Title Fight

1200 words – a 4 minute read.

Well, it certainly feels like one has been in a fight, what with both stock & bond investors facing one of the worst starts to a year in a century – that’s not easy to do. Coupled with the “Market Speed  backdrop we have written about at length and the confusion, apathy, illiquidity & whip saw price action across the financial asset space it’s been a lot to handle for both public & private markets alike (note Klarna’s near 90% down round fund raise).

As in a title fight there is the undercard and the prelims before one gets to the big match up. One can envision the pre lims being such melodramas as Italian political dysfunction, UK leadership transition, Pres. Biden coming back empty handed from Saudi (oil market barely blinks) while at home Sen. Manchin deep sixes his domestic agenda.

As one moves up the card one gets to the Russia – Ukraine conflict, Germany’s dash for gas, China’s post Covid recovery and the global economic fight between slowing US and EU economies and China’s economic acceleration out of its lockdowns.

Then comes the title fight. The match up between what has seemed like an unstoppable champ – rising inflation & the Central Bank response (mainly the Fed to this point among the majors) and the havoc it is creating among risk assets vs the upstart Earnings challenger, who counters that while a shallow recession is possible, anything deeper is unlikely and earnings are likely to be fine given a high nominal growth rate.

The early rounds have been fast & furious with the champ ahead on points. Inflation has surprised to the upside for the past 4 months, deeply frustrating those of us who thought it would have clearly rolled over by now and keeping a chokehold on asset prices - even bringing down commodities over the past month. Yet long rates appear to have peaked for now while US & EU inflation breakevens have rolled over suggesting a bond market that expects the Fed to be successful.

Earnings are starting to come through and while banks have started off with weak results here is the money quote to date: “We’ve looked a lot very carefully into our actual data,” Jeremy Barnum, JP Morgan’s CFO, told a media conference call. “There is essentially no evidence of actual weakness.” In fact, loan growth is surging (Autonomous Research says Q2 best since 1984); arguably the banks are just playing the Wall St game – market expects weak earnings so give it to them and pile up reserves to add back to earnings when we really need to.

The champ just threw a big shot with June’s inflation print, staggering the challenger but no knockdown, let along knock out. In fact, the SPY remains well above its mid June lows (when coincidentally gasoline prices & interest rates peaked) and rates and commodity prices remain well below recent high levels. The VIX and MOVE volatility indices are remarkably calm.

 At ringside, questions turn to how much the champ has left in the tank with rate cuts priced into 2023, suggesting the bond market believes the Fed will be successful in bringing down inflation and doing it quickly –  Market Speed style. YC inversion (2s -10s though not the more reliable 3M – 10 yr.) suggests a quick end as do the Comm and rate moves of late.

Its been a long & painful fight, the middle – late rounds have become a bit of a blur, but as the challenger gets off the stool, he notes the wind from the East as China’s desynchronized recovery gives the global economy a bit of a lift (June data BTE across the board) recalls the possibility that Russia will resume gas shipments in a week or two thru Nord 1 (note EU Nat gas prices flat this week), and pictures inflation & King Dollar hitting the canvas together on the back of more, not less, Russian gas, improving supply chains, falling commodity prices, housing, ebbing wage pressures and more.

The “middle path” we have espoused between towering inflation and gaping recession still exists though arguably it has narrowed to more a footpath than a walkway. High nominal growth rates, record employment levels, cashed up companies & consumers all support US & EU economies. Near record short positions in US equity futures, a bond market priced for 60% chance of a 100 bp hike (unprecedented) in a few weeks, a dollar (up 6 weeks in a row) that is steamrolling the globe, are all positioned the other way.

It has been a one way fight to date. The challenger has hung in, but has barely won a round & taken quite a bit of (portfolio) damage. Can he stay in the fight? Is there a path to victory? MS notes that “Consensus S&P500 estimates have been stubbornly sticky even with mounting macroeconomic risks; FY 2022 and 2023 EPS estimates have increased 2.8% to ~230 and 1.9% to ~250, respectively while consensus  2022 EU EPS calls for 14% growth”.

We updated our model portfolios this week and in so doing reviewed the technical positions of each holding. The technical picture remains weak as we all know. Yet there are signs of bottoming in Chinese equity and the Innovation Space – the two areas that led us into the equity bear market. Given the rate rollover, Growth is showing signs of relative strength vs SPY with energy down more from its recent peak than tech. The climate area has also stabilized in our thematic work.

We continue to focus on improving the quality of our models and feel like we have done so in the latest period, adding to healthcare, China & Climate & reducing our exposure to the 3 Cs: Commodities, Crypto and Cannabis.

China tech has been hit again on regulatory fears but it seems excessive. Here is Krane Shares take: “Adding to Hong Kong’s Mon downdraft were several internet companies, including Tencent and Alibaba, being fined for previous anti-trust violations. Tencent was fined HKD 7.03 million ($895,000) while Alibaba was fined RMB 2.5 million ($372,000). Tencent lost $13 billion in market cap due to a $895,000 fine! Alibaba HK (9988 HK) lost $20 billion on a $372,000 fine! We do believe China’s internet regulatory cycle is over as no new rules have been announced. However, that does not mean companies cannot run afoul of the new rules. The market’s reaction seems just a touch dramatic.”

We are in the late rounds now – Fed policy mistake risk is rising and time is growing short for the challenger. While it feels a bit like rearranging the deck chairs on the Titanic, the challenger still has a path to victory with high nominal growth leading to strong revenue growth and the operating leverage needed to support EPS. The inflation champ looks unbeatable at the moment but that’s essentially priced in. Who knows: the champ might have just thrown his knockout punch and guess what the challenger is still standing with the SPY up over 2% from the 9% y/y CPI print.

I had the chance to opine in near real time on the US CPI print via BTV Daybreak Asia. Enjoy the clip.