Tug Of War

1628 words – a 4.5 minute read.

It seems like there are two sides set for an epic tug of war: on one side is the Fed, its army of speakers & bearish investors, determined to keep the animal spirits genie in its bottle; on the other side is the reality of slowing US inflation (recent CPI and PPI prints), better EU energy outlook and what looks like an accumulation of small policy moves in China designed to support the property market and gradually ease away from Zero Covid. Whichever side wins will determine the direction of risk assets in 2023.

Recall it was summertime when we anointed these three issues as our 2H keys  the pace of the US inflation slowdown, the path of EU energy prices and the speed at which China moves off Zero Covid. Recently, we noted our view that China has put a floor under its property sector and recent policy changes such as allowing developers access to pre sale funds and subsequent risk asset price action supports that thesis.

We even have China and the US playing nice at the G 20 with Presidents’ Biden and Xi engaging in a substantive 3 hour long meeting. Its important to note that we do not expect big headlines on these issues declaring the all clear. Much as we don’t expect the Fed to announce its famed pivot, we also don’t expect Pres. Xi to announce the end of Zero Covid yet arguably both are already underway.

All this supports our 2023 outlook which argues for more stability ahead as these issues play out & shift from market headwinds to tailwinds. As US inflation falls risk asset prices should go up; as it becomes clear that Europe has a handle on its energy needs, European risk asset prices should go up and as China demonstrates sustained conviction in the new policy mix Chinese risk asset prices should go up.

 JPM for example, expects US inflation to average 4% this quarter vs 10% in the 1st H. It further notes that Europe’s industrial output is running at BTE level in both August & September while pointing out that EU equity trades at .67x US on a forward E basis – cheaper than during any of the prior 4-5 crises.

One asset price that should fall as stability returns is the USD which we continue to believe is the biggest loser from growing stability. The dollar has rolled over in pretty convincing fashion (fastest since 08) and it has further room to decline relative to both DM and EM FX. Sustained dollar weakness is likely to signal a wholesale AA shift out of the US and into the ROW just at a time when the US vs ACWX ratio is at an ATH.

Its understandable that the Fed wants to jawbone markets into taking it slow on the upside given worries about potential impacts on financial conditions & inflation. The US economy continues to demonstrate its resilience with the Atlanta Fed’s Q4 GPD nowcast running above 4% with consumption stable to strong. Manufacturing, housing and production are weak but its worth noting that cap ex spending remains robust running at some 20% up on a Y/Y basis.

The soft landing or as we call it here at TPW Advisory, the “Middle Way, whereby core inflation declines w/o significant labor market weakness continues to manifest as it becomes clear that the US economy is resilient with a large savings buffer supporting the  consumer side (retail sales data) coupled with the lack of imbalances on the corporate or banking sides. The consumer is fine, housing is approaching its bottom given that mortgage rates have peaked & while manufacturing is weak it represents barely 10% of the economy. 

The holiday shopping season is expected to be the smoothest in three years as supply chain woes recede. Credit is rallying not selling off with US HY spreads over 100 bps lower than their July peak, so are financial stocks in both the US and Europe. We are not going into a 2008-9 scenario, nor a 2001-2 scenario.

We continue to pay attention to cap ex as it is an integral part of our medium term outlook for a high nominal growth world driven by a global cap ex boom to deal with the 3 Cs of Covid, Climate & Conflict. This should be accompanied by rising productivity which will in turn provide for higher wage gains without surging inflation. 

In contrast, here is what the global fund manager community expects according to BofA’s FMS: “More than 90% of money managers expect stagflation in 2023…Tail risks also include geopolitics and a systemic credit event. An absolute 0% see a "goldilocks" scenario, while 77% expect a global recession”. You gotta love a zero weight to goldilocks!

This is the consensus mentality as we approach 2023 (from a Bloomberg article – “it’s been a miserable year for the global economy. But things can always get worse”). While that mentality is consensus, the reality is that things could improve more rapidly than many expect – here is Pantheon Macro on US inflation: “But the pace of rent increases has peaked, and our chart suggests that the steep drop we expect to see in core PPI inflation will drag down the core PCE measure faster than markets and the Fed expect”. Pinecone Macro notes: “The trailing 4-month annualized inflation rate is now carrying a 2-handle”.

At some point the bears are likely to have to capitulate – it seems here to be a matter of when not if. The recent sharp bounce in risk assets was courtesy of the CTA community according to JPM who notes that the CTAs, known for being fast money, shifted from a large net short position to flat or slightly long risk in the past two weeks. Dare one say BTFD? Here is BofA again: “FMS on AA: investors >2sd UW stocks vs 2sd OW cash, long US$ most crowded trade for 5th month (US$overvaluation@recordhigh)”.

There are plenty of signs of continued deep and dug in bearishness including the record cash levels and record low risk appetites reflected in the BofA data. Bears are not giving up without a fight as suggested by the CBOE’s record breaking equity put call ratio at 1.46 made this week, dwarfing that even seen in 2008. This type of positioning is not limited to equity either as the net short position in the 2 yr. UST also is at record levels – watch the 4.25% level, if it goes risk appetites should soar according to MRA Advisors.

The set up from a constructive point of view into YE & 2023 seems pretty appealing: our 3 key big picture issues are moving in a constructive fashion, the Fed and ECB will follow the data and the data should be supportive of declining inflation, investors are badly offsides and unlikely to want to enter 2023 behind the 8 ball (so in other words buy any weakness & thus putting in place a good risk – reward set up). Seasonality is quite supportive, high nominal growth (Q3 US nominal GDP grew at 9%) supports the top line (Q3 US sales growth +12% y/y, + 26% in Europe) and hence earnings.

While leading investment banks including JPM and GS have cut their 2023 US EPS estimates to basically flat y/y they do not see the big earnings decline that the bears continue to hold out for. Neither firms’ economists expect a US recession next year – neither do we. Nor do we see the big earnings decline. Should inflation decline as we expect the potential then shifts to possible multiple expansion as rates fall though note we do not expect major rate declines given our high nominal growth outlook.

Rather we see a year of increased stability ahead which should support corporate cap ex, consumer spending and a decent economic outlook. As the big worries, run away US inflation, Europeans huddled in the dark, cold and afraid, Chinese citizens locked down for months on end – as these dystopian nightmares fade we expect reality to win the tug of war. US fixed income is already suggesting a “long pause” for the Fed in 2023; low bond volatility should encourage equity risk taking.

 Its likely to be a gradual thing rather than a one off surge into risk assets. This is of course preferable as it suggests a longer lasting up move. We remain focused on Small caps & Value in the US, non US equity, Credit (especially US and EM HY) and Commodities. Arguably there are opportunities galore; for example China’s big 4 banks are trading at 11 year lows & 0.4x book – the level US banks traded at during the lows of the GFC. While COP27 has yet to conclude, we continue to see the potential for Climate and Innovation to gain attention as the new growth names as Crypto and Big Tech fade.

The much maligned (often unfairly) Cathy Woods sees a growing chance that the Roaring Twenties will be replicated in the coming years as multiple general purpose technologies become mainstream. Innovation & Climate have had a full fledged, nearly 2 year bear market with an 80% type drawdown – left for dead, they could become the big beta plays of the coming years which would be very good news for our TPW 20 thematic model portfolio. VC funding for climate tech remains a rare VC bright spot with Pitchbook noting decarbonatization & emissions tech fundraising is on pace to exceed 2021’s levels.

Please note there will not be a Musings next Friday in honor of Thanksgiving. Next up is the December Monthly to be published Friday December 2nd. Happy Thanksgiving to all!