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Cheshire Cat’s Smile Redux: ‘Not Exactly A Party Cocktail’

And see, that's where the problem comes in.

For those of you with short memories or for anyone who, like me, spent too much of their life drowning the synapses in expensive scotch, it’s worth remembering that the last time the market got caught flat-footed by a super-hot average hourly earnings print was on February 2.

Let’s take a trip down memory lane. January payrolls came on the heels of a truly terrible week for balanced funds and risk parity, which were under pressure from a simultaneous selloff in stocks and bonds. Here are some fun excerpts from our jobs post on that fateful Friday:

Ok, well it’s time for the jobs report or, as I would have thought about it up until pancreatitis almost killed me in 2016, “the last data hurdle to clear before the drinking can start.”

Obviously, this comes at a rather delicate time, with stocks now taking their cues from the ongoing bond rout which has driven yields to near 2.80 and threatens to upend the equity rally that crescendoed last month with a truly absurd avalanche of inflows that seemed to signal retail euphoria.

Given that, the AHE print (which, given the focus on inflation, has been more important than the headline payrolls number for quite some time), will be even more closely watched than usual.

While there’s an argument to be made that considering the sheer rapidity with which yields have recently risen, it would take a lot in terms of a beat to really move the needle here, it’s possible that the market will read any strength as another reason to sell stocks and bonds simultaneously – especially in light of the “hawkish” Fed statement.

Minutes later, as the dollar rose and yields spiked, we said this:

If what you were looking for was an AHE beat on top of a headline payrolls beat from Friday’s jobs report, you got it and the knee-jerk is 10Y yields spiking with the dollar.

As noted, this is a risk for stocks. It’ll be interesting to see if equities manage to shake off the continued yield rise.

The rest of that day was indeed “interesting” and the next trading day (Monday, February 5), was a day that will live in market infamy. Liquidity evaporated at roughly 3:15 ET, and after the close, the short VIX ETPs imploded as the rebalance risk inherent in their structures was finally realized.

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“S&P 500 futures market depth dropped over 90% during the February selloff”, JPMorgan’s Marko Kolanovic later wrote, adding that “the sell-off was driven by a waterfall of selling flows from systematic strategies (Vol Targeting funds, CTAs, and dealers hedging short gamma exposures) triggered by the rising volatility and bond/equity correlation, and reversal in momentum, as well as fundamental investors who sold in anticipation of these flows and due to weakened sentiment.”

The setup for Friday’s hot AHE print (+0.4% MoM, +2.9% YoY) is different, but you should most assuredly not ignore it.

AHE

 (Bloomberg)

This time around, the risk isn’t so much a sudden spike in the stock/bond return correlation (although jitters about whether the tried-and-true strategy of depending on stocks and bonds to diversify one another have by no means gone away) or an unwind in leveraged and inverse VIX products (the rebalance risk was cleaned out in February), but rather the possibility that the Fed will see the latest wage data as further evidence to support the idea that the traditional late-cycle Phillips curve dynamics are again asserting themselves. Recall this from Deutsche Bank’s Aleksandar Kocic:

Through the last four cycles, Phillips curve has asserted its importance in an unorthodox way and, as such, attained a special status; it inhabits a space different from other macroeconomic frameworks and metrics. In each cycle, it falls apart, but after every annihilation, it re-composes itself and continues to play an important role. It appears “indestructible”, but not in a conventional way, more like a survivor of one’s own death. Phillips curve functions like an organ without a body, an equivalent of Cheshire cat’s smile (in Alice in Wonderland) that persists alone, even when the cat’s body is no longer present. This time is no different in our view. The figure shows the Philips curve through several cycles starting in mid-1980s. Each cycle has a different color which implicitly marks their beginning and end. The first thing one observes is that this is more of a “spaghetti” then a curve. The main reason is that it captures different cycles – a testimony to its falling apart and recomposing itself after each.

