Testing Times

1780 words – a 4 minute read.

It sure feels like testing times: from UST volatility to poor stock market breadth to 7 rainy NYC weekends in a row (got to be a record) to war in the Middle East & on to the chop fest which is the global equity market.

Yesterday was also the 36th anniversary of my 1st Wall St crash – October 19, 1987. As a young pup I had no real idea of what I was watching on the old Reuters machine in the corner of the office. Life lesson - four months later the small shop I was at, my 1st job on Wall St, shut its trading operation. I was let go on a Monday morning – no severance, no notice… just good bye.

So, the good news is there is little to suggest we face another October 1987, the bad news is that the path through transition, the path to stability and the $1T reward unlock, remains a work in progress – one step forward, two steps back (LINK).

One good example of today’s environment comes from Jim Bianco: “On June 27, three days before the quarter started, the expectation for Q3 2023 GDP was 0%. 100 days later (18 days after the quarter ended), the consensus is at 3.5%, and Atlanta Fed GDP Now is at 5.4%.  Atlanta is often wrong, but not by several hundred basis points. Q3 was considered a recession before it started, and it now looks like it is one of the better quarters of the decade, excluding the shutdown/restart quarters in 2020.” It’s been real hard to get a good handle on the post Covid  future. 

I thought the following 2 comments really capture the current cross asset environment – the first from Finom Group, the 2nd from Ren Mac. PRO - Nasdaq OVERSOLD sentiment (< 35) has sustained in October, setting up another historically oversold bounce near-term? Backdrop of rising yields/dollar has proven nasty recipe for equities 2-months running. Mother-of-all rallies when trend abates, as EPS demands?  CON - Real yields closing in on 2.50%.  Anything above 2.25% starts to negatively impact $SPX with convexity (i.e. geometrically worse the higher it goes).

So which way will it go? Will the rising rate trend finally abate leading to a mother of all rallies as Finom suggests or will real yields break well above average and get to the danger zone noted by Ren Mac? We remain positioned for the former.

Some straws in the wind: Bespoke notes that the USD has not been able to continue its up move with rates – highlighting that Thursday was the $’s worst day in almost 6 weeks. Perhaps more importantly, BofA notes that cross asset correlations are finally starting to break down: 

“The 20-day positive correlation between US investment-grade spreads and 10-year Treasury yields has dropped to 21%, down from 53% in early September. Meanwhile, the negative correlation between rates and stocks has moderated to 24%, up from 85% in early August. 

That’s theoretically good news for stocks and bonds alike amid a still-vicious sell off in Treasuries which has sent the S&P 500 lower, and credit spreads wider, as Wall Street frets over the impact of higher rates. But the easing correlations suggest that perhaps the two asset classes have almost worked through that repricing.”

It feels that way as well though the equity chop fest has had a noticeable effect on breadth with very few places to hide in the equity space. Perhaps though the rate cloud can lift a bit and allow earnings to shine through? Pinecone Macro notes that with 20% or so of the SPY reporting, earnings are coming in BTE vs Bloomberg consensus.

We have long hung our pro economic growth, pro risk hat on the earnings picture as one that supports being long global equities and have argued that with US 2024 consensus earnings suggesting double digit EPS growth, stocks can do ok. LPL notes that the ROW offers valuation support as well: The current forward P/E of 12.5 for the MSCI EAFE is 13% below its 10-year average, while the U.S. is 3% above average by the same measure. 

Yesterday was also where the US stock market has bottomed over the last 10 pre election years as noted by Finom Group: “Typically, this has been the exact day, in Pre-Election years, where the market bottoms in the Q4 period before lifting higher through year-end.” 

Piper Jaffrey sees the technical picture like this: “Given the increased headline risks thrown at this market, we remain impressed by its resilience .. As long as the $SPX remains above 4,200 support, we suspect it is just a matter of time before bulls take firmer control ..Sees year-end 4825”. John Kolovos of MRA Advisers sees a similar set up with 4145 as key support & potential double digit gains through YE.

Is your head spinning yet? 

Ours has been. This is where one goes back to process, reminding oneself this is a transition period, that progress is being made and that the rapid pricing out of recession risk by the bond market is a good thing as long as nothing big breaks. So far, so good as both big & regional bank results this week suggest the financial system is fine. Credit suggests the same with spreads not close to blowing out and US HY continuing to significantly OP the AGG. The UST YC is disinverting with 2/10s spread now under 20 bps. We will take the higher for longer rate structure in return for decent economic & EPS growth.

