The “big low” isn’t in.
That’s the overarching (and all too familiar) message from one of the sell-side’s most recognizable names.
At times this week, you could spot a faint glimmer, barely perceptible through an enveloping fog of recessionary gloom. It was still there on Friday, but disconcerting reports from Snap and Seagate, along with a big post-earnings drop for Verizon, once again suggested market participants might be squinting at an oncoming train, not the light at tunnel’s end.
Most bears are waiting for a tsunami of earnings misses, guidedowns and revisions to call the bottom in US shares. For BofA’s Michael Hartnett, the “big low” requires policy panic, which won’t come before a negative US payrolls print, a credit event, or both.
“Putin/China catalysts will be less bearish in the second half, but a bull run needs peak CPI, peak yields and the Fed done by 2023,” Hartnett wrote, in the latest installment of his popular weekly “Flow Show” series. Despite market pricing for the commencement of rate cuts as early as next summer, inflation realities make an outright dovish pivot “unlikely without a big recession and/or a big credit event,” he added.
Of course, Fed hiking cycles always end in some kind of “event.” This one won’t be any different. Especially considering the aggressive nature of the Committee’s posturing in the face of an inflation impulse that’s more “crisis” than “problem.”
But that only begs the question. For a market event to supersede the inflation fight in the Fed’s decision calculus, that event would have to pose a greater threat than that associated with unanchored long-term inflation expectations. That’s a very high bar. After all, “unanchored long-term inflation expectations” is just an academic euphemism for the Fed’s credibility. Emerging market capital flight, mini-tantrums in rates, stock swoons and myriad other side effects commonly associated with Fed tightening campaigns, all pale in comparison to the primacy of preserving whatever’s left of the institution’s credibility as a check on domestic price growth.
“I see almost zero scope whatsoever for the historically-conditioned equities investor definition of ‘dovish pivot,'” Nomura’s Charlie McElligott said, suggesting that if market participants expect the Fed to cut rates or expand the balance sheet in 2023, they may be disappointed. A return to anything like 2% inflation in the near-, or even medium-, term is highly unlikely.
One problem — and McElligott, among others, has mentioned this before — is that inflation isn’t a “random walk.” It trends. If it’s higher this month, it’s likely to rise again next month. Needless to say, the current trend isn’t anyone’s friend. A quick look at the Cleveland Fed’s inflation nowcast shows July CPI tracking at 8.9% YoY, a trivial decline versus June’s headline print (figure below).
But the real problem is the monthly projections, which suggest headline and core are on track to rise 0.33% and 0.5% from June, respectively. Those figures represent MoM improvement, but they’re wholly insufficient to cajole inflation low enough, fast enough, to justify any kind of overtly dovish pivot in the traditional (i.e., post-Lehman) sense.
“Think about the impact that the Fed signaling a ‘pause’ would have on the housing industry, where buyers would immediately rush back into the market… likely driv[ing] home prices back up,” McElligott went on to remark. And that’s to say nothing of equities and credit which, as he correctly pointed out, “would obviously… try to jump the gun and surge higher on any Fed signaling of an ‘end to tightening.'”
Those are unacceptable outcomes for policymakers attempting to preserve a durable (if not totally destructive) tightening impulse in order to keep demand in check and do their part to lean against price growth. The last thing the Fed needs is a “sudden gap easier in financial conditions,” Charlie said.
So, again, we’re left to ponder Hartnett’s contention that the “big low” for stocks can only come about as a result of a clear policy panic from the Fed which, in turn, requires an honest-to-goodness recession in the US, some manner of domestic credit event with contagion potential or an outright meltdown in emerging markets with enough “boomerang” risk to given Jerome Powell plausible deniability for a pivot, inflation or no inflation.
Hartnett rekindled the “three Ps”: Positioning, Profits and Policy. Positioning is “the closest to [giving] the green light” for a new bull trend, but Profits and Policy aren’t close, he said. The figure on the right (below), shows fund managers still expect higher short-end rates, while clients’ equity allocation remains well above that observed during prior crises.
The figure on the left (above), suggests global equity fund flows are finally beginning to catch down to fund manager sentiment, but there’s a lot of ground to cover before the tidal wave of inflows seen post-pandemic recedes enough for the flows picture to mirror the anecdotal “capitulation” reflected in BofA’s poll of the folks who do this for a living.
