Thrashing About

1210 words – a 3 minute read.

Cross asset market action increasingly resembles an animal caught in a trap, thrashing about, trying to free itself.   A kinder, gentler version would be akin to the child’s game: pin the tail on the donkey, where each child is blindfolded and given chance to try and pin the tail.

Investors, Govt officials, Central Bankers, business people and the ordinary Joe are all trying to pin the tail – ascertain the direction of inflation, the odds of recession, the outlook for earnings, not to mention housing, the labor market and any number of other issues. At least Covid doesn’t feature as it once did.

The outcome of all this thrashing about in the dark is some pretty wild moves ranging from the bond market gyrations with yields spiking and collapsing by 30-50 bps in a week (MOVE index hit highest level in two years last week) or the Commodity markets with huge swings in wheat, fertilizer, copper, iron ore, oil, Nat gas. Equities have actually been the the calm one (VIX under 30 as I write) with many markets up on the week – only the 2nd such advance in the past three months.

Last week  we noted our focus on US gasoline prices as the front edge of the wedge the Fed was looking at to determine headline inflation risk. We dug into it this week with some experts and learned that the spread between wholesale and retail is usually 70 cents or so so $380 wholesale (July futures) corresponds to roughly $4.50 retail. We also learned that it can take weeks for prices to come down given the incentive for gas station owners to run the tank dry before bringing prices down. We learned furthermore that even though the peak driving season extends to Labor Day (early Sept) retail gas prices typically peak in late July.

As we view it, declining gasoline prices represent the quickest way to fewer Fed rate hikes. Today, wholesale gasoline prices are off roughly 12% from recent peak amid signs of visible demand destruction while ebbing food/fertilizer prices (wheat-fertilizer prices are down 30% + from peak & back to Jan – Feb 2022 levels) should further alleviate the headline inflation issue. Discount stores report being offered their best deals ever. Those areas the Fed can attack directly with rates – housing, labor, are already softening, housing especially with the number of single family homes for sale jumping 33% in the three months to May.

Waiting for inflation to peak has been like waiting for Godot. It has been a hugely frustrating exercise for those like us who thought inflation would peak this Spring and while arguably it did (core peaked in March) it has not worked out that way in asset markets. It begs the question if Chair Powell’s presser last week was in fact the long awaited and elusive “peak Fed hawkishness”? Oh may it be so.

Inflation fears have suddenly become yesterday’s story, replaced by recession fear all across the land. Two year inflation breakevens started the year at 3.2%, spiked to nearly 5% in late March and now sit at roughly 3.7%. Whether in rates, which have rallied hard – the 2 yr. broke under 3% after almost hitting 3.5% or commodities where energy stocks had their third worst 2 week decline (-23%) in the past 40 years - its been whiplash city.

One key area that has remained relatively immune from all this volatility has been US earnings estimates which have remained in a gentle upward slope all year. Typically, June is when analysts reduce their estimates yet even amidst all this recession talk, analysts have slightly increased their 2022 estimates.

Bloomberg reports that analysts have increased their 2022 S&P EPS estimates from 8.7% at the start of the year to 10% at the start of June and now 10.6% as we approach earnings season. Clearly there is a disconnect between the analyst community & investors. This earnings season should be an interesting one. Will companies make their Q2 #s, what will they say about the 2H and perhaps more importantly early inklings on 2023?

JPM has done some good work recently on how earnings outcomes can differ depending on whether a recession is deep or shallow. It reports that shallow recessions (1969, 1980) usually result in a high single digit earnings impact. A deep recession (1973, 1981) results in an earnings hit that is closer to 20%.

Thus we come full circle – back to the donkey as it were. With commodity prices clearly softening while tightening financial conditions impact housing and labor markets, perhaps the Fed won’t have to tighten as much as many expected even two weeks ago. The FFR terminal rate has come in roughly 50 bps to 3.5% in Q1 2023 and rate cuts are now being priced in for late next year.

A Fed that doesn’t have to go whole hog on inflation is a Fed that is less likely to push the economy into recession or certainly a deep recession. Our base case remains no recession. A stock market that doesn’t face a deep recession & sharp earnings slowdown is one that could be looking to find a bottom rather than prepping for another 15% downside. This game of pin the tail on the donkey is a high stakes game.

Amidst it all we continue to focus on those areas that led us down, namely China equity and the Innovation space. Both appear to have bottomed & continue to move ahead with broad China equity up roughly 10% for the past month vs SPY down 2%. China tech has done even better with KWEB far outperforming Nasdaq. China stocks leading suggests China’s economy should pick up which should in turn support Commodities. Broad EM and EAFE continue to OP the US ytd, suggesting new global equity leadership.

Within the Innovation space, ARKK, the poster child, continues to power ahead, not making a new bottom with Nasdaq last week and now up a roughly 30% since its mid May low. We note that the climate thematic has also held in well of late, reflecting perhaps the clear need to accelerate the shift to clean energy.

We remain of the view that Commodities are in a secular bull market; currently the space is at its most oversold this year suggesting a buyable pullback for LT investors. Our view of a secular bear market in Sovereign debt also remains intact; we would not be a buyer of this rally. We plan to watch this earnings season carefully.

We have had a global equity valuation de rating and a 20% + pullback. LPL points out only 2% of the S&P 500 are above their 50dmav – a historical low matched only by March 2020 & October 2008. A Fed that doesn’t have to break things and an earnings outlook underpinned by today’s high nominal growth rate environment coupled with rock bottom sentiment & positioning suggests an ongoing bottoming process. There is arguably potential for an imminent short squeeze in global equity as JPM points out that quarter end flows are expected to be “well above historical norms”.

 It pays to keep an open mind. 

TGIF – NYC gonna be in the high 80s this weekend!