You could make a fairly long list of compelling reasons to distrust the rally in US equities.
Earnings wouldn’t be on that list. Not yet, anyway. So far, with more than half of S&P 500 companies reporting, dire predictions about margins, profits and guidance haven’t materialized.
Generally speaking, stock prices are a function of profits and rates. If earnings don’t play along with the recession story but bond yields do, that’s a recipe for counter-trend rallies, especially when benchmark indexes are dominated by long-duration growth stocks with massive revenue and earnings power.
So, why not “go with it,” so to speak? Well, from a fundamental perspective, the economy is decelerating and the American consumer, “resilient” or not, isn’t enamored with generationally high inflation and deeply negative real wage growth.
At this juncture, defending margins is almost purely a function of corporates’ ability to offset lower volumes and higher costs by raising prices to irritated consumers who, when they’re not frowning at higher prices in the grocery aisles, are on the clock, stocking those same shelves. That’s a problem for a number of reasons, not least of which is that it’s conducive to the dreaded wage-price spiral — just ask Q2’s scorching hot employment cost index.
For now, it looks like retailers will absorb the hit through discounts on consumer goods. Eventually, though, services spending could wane too, unless inflation recedes. You’re reminded that leisure and hospitality is where wage growth is running the hottest, so if spending decelerates there, the risk of profit erosion is particularly high.
Beyond the fundamentals (because when have those ever mattered?), recent gains for stocks were in no small part attributable to short covering of one sort or another. “Equities flows continue to be largely technical in nature, which for some reason almost adds to the consternation of feeling ‘left behind’ on this rally,” Nomura’s Charlie McElligott said, noting “more of the same” vis-à-vis “buying from systematics [and] Net $Delta being added in the options space,” as puts are sold and closed.
On the bank’s model, CTA signals for global equity benchmarks are either long or much less short than they were a month ago. The figure (below) gives you a sense of how systematic covering may have worked to accelerate rallies in stocks and bonds.
Going forward, vol control could take the systematic baton for equities as three-month realized (still perched in the 90%ile on a one-year lookback) catches down to trailing one-month (which has collapsed to just 57%ile).
Notwithstanding the potential for a material re-allocation from the vol control universe (contingent, of course, on a relatively well-behaved distribution of daily outcomes), you could argue that the impulse from systematic flows will abate. At the least, you might suggest a rally juiced by mechanical flows is a rally built on a shaky foundation, especially given the sheer number of prospective macro “shock-down” catalysts just waiting to “realize” — spot is one adverse Nord Stream headline away from gapping lower, which could destabilize newly comfortable long dealer gamma positioning, for example.
But perhaps the most compelling reason to distrust the rally is that it’s unpalatable for a Fed desperate to preserve gains made on the road to tighter financial conditions. I discussed this at length in “Jokes On Jay,” a piece Bloomberg predictably xeroxed less than 24 hours later. Katherine Greifeld’s reliably capable pen rescued their version from being a pitiable (not to mention expensive) facsimile.
“A dynamic in which surging stocks complicate the goal of subduing inflation is one reason giant rallies are rare in times of tightening,” Greifeld wrote. “While the Fed may be ambivalent about equities in general, the role of markets in mediating a real-world economic lever — financial conditions — means they are never completely out of mind.”
That’s where the problem is for bulls. The Fed doesn’t want this rally. The two-day gain for US shares on Wednesday and Thursday (i.e., the FOMC rally) was among the largest ever. The figure (below) provides some context.
Again, that’s counterproductive. Among the last things the Fed needs is a rekindled wealth effect through the equities channel.
“I think most would agree that the FOMC probably isn’t loving the market’s post-meeting response,” McElligott remarked. “It simply makes their job of taming inflation that much more challenging via the risk of resumed ‘animal spirits’ and looser financial conditions.”
In his latest, BofA’s Michael Hartnett called optimistic views about the Fed being “done by Thanksgiving” premature. “A neutral fed funds by definition is not a ‘tight’ fed funds,” he said. “Big stock rallies are unlikely to encourage a Fed pause.”
Hartnett cited a chart he uses often: The ratio of US private sector financial assets to GDP (figure above). The parabolic ascent observed in the wake of pandemic stimulus appears, in hindsight, as an inflationary bridge too far, paired, as it inadvertently was, with the sudden demise of myriad disinflationary dynamics which enabled monetary largesse over the past dozen years.
Should the rally extend — Hartnett suggested 4,400 on the S&P would discourage a Fed pause — look for officials to use speaking engagements (and television cameos) to push back against any perceived FCI easing “overshoots” between now and the September FOMC meeting.
That’s the biggest rally impediment. Buying now is tantamount to fighting the Fed. “Nice rally you got there. Shame if something happened to it.”