PhillipsCurve

When you throw in the fact that the proposed next round of tariffs on China would likely feed through to prices for consumer goods, you’re left with the impression that the Fed is likely to be particularly sensitive when it comes to nascent sings of inflation.

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But here’s the thing, if Goldman is correct to suggest that Jerome Powell’s Jackson Hole speech tipped an inclination to lean hawkish in light of the incoming data on the labor market, well then you’ve got a Fed that’s predisposed to being hawkish on both sides of the mandate.

Now, think about this week’s ISM manufacturing print which, you’re reminded, registered a 14-year high.

ISM

(Bloomberg)

In his latest missive documenting the disconnect between the ISM print and the Markit survey, SocGen’s Albert Edwards highlighted some commentary from Nordea. “As our friends at Nordea show, given the degree of monetary tightening to date, the 14–-year high in the ISM looks very odd indeed”, Albert said, referencing the following chart:

AENordea

(SocGen via Nordea)

Well on Friday, Nordea is out putting the pieces together on all of the above. To wit, from a note out Friday morning:

The ISM index jumped to a reading above 60, despite Trumpbulence, despite EM turmoil, despite a stronger USD and despite a flatter yield curve. Is it the Trump stimulus that is wreaking havoc with our view that the ISM index ought to drop? It is noteworthy that the gap between the ISM and the US Markit Manufacturing PMI jumped to the third largest reading on record. The Markit index is behaving a lot more like we would have expected the ISM to do.

GapISMMarkit.png

When the gap grew this big on 17 September, the ISM retraced 2 index points lower the following month. Will history rhyme again next month?

Who knows if “history will rhyme again next month”, but what we do know is that if it’s the ISM you’re going by, one of two things must be true. Here’s Nordea again:

  1. the S&P 500 index has some catching up to do or
  2. the equity market is viewing the recent ISM strength as a false signal and is already partly pricing in a setback down the road.

They quantify that first point. If what you’re going by is the ISM, the S&P should rise at least 25% YoY, which is “a strong bullish signal given the current 15-17% YoY performance of the index”, Nordea writes.

Nordea

(Nordea)

If somehow the ISM manages to remain above 60 through the end of 2018, well then “fair” value on the S&P would be 3,350 by December 31. Needless to say, that seems pretty far-fetched – even for the bulls among you. Here, again, is the S&P versus Wall Street year-end consensus:

TargetVsSXP

(Bloomberg)

So putting this all together, one wonders what the end result will be if ISM catches down to the Markit survey’s “reality” at the same time that wage growth continues to accelerate. Remember, employment costs rose in Q2 by the most in the current expansion (YoY).

ECI

(Bloomberg)

Here’s a fun set of charts posted this morning on Twitter by Nordea’s Andreas Steno Larsen that help to tie all of this together:

PartyNo

(Nordea)

No, “not exactly a party cocktail”. In fact, it’s a stagflation cocktail. While I realize it might seem absurd to say that at a time when the U.S. economy appears to be behaving like someone who just snorted that first line of blow at 8:30 PM, presaging a manic all-nighter, it’s probably more accurate to describe this situation like the last line of blow at 4:30 AM right before the nauseating crash.

And see, that’s where the problem comes in. When the effects of the stimulus start to wear off, you don’t want that to coincide with a Fed that’s been cornered into hawkishness by the restoration of the Phillips curve and the threat that tariffs-gone-wild are all set to drive up prices on consumer items.

With that, I’ll leave you with a couple of additional excerpts and another visual from the above-mentioned Aleksandar Kocic:

The Figure shows the post-2007 Philips curve with four quadrants corresponding to different economic regimes. As of mid-2016, the slope has turned from nearly zero to above 60 degrees as we crossed the NAIRU.

Cheshire

If we enter the goldilocks region (upper left corner) too fast, the Fed could be caught behind the curve and might be forced to hike aggressively which could have a negative impact on growth while leaving only inflation behind.

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