Where There's Smoke There's Fire

1607 words – a 4 minute read.

Given how apocalyptic the NYC skyline looked Wednesday morning it seemed only fitting to use the title above in my comments on BTV’s The Open show later that morning. https://www.youtube.com/watch?v=fzk1yVQwhrM

However, I wasn’t referring solely to the Canadian forest fires burning well north of us and the resulting smoke over NYC which was something I had only witnessed in Delhi or Beijing. Thankfully, the smoke has cleared out of NYC joined perhaps by our famed Curtain of FUD (Fear, Uncertainty & Doubt). 

No, the title also works as a comment on current market conditions as well. This is especially the case relative to our rotation call made roughly a month ago (from Big Tech to Cyclicals & from US to Non US equity leadership). Here there clearly is both smoke and fire.

It’s obvious from the charts; we held our model portfolio meeting this week and as usual, we reviewed the charts on all holdings, all relevant indices and all potential adds. The takeaway: more and more ETFs are breaking up and out as we wrote last month. 

Tech has led but over the past week or two we have seen small caps break above their 200dmav (IJR); transports have joined them as the US truckload spot market saw a 14% jump M/M in May (IYT) while homebuilders continue to power ahead, setting new 52 week highs (XHB). Catch up potential is large: huge valuation gaps exist for example between large caps trading at roughly 19x PE and SC’s trading at 13x.

We expect next week’s Fed meeting to mark a watershed, not just for the pause in rate hikes we expect (a pause that will become permanent as y/y inflation falls under 4% by mid July). More important than the rate decision is the update of the Fed’s economic forecasts where we expect it to raise its 2023 and 2024 GDP estimates.

We expect this update to in turn put paid to near term recession fears, especially as Bloomberg’s US Economic Surprise index continues to power ahead. As that shibboleth is finally put to bed, we expect the bears to throw in the towel and allocate some of the massive amounts of cash on the sidelines (one of the worst performing assets YTD) back to equities & credit.

Arguably its already happening (the smoke) with the rotation noted above, broadening out the stock market advance as the S&P breaks out and UP first thru 4200 and now thru 4300 to levels 20% above the October lows – thus the new bull market calls.  Focus forward: as JPM notes, in the last 11 bear markets, after stocks rallied back 20%, the S&P was up on average another +22% over the next year.

This is all according to plan for us here at TPW Advisory. What’s interesting to us now is the room to go higher shown on many of the charts we looked at. Big tech, which got overbought and needs a rest, is still well below its ATHs. The S&P is likewise roughly 10% below its ATH… many of the Cyclical sectors are cheap, under owned and have lots of room to catch up & move higher over time alongside the economy and earnings. We note the S&P Global Composite PMI hit an 18 month high in May.

That’s all before we get to things like Future Tech or Climate related ETFs. We have exposure to both in our TPW 20 thematic model as well as smaller slices in our Global Multi Asset (GMA) model. Many of these holdings had huge 2020 Covid run ups before selling off in 2021 with the Fed rate hike cycle serving as the knock out blow – taking them down to their lows roughly a year ago. Talk about markets as forward looking, discounting machines – most effectively bottomed within months of the 1st hike, even as rate hikes continued for another year.

Many of our holdings in these spaces have thus been trading sideways for the past year and are just now breaking above their 200dmav. There is loads of room to continue higher – just look at 2 yr. or 5 yr. charts. ARKG, for example, went from $34 in 2018 to $110 in 2020 and is back to $34 today; it just broke above its 200dmav for the first time since July 2021. The difference to focus on is that its 5 years later and the companies making up the ETF have been through the fire.

ARKF is another example; its back to pre Covid levels as well. It is up roughly 40% ytd but only 8% over the past year. Coinbase is one of its top holdings – it has been hammered this week due to SEC action against it, yet ARKF continues to power ahead. The strength is impressive.

