“All-clear” isn’t quite right. In fact, it’s not right at all, really. A dizzying array of macro catalysts still threaten to undermine risk sentiment and thereby trigger a deeper equity swoon than that seen in September.
But, as discussed here briefly on Tuesday, positioning is no longer itself a major concern. And that’s close to an “all-clear” on at least one important front.
As we’ve seen time and again, positioning matters. When it tips over, crowded positioning can exacerbate price action, not itself a novel observation, but when viewed in the context of modern market structure, a conversation always worth having.
I’ve talked ad nauseam about vol control de-allocation. Note also that CTA exposure was pared dramatically over the past several weeks. On Nomura’s models, CTA net- and gross- exposures sit in just the 5th and 12th%iles, respectively, after getting “hammered in recent days and weeks,” as the bank’s Charlie McElligott put it Wednesday.
So, with positioning by itself “no longer an argument [for a selloff] in the absence of clear catalysts impacting the fundamental outlook,” to quote Deutsche Bank, what are the catalysts for an extension of recent equity weakness?
Well, if you ask Deutsche, one possibility is that concerns about growth might “shift from supply to demand.”
This is an ongoing debate. It’s obvious that supply constraints are holding back the US economy. That’s evident in, for example, PMI anecdotes. Eventually, though, higher prices beget demand destruction in the absence of evidence that regular people (i.e., everyday consumers) can afford to pay exorbitant prices. Demand destruction may be an underappreciated risk right now, as self-evident as this all seems.
“Growth indicators have stalled, but these have been attributed primarily to temporary supply constraints,” Deutsche’s Parag Thatte and Binky Chadha said, noting that “a further selloff will likely be prompted by concerns around the strength of demand.” Typically, growth peaks presage equity selloffs of approximately 8.5% (figure on the left below).
The paradox for rates, then, is that “higher inflation and energy prices actually help firm-up the long-end, as concerns are mounting that it will act to drag on consumption and growth,” McElligott said. “While conversely, the front-end is scrambling to pull forward potential hikes, as central banks are forced to play ‘catch-up’ and put the genie back in the bottle.”
On the right (in the figures above) is the S&P’s forward multiple. The current conjuncture needs no introduction, but just in case, Deutsche wrote that the “forward earnings multiple was at 19x prior to the pandemic, already the highest outside of the late-90s bubble, then it soared to 23x in May of last year.”
Chadha said that if earnings beats fall back to more normal levels, we could see “a quick return to the pre-pandemic multiple of 19x,” which would entail the S&P falling around -11% peak-to-trough.
Although I wouldn’t call that a particularly “nuanced” argument, that’s really the point, isn’t it? There’s certainly room for “this time is different arguments” in the post-pandemic world. Indeed, this time is different in too many ways to count. After all, we just witnessed a once-in-a-century global health crisis and the first depression in 100 years. Consumer psychology has been altered, certainly over the near- and medium-term, and maybe over the long run too. Tech companies are more embedded in our everyday lives than ever before, and they’re likely to keep churning out unfathomably large profits.
But, at a certain point, it’s helpful to step back and ask the simple questions, which often don’t entail extrapolating any kind of dour outcomes. As Deutsche noted, the pre-COVID multiple was the highest since the dot-com bubble. So it’s not as if a material derating would represent some kind of outlandish black swan that only exists in the minds of the most irascible bears and incorrigible pessimists. S&P 4,050, for example, would still represent an absurd 80% gain from the lows hit in March of 2020.
In any event, those are just a few fundamentals-based catalysts for a prospective continuation of recent equity weakness. The concern, obviously, is that fundamentals-based selloffs don’t generally happen in a vacuum. Sure, you might posit a disappointing earnings season and/or a kind of benign, gradual derating that takes the S&P into a technical correction. But more likely is a shock-down catalyst in the form of a deeper-than-expected Chinese economic downturn or something out of left field.