For Hartnett, it’s unlikely that Wall Street will “unwind the financial excesses of the past 13 years with a six-month, garden variety bear market.”
It’s hard to argue with that assessment. Then again, pervasive pessimism is almost always a contrarian indicator. As Hartnett put it, channeling an archetypal trader, “Only time you’ve ever seen this level of pessimism and not made money being contrarian long was Lehman.”
The economy seems to be slowing faster than most strategists have contemplated. If that continues you can expect a Fed pivot early next year. End of Q/T and some modest rate cuts look like a base case. And you may only have July and September for increases. When inflation unwinds due to slower growth it unwinds very quickly…..
So your position is that the rate hikes are transitory, LOL
(For the record, I agree.) Core inflation was abive 8% when the Fed finally eased off the accelerator, it’s going to take some time for the cruise ship to slow down. If the Fed brakes too hard, (which it appears they’re going to do) they’re going to find out that the deck chairs weren’t bolted down (deck chain this analogy is the housing market)
Walt, this was a wonderful blend of Charlie M. and Hartnett, my 2 favorites. Delicious stuff !
That Cleveland Fed nowcast number is ugly. Still think we could see 75bps hikes in July and September.
Multiple questions to ponder.
What will make equities bottom.
When to start front-running.
What to do while waiting.
#1 is the issue addressed in this post. It is a cause & catalyst question, is how I’d think of it. I don’t know that it makes sense to try to point-estimate “when”, just having a correct view on “what” will be hard enough.
#2 is more of a valuation question, in my mind. You start front running when the loss you’ll suffer (from being too early, because you don’t know “when” in #1) looks tolerable to you but not to most (when everyone is front-running, no-one is). We’ve talked about valuation at length.
#3 is my focus right now. We might wait for 2 months or for 12 months (there are tail cases too). Two months, cool, enjoy your summer. Twelve months, really should try to do better than nothing.
Trying to do better than “nothing” probably entails a significant risk of a negative return at this point. You’ve made a good case for SP500 at or below 3000. Just wait for it.
I can’t tell you when there will be a bottom, but I will stick my neck out and say that I will be surprised if the market sails smoothly through the next five months to year-end. There’s an election, BA.5 is only two-weeks into its reign of terror in China, Europe and especially Germany will be tested with respect to gas supply going into the winter, and we can’t predict what will happen in Ukraine.
I’m not thinking so much of buying equities here.
Though I think some specific stocks are nibble-worthy here, swimming against the tide is tough.
But I’ve thought at some point, the time to buy fixed income would come. The more bearish one is about the economy, the more interesting duration looks.
I’m putting most of my income slated for reinvestment in fixed income CEFs, maybe half of that in muni-CEFs. Prices are down so these are cheap and yields on new stuff are rising. Stocks? Nobody knows anything.
The time to buy was last week. Yields on the 10yr fell 25bps this week, with a big move down on Friday. With the eurozone and EM markets on the verge of implosion, the flight-to-safety trade may overwhelm efforts by the Fed to get rates up across the board. The question is, how low can the yield on the 10yr go with a 125bps increase in the Fed Funds rate pretty much baked in? And how low can it go in an all-bubbles-burst (incl. eurozone, Japan, China credit) scenario?
It seems we’re at a stage where people think that peak inflation will mean peak rates, and that positioning is already too pessimistic.
There’s little scope in the short term for a hawkish surprise, so I’m thinking the S&P rallies to about 4,500 until September. At that time folks will realize that Powell must continue tightening continuously until inflation goes well below 2%. Only then we get a 2018-style spasm with a symbolic backstop from the central bank.
But rates will need to remain high for a couple of years for inflation to go back to normal, so equities will have a pretty bad Sharpe ratio for long enough that everyone, including pension funds, will throw in the towel.
Somehow we’ll get back to P/E ratios of 12 in 5 years.
In the current environment there are two forces working to bring down inflation – central bank tightening and the world’s productive capacity. Filling gaps in the supply chain will go a long way to bringing down inflation. If we can muddle along long enough without manufacturing a deep recession, supply will catch up with demand. Time is on our side. Meanwhile, I’ll continue trading and keep some dry powder close at hand.