We continue to follow our 4 guideposts on the path to stability as we have for the past several months.

First is continued disinflation in the US and Europe. This process remains on track with Europe data surprising positively. We expect falling shelter costs to cap US inflation over the coming quarters (listed rents down 1.2% over past yr.) and look to October’s inflation report as a potential turning point in market sentiment towards growth w/o inflation. Q3 GDP reflects strong growth yet most 3m annualized inflation measures are quite benign.

Here's Moody’s chief economist Mark Zandi: “As a professional economist, I do lots of forecasting. Some forecasts I’m confident in, some not so much. I’m confident that the growth in consumer prices for shelter is headed much lower and that this will push overall inflation back near the Fed’s target by this time next year.” https://pelosky.com/friday-musings/stability-wanted-1t-reward

Second is our expected manufacturing recovery as destocking turns to restocking. The most recent data remains supportive on a global basis; Oxford Economics notes: “US Business inventories were up 0.4% in August, in line with our above-consensus forecast, and have strung together two consecutive months of gains.”  US consumption remains strong as evidenced by retail sales data & so we continue to expect US ISM Manuf PMIs to break back above 50 in the coming months.

Here's JB Hunt’s President on this week’s earnings call: "we are not at a point yet to say we're out of the freight #recession, but we do feel like we're coming out of it..., directionally, we are seeing signs of things moving in a positive direction."

Third is earnings growth; we continue to expect solid global growth which should support corporate earnings as consumption remains robust in the US and Europe, picking up in China. Rate risk is very limited in US corporate world with many cash rich companies – especially Big tech, seeing expanded earnings as a result of the rate rise. Banks have also been big winners of the rising rate environment even if the stocks don’t reflect it (yet). BofA notes: 75% of S&P 500 debt is fixed rate--in 2007, it was just 44%. We are watching upgrades vs downgrades and analyst revisions to 2024 forecasted EPS.

Fourth is an economic pick up in China as policy support puts a floor under the economy and helps bolster consumer & corporate confidence. Here is Marc Chandler’s take: “China reported stronger than expected Q3 GDP. The 1.3% quarter-over-quarter growth compares with a 0.9% median forecast in Bloomberg's survey. This put year-over-year growth at 4.9%, better than the 4.5% pace anticipated. Beijing has promised more measures to bolster growth, and this looks to entail more fiscal and monetary support. The September details were mixed. Industrial output was steady on a year-over-year basis at 4.5%, but retail sales picked up (5.5% vs. 4.6%). Fixed asset investment was slipped to 3.1% (from 3.2%), while property investment contracted by 9.1% (vs. -8.8% in August). The surveyed jobless rate eased to 5.0% from 5.2%.”

Bottom line: Growth year-to-date was 5.2%, meaning Q4 GDP growth needs to be 4.4% or better to meet the government’s 5% GDP growth target. 

We recently added to our OW China equity position in our Global Multi Asset (GMA) model and so are feeling the sting a bit but stay positive noting that the economy is picking up, valuations are at record cheap levels, foreign selling is at record high levels, US semi chip sanctions have been levied, the dead horse property market has been beaten and continued policy support is likely. 

That’s our feeling overall as we sit here – solid fundamentals should win out as global cross assets swing back and forth amidst the overhang of war (while we don’t see it as a catalyst for market moves it does cast a pall over risk appetites) especially with all the market luminaries talking about the exceptionally dire nature of things – Paul Singer being just the latest example. Shorts taking their book maybe? Barchart reports that CTAs are short $30 billion of U.S. equities, one of the largest short positions recorded in the last 8 years.

In a nutshell, we believe bond market repricing is close to its end & nothing has broken; its effect on other assets is ebbing, the Fed is happy to let rising LT yields tighten market conditions for it  & so is done with the tightening cycle, the USD has not been able to make headway, $90 WTI supports our Commodity OW, rising earnings supports our equity OW, a growing economy supports our Credit OW and a recovering China supports our EM equity focus.

Speaking of China, enjoy this China Bull – Bear Debate hosted by Your Finance TV with Jeff Huge of Alpha Insight & myself  -a tight 30 minutes of good back and forth – I am the Bull and Jeff the Bear - you decide.https://www.youtube.com/watch?v=mLnpCS9Xo4c

And of course, the best of luck to my 16th ranked Duke Blue Devils as they take on # 4 Fla St in our 3rd Natl TV game of the season – Sat at 7:30 on ABC – Go Football Devils!