The Old Wall St Two Step

1200 words – a 3 minute read.

The two step feels like a good analogy for the last Musings of the year – a year with multiple two month periods of both big downs & big ups, today’s dance between an ahistorical set up and Wall St history (December statistically the best month for positive returns) and even this week’s back & forth between solid growth data and Fed fears counterbalanced by weak data and recession fears (Q3 GDP/LEI).

All in all its been a meat grinder of a year with few places to hide culminating in the worst year for the balanced  60-40 portfolio on record. So will Wall St’s two step take the SPY down two years in a row? It rarely happens according to history but will history be a better guide in 2023 than it was in 2022? If our outlook for gradual stability to emerge as the year progresses proves right then perhaps it will.

What about the famed Santa Claus rally (almost titled this piece – Here comes Santa Claus, Here comes Santa Claus) will it materialize this year? According to All Star charts the formal Santa Claus rally commences today and extends for seven trading days so through Jan 4th. In true two step fashion the real issue is if Santa does NOT come to town as that usually signals a weak year for Wall St.

The two step is not limited to Wall St but extends globally. Just look at Asia where the music’s pace is much faster than forecast. Take China for example – Zero Covid, Zero Covid, boom no more Zero Covid… markets rally and then boom give much of it back as infections spread fast. We expect the post Chinese New Year (Jan 22nd – Feb 5th) period to provide the true reopening – by then Covid should have swept through most of China and folks will be ready to travel, spend and drive domestic consumption. That is MS’s view as it calls for 5.4% GDP growth in 2023 led by private consumption growth of 8% vs less than 1% this year.

Japan’s version of the two step centers around the BOJ’s famed Yield Curve Control (YCC) policy. In a similar fashion to China, no change in YCC, no change in YCC, presto, YCC is flexed to improve the JGB market’s workings. What happens next is the subject of much speculation –  here the 2nd step is likely to come in the Spring when BOJ Governor Kuroda steps down and a new Governor will have the chance to adjust policy.

We note that the Fed is slowly shifting its stance because inflation is finally coming down (today’s PCE report) while the BOJ is shifting its stance because inflation has finally picked up above the long, long, long sought after 2% level (now well north of 3% and so rates can rise). While much of the speculation around Japan and YCC has to do with the Yen and its famous carry trade we look to the domestic market for the big action.

Way back in the day, Japan’s Mrs. Watanabe was a famous avatar for retail buying of stocks. Over the past decade though Mrs. Watanabe has become a bond buyer backed by the BOJ and rewarded for the lack of inflation and even deflation. Well inflation has finally returned and it seems like the BOJ might be thinking its here for good – as such bond rates will rise and bond prices fall signaling the end of the bond bull market as witnessed in the US and Europe. The question is whether a bull market in stocks will take its place – we think the odds are good - certainly the big banks in Japan are very excited about rising rates.

Europe has not been left off of the two step dance card – Russia invades & natural gas prices soar and then soar some more – fears of deep recession, of Europeans huddling by candlelight as the power goes off due to lack of supply – those were real fears just a few months ago. Well lo and behold Europe’s Nat gas storage units filled up, the power remains on & the economy actually seems to be improving (Dec PMIs best in 4 months). What about Nat gas prices you ask?

Well Dutch benchmark prices have collapsed down to the mid 80s from a peak around 350 in August… the front month futures contract is down 40% over the past month and is now just 2x the average price for this time of year vs a peak of close to 4.5x the average price last summer. Oh and Europe is the best performing equity region QTD while EAFE is OPing the US YTD.

So as we exit 2022 – good riddance  - and welcome 2023 we continue to focus on our 3 keys: the pace of inflation’s decline in the US, the path of EU energy prices and the success of China moving off Zero Covid. All are moving in the right direction at speed.

We expect the Fed to shift from being the most hawkish of the DM CBs in 2022 to one of the least hawkish in 2023 (ECB raise more, BOJ policy shift). We expect EM CBs to initiate a rate cutting cycle. KKR expects the % of top 25 CBs tightening a year from now to be only 12% vs 84% in Q4 2022. As this shift develops we continue to suggest as we did last week that investors watch what CBs do, not what they say.

All this sets up what we expect will be the continuation of 2022’s silver lining – non US equity outperformance. We look for a flattish SPY return next year as the US avoids recession, the Fed goes on an extended hold & the USD weakens. Wall St sell side consensus calls for a down year – the first such call in over 20 years. Fundstrat notes that stocks bottom nearly a full year before earnings do – something for the bears who expect EPS weakness to drive stock market weakness to ponder. China recovery & dollar weakness fuels the non US equity opportunity across both DM and EM.

We have been positive on Europe this year and caught a lot of brickbats for it – we look into 2023 and see the potential for Japan to be a surprise outperformer as both domestic and foreign investors return to its equity market. From a global AA perspective, the non US equity opportunity is the big one to get right – it will likely last years as the US has been the big winner since the bottom in 09 and it is very extended vs the ROW across virtually all metrics. We remain significantly OW non US equity in our Global Multi Asset (GMA) model portfolio.

We had the chance to discuss some of these issues on Bloomberg TV mid week – enjoy the 7 minute clip.

Thank you for reading our work this year – this is the last Musings of 2022. We look forward to more engagement in the year ahead and wish one and all a very merry holiday season!  Our Friday Musings will return in January.