When the Levee Breaks
1,026 words – a 3 minute read.
Ok, I admit it – when I am at the gym I like to listen to classic rock - The Who, Zeppelin, Pearl Jam, Neil Young. So as I was on the bench press yesterday and When The Levee Breaks by Led Zeppelin came on I was pumped – up went the weight and even better than that I came away with the title and thrust of today’s Musings.
The lyrics that really resonated were: “Cryin wont help you, prayin wont do you no good, when the levee breaks, mama, you got to move”. Well, the inflation levee finally broke yesterday and investors need to move.
The crying & praying part we have already suffered through as inflation surprised to the upside 7 of the past 10 months leading the Fed to front load rate hikes and rates/USD to follow going higher and higher while stocks just kept on sliding. It left folks like us dazed & confused to throw another Zeppelin song into the mix.
Investors moved out of stocks to the point where cash allocations are at ATHs, equity allocations close to ATLs, risk appetites at record lows, put volumes at record highs (helps explain those 10% up moves in some of our model positions yesterday) all reflecting rock bottom sentiment and the worst year for 60-40 portfolios in history.
Well now that the inflation levee has broken and inflation has begun its long descent to lower levels (October’s core rate of 0.3% annualized =3.3%) it is worth considering how other relationships will change.
Macro volatility stabilizes and declines (VIX under 24, MOVE index already down 30% from 160 to 112).
Inflation rolls over, rates stabilize and decline, stocks should rally given that 5% terminal rate for FFR is already priced in. Thursday is likely to be the beginning not the end. CBOE reports 1.3 put-call ratio – only seen 2 other times since 1999 & widest since March 2008.
Rates fall and the USD follows (worst day for USD vs Yen in 24 years yesterday – CFTC shows massive short positions; worst overall day for USD since 2009, DXY under 107 & falling like a stone) as the cornering effect of collapsing risk appetites and subsequent demand for USD starts to unwind.
Commodities should be a big winner from USD weakness coupled with a BTE European energy outlook and China easing up on Zero Covid – as we highlighted in the Monthly, copper inventory levels are at ATLs – check out the copper – gold dynamic in the past few days.
As the USD falls the opportunity set for global investors expands beyond the USA to areas like Japan (FYE 3/23 EPS upgrades running 2:1 vs downgrades in Q3), Europe, EM that are at record low valuations vs the US as multiple markets break back above their 200dmav.
As inflation unwinds over the coming quarters the surprise could be that the growth line going up (Atlanta Fed Q4 GDP nowcast is at 4%) passes the inflation line going down – who would a thunk it? Our “Middle Way” is starting to look more feasible – even Goldman says there is a “very plausible” path to avoid US recession which it gives only a 35% chance of occurring.
As inflation unwinds and the Fed starts to cool its rate hiking jets, investors can start to focus on earnings which have already been cut back substantially.
No levee break by US consumer (BofA reports $1.1T remaining in Covid related savings) or corporates (75% of debt is LT and fixed – we have written at length about HY). JPM reports rising HY stars should total $160B by YE 2023, 3x the YTD level and quite the opposite of fallen angels.
As macro volatility ebbs & inflation rolls over the outlines of a more stable 2023 start to become visible as we have written about extensively.
A more stable 2023 could be assisted by three other macro points; first, the potential for some stabilization - ceasefire in the Ukraine – post Russia’s Kherson give up there is growing chatter of just that.
Second, Europe’s energy woes could continue to ebb (Dutch Nat gas BM price threatening 100 Euros vs peak of 360 a few months ago), reducing deep recession risk & helping to stabilize global growth. Note EU stocks up 15% P1M – best performing region in world.
The third potential key could be China’s gradual easing of its Zero Covid approach – again lots of talk and growing signs of much more micro targeted approach to Covid outbreaks. 20 such measures were just announced overnight. China pivots before the Fed? GS sees 20% upside.
There was a serious levee break in Crypto with FTX imploding in a matter of days – no contagion to traditional risk assets which is healthy. Our choice of Climate over Crypto continues to benefit our model portfolios.
One levee that didn’t break? The Democrats MT performance – as Pres. Biden defied history with best MT performance since the 1960s. The Red wave never showed; as the New Yorker noted: Trump’s tainted brand is magic to Republican base but toxic to everyone else resulting in Trump being seen as the election’s biggest loser (again).
With the inflation levee finally breaking the risk of a Fed that doesn’t know when to stop declines thus reducing the risk of a deep recession/earnings collapse that makes up the bear case for another leg down in equity markets.
As macro volatility eases, the bear case collapses & signs of stability appear the potential for seasonality, models and a more normal approach to risk assets becomes increasingly feasible.
When the levee breaks, mama, you got to move – sounds like the soundtrack for the masses of bearish investors out there. Move off the sidelines, move out of the USD, move into non US equity. Can’t wait to read about all the market timing folks who timed it perfectly & jumped back in Wednesday – yeah right.
Thankfully we here at TPW Advisory & our clients invested in our Model Portfolios don’t have to move at all – we are already there and welcome you with open arms.