Zooming out a bit, our view remains: Fed on hold = USD weakness = ROW equity, Climate and Commodity OP. Where there’s smoke…ACWI just hit a new 52 week high. Europe was the rabbit; a look at the charts suggests its recent healthy pullback is complete – recession news or not. Now Japan is leading the way, up 15% or so YTD; as we wrote in: Birth Of The New  the end of YCC lies ahead and should stimulate massive domestic reallocation into equity.  Japan remains one of our big OWs.

What’s coming next could be a good EM equity run. EEM, like many, is roughly flat over the past year, notwithstanding China’s big 2022 YE run up and subsequent roll over. Here the fire is coming from Lat Am with both Mexico and Brazil up sharply ytd. Mexico is the world’s winner from the regionalization of supply chains, especially EV and semi fab plants setting up shop in the Americas… we have been and remain OW EWW.

Here is what JPM just had to say on the case for EM equity: “The fundamental and positioning drivers for EM equities remain solid driven by EM/DM relative growth acceleration into 2023 and 2024, room for EM to cut policy rates ahead of the Fed, massive under positioning of global investors to EM equities (6% current vs. 11% neutral on MSCI ACWI), and favorable EM/ DM equity valuation gap”. StoneX notes that stripping out Turkey and a few others EM inflation is running at 2% vs 6% for DM, suggesting plenty of room for EM led rate cuts while GaveKal highlights China’s M2 is running at twice that of GDP suggesting plenty of liquidity for stocks to move higher in the 2nd H.

Brazil’s equity market consists primarily of financials and commodities – neither of which has been in favor this year yet EWZ is up roughly 20% ytd. Why? Because Brazil is likely to be among the first EM’s to cut rates. A Fed on hold signals to the ROW that its ok to begin the rate cutting cycle which will drive cross asset pricing over the coming year. Oxford Economics forecasts that Brazil will cut rates later this Fall and expects 400 bp of rate cuts in 2024 as ST (SELIC) rates remain above 12% while inflation is roughly 5%. 

Where the smoke has not produced the fire is in two areas; the first, inflation worries in the US with 5 yr. inflation breakevens at roughly 2%, down from over 3.5% a year ago. The NY Fed’s 5 year inflation expectation consumer surveys shows a similar decline to under 3%. As the Monthly notes, our high nominal growth view suggests that inflation will settle in the 2-3% range and the Fed and other DM CB’s will be fine with that given the new industrial policy, Govt debt and deficit levels etc. Commodities should also benefit – we note COPX has just reclaimed its 200dmav – now if only oil could catch a bid.

The 2nd area is Climate related ETFs which even when Climate is the top US story (now swept off the front page by news of former Pres Trump’s 2nd indictment in as many months – so much winning) still can’t really catch a bid. This is quite frustrating – the stage is set as many of the charts display the same characteristics noted above but it seems like Climate plays have yet to find a stable buyer base and as such have been viewed as beta plays. Well, in a new bull market that should be a good place to be. 

More importantly from our POV are two factors: the first being the visible roll out of IRA climate related spending, the EV explosion etc. The second is the return to stability highlighted by a VIX under 15 and a MOVE index under 120. All Star Charts notes that last Friday was the first VIX reading under 15 in 835 trading days, dating back to February 2020, pre Covid. This is very much in line with our chart analysis noted above.

Now that we have moved past Covid, its inflation spike and subsequent rate hike cycle to approach the stability forecasted in our 2023 Outlook Stability Ahead we expect Climate to start drawing investor interest because there is certainly fire going on in terms of renewable power coming on line, new battery plant development, EV take up etc. etc. 

We covered much of this and more in an engaging 90 minute discussion with Antonio Atanasov of Resource Talks on Monday… enjoy the show. https://www.youtube.com/watch?v=UE1paKDsWjA

For those new to TPW Advisory (and we do have a bunch of newbies – welcome) this is a good walk thru of our origin story, framework and current investment thinking.