Things I Don't Understand

1230 words – a 3 minute read.

The extrapolation trend we have written about continues with the 10 yr. UST selling off for the 13th straight week, mortgage rates soaring while the dollar gains vs the Yen extend for the 13th straight day to levels not seen in decades.

To be fair, the two sided market action we mused about a few weeks back is also evident – especially in how stocks are holding up amidst this bond carnage. SPY bottomed in June with the 10 yr. at 3.48% - rates are now up 90 bps from that level and yet stocks are flat to up slightly. MTD thru yesterday the Barclays Agg is down close to 3% while SPY is up 2%.

We believe this is mainly due to the other piece of the stock market puzzle – earnings. Our take, noted last week, remains that the high nominal growth environment coupled with dour expectations should make for a fairly good earnings season. So far, so good with roughly 70% of companies beating and more companies raising their forecasts than lowering them.

What we want to write about today is the frustrating part of the job – the part where one has to tangle with things one doesn’t understand and yet feels like he or she should understand or worse needs to understand. The topic stems from an enjoyable mid week lunch with one of the more thoughtful macro guys I know.

As we broke bread, we kicked around our views & concluded that we are both dug in and fearful that were we to change our POV we would do so just before the reversal we both expect (in rates, the USD, stocks etc.) occurs. My friend, visiting from out of town, commented that most folks he met with on this trip were in the same spot – battered and bruised, dug into their POV and unwilling to change as the reversal is just ahead. This worried both of us.

Our conversation grew more dynamic when we started to discuss things we don’t understand – though that was mostly me talking. Here are a few examples from Europe & the States.

In Europe I really don’t get how natural gas prices have collapsed by close to 70% from their recent peak and yet EU risk assets are LOWER in price today than at the peak. Remember all the talk about a freezing winter with poor Europeans huddled in dark rooms with no heat? Well, that is just not going to happen - in fact the situation has improved so much that storage tanks are full, the latest winter weather forecasts call for a mild winter and there are roughly 35 LNG carriers circling European LNG terminals bc there is no room. The Euro however sits at roughly .97 vs 1.01 at the peak while EU stocks prices are down roughly 6% from the peak.

Now, I get that this is not the be all and end all for Europe, that inflation rages close to double digits, that the ECB will hike more and that the 2023 GDP forecast is for slight negative growth.  I am not looking for new highs in stocks but I don’t get the new lows when the biggest risk is taken off the table (though I guess there is always battlefield nukes to worry about).

The second thing I don’t understand concerns the US airlines and their recent results. We have been keen on them as part of our reopening play and like many things this year it hasn’t worked out very well. Yet most US big carriers just reported BTE Q3 results and in some instances better results than Q3 2019, pre Covid. The UA CEO called Q3 “the best operational quarter in our history” for example. Now not every financial metric is better as FinTwit reminded me, but stocks are down and down big. In fact, JETS, the airline ETF, is down a cool 50% from Q3 2019 levels…I don’t get how that squares with the best operational Q ever.

One other thing I don’t understand is how US inflation seems to be levitating around 8% when virtually every indicator suggests price pressures are waning – be it supply chains (just 4 ships waiting to unload on the West Coast vs over 100 earlier this yr.), the collapse in commodity prices, used car prices etc. while housing rolls over more sharply than in 2008. Some of it may be how we represent inflation – if one looks at the past 3 quarters annualized for example,  inflation falls from roughly 10% in Q1 & 2 to 2% in Q3.

Many forecast sharp declines in inflation between now and mid 2023 – here is Moody’s Mark Zandi: “CPI, the consumer price inflation, will go from something that’s now about a low of over 8% year-over-year to something close to half that of 4%,”. JPM expects headline CPI to fall to 6.8% in December and 3.2% by 9/23.

Yet, the Fed has appeared oblivious to these perspectives until literally just today when the WSJ’s Fed whisperer hit the street with a report suggesting the Fed will raise 75 bp in Nov and then pull back to 50 bp in Dec before possibly pausing to assess the real economy response given the known lags to policy impact. This could stop the bond selloff in its tracks.

Now there are plenty of other examples of things I don’t get for sure but I want to cover some of the things I do understand just to keep things balanced.

I do understand for example why earnings are doing ok – when the consensus is for 2% EPS growth y/y and nominal growth is roughly 8-10% that is not a high bar. I understand those earnings and the BTE outlooks support current stock price levels in the midst of the most aggressive Fed tightening cycle ever -one that bond investors seem determined to keep extrapolating higher and higher. Silver lining here is that the 3M – 10 yr. UST spread is back out close to 40 bps vs under 10 earlier this week.

I also understand that this cycle is running on fumes though with a 5% terminal rate priced in on the back of another 75 bp hike in early Nov and perhaps another in December. Here is this week’s $ quote from noted Fed hawk James Bullard: “In 2023 I think we’ll be closer to the point where we can run what I would call ordinary monetary policy,” he said. “Now you’re at the right level of the policy rate, you’re putting downward pressure on inflation, but you can adjust as the data come in in 2023.” I note that 2023 is roughly 70 days away.

The combo of BTE earnings, decent forecasts and a Fed that is telling the bond market to hold on there big fella suggests the possibility of an imminent reversal in the trends noted above.

We remain of the view that as rates cool, the USD should roll over (note DXY peaked 9/27 at 114.8 vs 113 currently even after roughly 60 bp in subsequent rate back up) and that should set the stage for a better end to the year for risk assets given sentiment, positioning etc. as markets start to price in a more stable policy environment ahead.

Enjoy Monday’s BTV clip where I try to lay some of this out.