, uncertainty and doubt.

Bloomberg stories about how the smartest guys in the room, the hedge fund community, have been turned around such that they massively underperformed in June and then failed to buy in July and underperformed again tells one it is indeed a challenge to get the temperature right. Long, short, hot, cold… I don’t know – you tell me.

Well, we at TPW Advisory believe in letting the market tell us and Mr. Market has been speaking loudly these past few weeks. We have noted how market bottoms are a process not a date & usually only known in hindsight. We are in the camp that says peak inflation = bottoms in stocks as markets discount future Fed action. Finally, we have also been big proponents of the “middle way” or “middle path” between towering inflation and crushing recession. 

The strong jobs & peak inflation reports suggest the middle way is starting to take shape and markets have taken notice. We have also argued that in a high nominal growth world earnings would serve as a bridge between current high inflation and its deceleration. Q2 EPS results show exactly that with both US and European earnings coming in BTE at + 9% and + 16% Y/Y according to JPM. Sales growth was even more robust at +15% and + 28% Y/Y; that’s the high nominal growth world in a nutshell.

Perhaps more importantly is the extension of this earnings bridge through YE which seems likely given the lack of sharp downward adjustments to 2H EPS in either region. This should support markets as we deal with the Tri Polar World’s 3 key questions for the 2nd H: how fast will US inflation roll over; what will the path of European energy prices look like and how smoothly will China learn to live with Covid? We see these as the three main questions for the rest of the year.

We are of the view that in a “Market Speed” world  the surprise could be that inflation rolls over faster than folks expect, as we see both housing and labor adjusting quickly thereby providing continued support for risk assets in the coming months. July’s M/M decline was one of the largest in the last 60 years & could set the stage. We have seen the extrapolations that suggest inflation will be at 5-6% at YE even with very low prints going forward – we wonder what stocks will be priced at and think higher. This is especially true given all the offsides money that will act as support on pullbacks. 

Longer term we believe the Fed might be willing to shift its inflation target from 2% to perhaps 3%, supported by well anchored inflation expectations, aggressive fiscal consolidation and cognizant of the economic damage required to get to 2%. Former IMF chief Economic Olivier Blanchard made this very argument over the past few weeks. We expect this to be a 2023 question.

The European energy picture looks somewhat similar to us – lots and lots of negative headlines with the market already having to price in complete Russian gas shutoffs. GaveKal put out a VG piece earlier this week making the case that even with current very low Russian gas supplies the likelihood that Europe will meet its gas storage targets in the coming months is pretty good. This in turn suggests that the risk of major economic shortfalls in Europe is overstated and a Euro at 1.03, equities at 12x forward EPS etc. might offer PG risk reward.

China is making gradual headway coming out of its lockdowns and while its modest policy adjustments have been a bit of a surprise we expect continued economic recovery to support not only China itself but the rest of Asia & Europe as well. The desynchronized nature of China recovering while the US and Europe slow is a good thing. While it is not stated as such, we believe China is learning to live with Covid – perhaps in a way quite different from the West but  doing so none the less.

There has also been a temperature swing in the US political and policy circles as Pres. Biden and his Admin get some impressive wins, including the Inflation Reduction Act which should pass the House and go to his desk later today. The $370B that will go to the Climate fight gives the US a good shot at meeting its carbon reduction targets and repositions the US as a Climate leader together with Europe, itself pushing hard thanks to the juxtaposition of Climate and Conflict. No doubt this has helped the Climate ETF space return to the investor radar.

As we look at our Global Risk Nexus (GRN) of Climate, Economics, Politics, Policy and Markets across the Tri Polar World it strikes us that perhaps we are exiting the ahistorical Covid, Climate, Conflict crisis driven policy making period & moving to a more normalized policy backdrop. If so, we wonder if the historical studies so many are fond of in the investment business but which have mainly proven faulty in this ahistorical time, might be ready for a comeback in coming quarters?

Another way to gauge the market temperature is to look at the technical picture. We believe that in the current ahistorical period technical analysis rises in importance in an investors’ tool kit and we devote a fair amount of time looking at the technicals of all our positions within our two model portfolios. While far from a technician, those who are note that the technical picture is improving, fast and considerably.

We noted the same earlier this week when we had our portfolio meetings and updated our two models – our Global Multi Asset (GMA) and our TPW 20, 100% thematic model portfolio. There were several interesting takeaways: the first being that all 20 positions in the TPW 20 were above their 50- day mav, something we have not seen in months and months. This supports our long standing thesis that the segments that led us into the bear market some 19 months ago, namely the Innovation space, Small Caps and China tech, would lead us out and lo and behold that’s what seems to be taking place.

Another insight was how many ETFs in both the GMA and TPW 20 were above their 100 day mav for the first time this year and are now pressing up against some resistance levels. Some of the Climate positions have broken back above their 200 day mav; it was interesting to note that over the most recent period the top 5 performers in the TPW 20 were a mix of Climate and Future Tech – our two biggest segments at roughly 60% + of the model. Its nice when your biggest segments lead the way.

Following a tough June for our models the returns over most recent period were among the best we have seen for each model. Given the commentary above we decided to take on some more risk and focused on the EM space which has been a laggard across all three assets: debt, equity and FX. While the details remain for our Model Portfolio Delivery Service (MPDS) clients only, it’s worth noting that as inflation rolls over, Fed risk should dissipate and the USD should follow. This will be very supportive for both Commodities & EM assets especially on the FX front. 

A period of equity digestion and even modest pullback would probably be heathy at this point. We would not be adverse to such and would look to add further to some of the areas noted above. Much as the heat of August gives way to the cool air of Fall (hints of it this week) the 19 month old bear market may be giving way to a new bull market, once that sniffs out a high nominal growth world boosted by a global cap ex boom and supported by improving productivity.

Stay Cool!