Watch What CB's Do, Not What They Say

1600 words – a 4 minute read.

From one side of the Atlantic to the other the actions and messages were similar, a step down from 75 bp hikes by the Fed & ECB to 50 bps and a step up in hawkish language from Chairs Powell & Lagarde. It makes sense in a way – Central Banks (CB) want to keep animal spirits muted while they stepdown their hikes & allow the lagged effects of their previous rate cuts to cool economies and hence inflation. They say don’t fight the Fed – we take that to mean don’t fight the Fed’s actions.

The good news? That’s exactly what is happening with US CPI over the past five months running at roughly 2.4% annualized according to Bloomberg; one can imagine December’s price data being similar to prior months suggesting that inflation over the 2H of the year has been in fact in line with the Fed’s target.

This is true even as the Atlanta Fed’s Q4 GDP Nowcast is calling for roughly 3% growth – the juxtaposition of these two data points would seemingly imply the potential for the fabled soft landing (our Middle Way) derided by so many to actually manifest… inflation around target while growth holds up well above recessionary levels.

While the European story is not quite as clean given the energy price effect still working its way through Europe it seems clear that inflation has peaked there as well while the economy remains in a low growth mode with data (PMIs picking up M/M) suggesting the trough might have already been reached. Its important to note that Europe has been through its first cold snap of the winter and yet Dutch (BM) Nat gas prices remain stable and well below peak levels.

As such all three of the 2H keys we outlined back in June: pace of US inflation’s decline, the path of Europe’s energy prices and China’s ability to move off Zero Covid, are moving in the right direction. China’s move off Zero Covid has been the biggest surprise of the past month and it is a positive surprise for global growth & risk assets. BTW, Thursday’s announcement by the US Public Company Accounting Oversight Board (PCAOB) that it had free access to review China based auditor accounting of the 200 odd Chinese firms listed on US exchanges is further good news for China equity.

Some folks with Grinch like attitudes are making the case that as China recovers it will push commodity prices up and create a 2nd leg of inflation in the US and EU. This seems unlikely in part because China is focused on boosting domestics demand not Fixed Asset Investment (FAI) and in part because virtually all commodity prices are well off their highs.

We note McKinsey’s recent report highlighting that much as occurred in the US and EU, China has generated $2T in excess household savings in the first 3 Qs of 2022 – savings that will help jumpstart the Chinese economy next year and which gives some credence to China’s expected 5% GDP growth target.

From our POV the focus on dot plots and Fed – ECB language is beyond useless – it may be quite dangerous to the health of one’s portfolio. If you doubt this statement just go back a year and look at what the dot plot and ECB language was saying. The dot plot is a joke; the ECB is less clear cut because no one a year ago was expecting the Russian invasion of Ukraine and all that followed.

But that’s exactly the point we have been making: that the headwinds of 2022 will turn into 2023’s tailwinds: inflation falling, rates stable to declining (including US mortgage rates – already peaked?), USD weakening, Covid lockdowns easing, no more European land invasions etc. The Fed and ECB are and remain data dependent and as time passes the data will be irrefutable and so the dot plots and language will change.

Its interesting to note how little cross asset reaction the Fed meeting generated with bonds barely blinking across the curve – in fact the UST volatility index, the MOVE index, opened today at 111 – its lowest level in four months. The USD remains in a downtrend at 103-104 (DXY) and folks I respect a lot, like my former MS colleague & Chief FX Strategist, Stephen Jen, expect the USD to weaken materially from here. We agree & note that the spread btwn US and German 2 yr. yields has fallen from 225 bps to 175 bps in a matter of weeks, a trend we expect to continue as the ECB is likely to raise rates more than the Fed next year.

Credit is also widely considered to be the smart guy in the room insofar as economic risk is concerned and here too, barely a ripple in regards to Fed overtightening, making a mistake and causing recession… no visible worry about that whatsoever. We don’t worry about it either and continue to hold both US and EM HY positions.

Equities on the other hand do appear quite worried with the SPY down close to 6% from its recent high at the end of November with ACWX outperforming down only 4%. Europe, which has been the bell cow notwithstanding all the media angst about its recession, has pulled back as well but here one can say its healthy profit taking after a near 20% run up QTD.

Should equities be worried? We think not and note a few interesting tidbits from our reading this week; first Mike Mayo, Wells Fargo’s long time & well regarded US bank analyst came out saying its “showtime” for US banks which he sees as having 50% upside given the impact of high rates on their bottom line. Second, 95% of US energy stocks are now oversold – a level that has occurred roughly 20 times in the past 70 years and which has a very solid one year forward return history.

In addition, both Dr. Ed Yardeni and James Paulsen, Leuthold’s long time US strategist, have turned bullish with Paulsen saying a new US equity bull market has begun. Paulsen notes that 1st year of new bulls usually have 25-30% upside driven by multiple expansion as earnings are usually flat to down slightly – multiple expansion comes about as inflation ebbs and rates fall. Bloomberg notes consensus 2023 calls for roughly 3% EPS growth; his YE 2023 SPY target is 5k.

The technical picture suggests overhead supply around the 4100 SPY level suggesting that a true upside catalyst will be needed to break above that resistance – perhaps the Fed going on pause will be such. Non US stocks on the other hand are breaking out vs the US with Europe OPing the US by 10 percentage points in LC terms over the past year, Japanese IPOs are popping, Asian HY bonds are rallying sharply… are these the harbingers of global recession? Sure doesn’t look that way to us.

It’s a tricky time in what has been a very tricky and tough year for global investors of all stripes except maybe macro long short folks who have been in the performance doghouse for years so lets not begrudge them a turn on the podium.

It will be another 7 weeks or so before the next Fed meeting – a lot of water will pass under the bridge between now and then. We expect the Fed to downshift further to a 25 bp hike and at that point prep the markets for a pause which we expect to last a long time, perhaps thru YE. The bond market expects the Fed to be cutting rates next year – an expectation by the way that was not altered one iota by crochety Chair Powell.

We disagree with this outlook given our view that the US will avoid recession – we continue to struggle to see the catalyst for recession – especially calls for one to begin in the coming months. What will cause the US economy to go from 3% growth in Q4 to negative growth in the coming 3-6 months? We just don’t see it and instead expect falling inflation to boost real wages and  consumer sentiment thereby supporting our view of high nominal growth which in 2022 meant roughly 7-9% nominal GDP growth. Next year we expect it to mean roughly 5-7% nominal GDP growth broken out between 2-3% real growth and 2-3% inflation.

As such we disagree with those calling for bond rallies & sharp earnings declines/stock market falls based on a consensus recession view. Post the latest CB salvo earnings are next in line and perhaps contrary to one’s expectations US earnings revisions have been trending up, not down, perhaps bc dollar weakness helps US earnings. We remain of the view that 2023 will deliver a flattish SPY return coupled with a weak USD which will reinforce the nascent trend of non US equity OP led by both DM and EM equity markets.

This outlook coupled with our view of continued global growth and hence commodity upside remains the key drivers to our model portfolio positioning. On the commodity front we note this quote from Glencore’s CEO: “There’s a huge deficit coming in copper, and as much as people write about it, the price is not yet reflecting it”.

Pls enjoy today’s OETV video where we cover all the above. Next week’s Musings will be the last of the year.

Enjoy that Holiday shopping – seems like full shelves & lots of bargains this year!