Two Sided Markets

1290 words – a 3 minute read.

As we wrote in our recent Monthly  Extrapolation & Beyond, the markets have been taking current trends, be it inflation, Fed response, market reaction etc. and extrapolating them. Given the roughly year long trend of inflation surprising to the upside and the Fed following through with three 75 bp hikes in row – its been the right approach.

We then posited that to continue that approach would be risky, arguing that we are approaching a turn or reversal in many of these traits at a time when markets are positioned in a very one sided way. Well, we saw what that a data point or two in the opposite direction – JOLTS for example, means in a near 6% rally for the SPY over the 1st two days of the quarter – a record move for a Q4 start.

This suggests to us that the starting point of a move away from extrapolation is to create a two sided market, one where the pendulum can swing either way, keeping investors from tipping too far in either direction and perhaps reducing the potential for that big down draft some are waiting for by increasing the potential for a big up move.

We have all heard ad nauseum about the big down move with Elliott Wave purists for example calling for a move down to 2600 by month end. In the spirit of two sidedness, we note the Stock Traders Almanac tweeted out that its cycle work is lining up very nicely with the current market  suggesting 20% upside for the S&P by YE. To add support, the McClellan Oscillator just hit its most oversold condition since the pandemic low & we all know what happened next. For the icing on the cake FinTwit tells us that major market bottoms have occurred more often in October than any other month.

Today’s job report seems in line with expectations but with the UER drifting back down to 3.5% the consensus seems to be that the Nov Fed hike will be another 75 bp – don’t forget we have the Sept CPI print next week – if so, we would expect that to be the last such hike as the weight of evidence of falling inflation should build in the coming weeks and months. Commodity prices have come off sharply, used car prices as well while there is a ton of evidence that supply chains have cleared ranging from ISM data to container shipping costs to port reports and on.

Of course, the main issues are housing and labor. It seems beyond dispute that housing has rolled over and rents too as we showed in our monthly. The direction appears clear – to lower housing prices and lower rental fees as mortgage rates remain high and multifamily construction surges. On the labor side the JOLTS report noted that one of the Fed’s favorite labor indicators – job openings to underemployed - fell from 1.97 to 1.67, still elevated but clearly rolling over. Today’s job report showing 263k new jobs compares to north of 400k a year ago, a 6 month average of roughly 440k & a 3 month average of 380k – the labor market too is clearly slowing.

Thus the weight of the evidence is pointing to inflation rolling over and the Fed having done much of its work with markets in turn having priced much of that in – whether it be a 4.6% terminal rate, a 1.5% real rate or some of the tightest financial conditions since 2008. The Fed is likely to increasingly be on notice that its most aggressive tightening cycle in 40 years has had and will have significant impact on the real economy, that financial stability risks are building given those real rates & financial conditions & perhaps most importantly that rate hikes operate and impact the economy with a lag. We like Bloomberg Opinion writer Conor Sen’s description of an ”inflation burb” where inflation is likely to roll over almost as quickly as it spiked.

That suggests to us that the Fed will be looking in a data dependent way for the opportunity to pause and allow for that lagged effect to kick in while it assesses its recent policy moves. As the Fed moves away from its aggressive action it may start to verbally note some of the above, drop from 75 bp hikes to 50 or 25 and perhaps actually pause hikes at some point. The risk asset price reaction will be akin to what we saw to start this month.

This is a when not an if scenario & the when is coming closer with every day.

In the interim we have earnings season upon us and with consensus calling for 4% Y/Y Q3 SPY earnings growth while nominal growth remains in the 6% range it seems like a low bar event. As such we expect a successful earnings season ahead, not only in the US but on a global basis due in part to the desynchronized nature of the global economy where growth is picking up in Asia  (Japan Composite PMI at 51 up from 49.4 in August), supported by a much looser monetary policy mix with BOJ on hold and PBOC easing.

Here's what JPM had to say on the subject of high nominal growth and earnings – sentiments we have expressed before and share completely: “Strong nominal GDP growth underpins equity fundamentals: Equities are proving to be an effective real asset class as their earnings are linked to inflation. Unless nominal GDP growth downshifts drastically, earnings growth should remain resilient and defy expectations of a decline even in an environment of low real GDP growth”.

We had our model portfolio review and update sessions earlier this week for both our Global Multi Asset (GMA) Model as well as our TPW 20 thematic model. A couple of points to share – our review of the technical positions of our holdings showed a number hitting their 20 mav before stopping, suggesting more catalysts – earnings, inflation, other economic data -  are needed to take them higher. There were very few O/S or O/B conditions; significantly, many of our holdings did not make new lows in the September sell off.

Both portfolios performed well vs their respective BMs over the period, helped by some ETF specific issues (HYGH vs HYG/AGG for example) as well as the reality that non US OPed the US, that notwithstanding all the spooky Halloween talk about Credit Suisse, EUFN OPed ACWI and that Japan, who virtually no one pays attention too – other than as an FX crisis waiting to happen -  has broken out of a LT downtrend vs SPY & outperformed it. Note foreign investors have been net sellers of Japanese equity for the past six weeks.

We did not make many changes – the ones we did make continue our recent trend of adding to EM and Value opportunities in the US where we see the banking sector as attractive given cheap valuation and surging NIMs. We have noted that EMFX is OPing DM FX driven in part by the Euro’s need to offset the energy shock and the BOJ’s determination to not move off its YCC policy & in part by EM Central Banks having begun their tightening cycle earlier (Brazil is done for example).

We continue to think that the end of the Fed’s aggressive hikes – likely with Nov’s meeting – will spell the end of the USD strength and the EM FX relative OP serves as the canary in the coal mine. Note that the old firm, MS, just upgraded EM equity to OW.

Enjoy the long weekend – I am off to the mountains of NH to catch some fall foliage & get a walk in…