Dandelion Seeds

This is a pretty tough spot to be in if your job is to make directional calls on equities.

Plainly, macro risks are skewed to the downside. And even if they weren’t, developed market central banks, blindsided as they were by the hottest inflation in 40 years, are bent on orchestrating a growth slowdown, in part because they’re compelled to answer for something (supply factor-driven inflation) that’s beyond their capacity to control. The only option they have is to force the demand side to pull double duty. Stephanie Kelton summed it up: “Deliberate. Coordinated. Global recession.”

The Bank of England is the poster child. They’ve hiked rates for six consecutive meetings, ostensibly to help moderate inflation, but their own projections call for a five-quarter recession, which suggests the economy doesn’t need any help when it comes to slower demand. At the same time, the expected rise in inflation (to 13%) is mostly attributable to energy, something rate hikes won’t fix. But hike the BoE must. “It’s our job to get inflation back down to 2%,” the bank said last week, in a forlorn August policy statement. “So we have raised interest rates.” Earlier this week, Christopher Dembik, Saxo Bank’s head of macro analysis, said the UK looks “more and more like an emerging market country.” All that’s missing, he remarked, is a currency crisis.

Things aren’t nearly as dire in other advanced economies, but deciding whether to jump aboard the summer rally train in equities is a hopelessly indeterminate endeavor. There’s a sense in which the rally wasn’t real in the first place — just a pain trade as “the under-positioned bearish masses” (as Nomura’s Charlie McElligott put it) chased a systematic bid higher, like children bounding after elusive dandelion seeds carried along by a summer breeze.

All that “bearish ‘kindling’ — along with grossed-up ‘shorts’ in both single-name and ETF / Index from Long-Short, Macro and CTA Trend funds, plus over-hedging in legacy downside options at the time — got badly burned on the spot rally,” McElligott said.

Now, CTAs are done covering in equities and bonds. Their nets are flat. Signals could flip outright long, but there’s a lot of focus now on vol control, and the potential for a mechanical move lower in trailing realized to dictate re-allocation flows.

Of course, a lot’s contingent on July’s inflation print. The big drop in consumer expectations in the latest vintage of The New York Fed’s survey was a welcome development, especially when considered in conjunction with last month’s cooler read on University of Michigan expectations and sharp declines in ISM price gauges (figure below).

Much of what you see in consumer expectations is the drop in gas prices. That’s a double-edged sword. If prices stay low, expectations are likely to hold lower too. If not, not. On Tuesday, reports of a sanctions-related disruption to Russian oil flows through the southern leg of the Druzhba pipeline were a reminder that the geopolitical risk premium could reassert itself at any time.

As for whether the same bearish positioning which was caught so woefully offside in July presages additional gains for equities assuming inflation does, in fact, show signs of peaking, the answer is ambiguous. So, it’s no answer at all. The figure on the left (below) shows Goldman’s aggregate positioning and sentiment indicator tends to bottom around equity troughs.

However, as the bank’s Cecilia Mariotti wrote, “a prolonged bear market such as the GFC has been characterized by several sharp reversals in positioning before a sustained rebound.”

“We are not convinced that we are past the ‘true’ trough in positioning just yet, as we think the path from here is likely to become more dependent on macroeconomic data,” Mariotti went on to say.

And therein lies the problem. The macro is maddeningly indeterminate right now, and while it’s a (fairly) safe bet that inflation has peaked, or is at least close to peaking, in advanced economies (sans the UK), suggesting it’s all going to “settle” anytime soon seems far-fetched.

With that in mind, I’ll quote Rabobank’s Michael Every who, in a characteristically colorful Tuesday note, lampooned a soundbite from a Bloomberg story about Chinese property debt. “Few imagined the Chinese Communist Party presiding over such a dramatic, sector-wide collapse,” Rebecca Choong Wilkins and Lulu Yilun Chen wrote, on the way to citing a local fixed income CIO who said, “No one could have predicted this. If someone tells you they predicted this, they’re a genius or lying through their teeth.”

Every had quite a bit of fun with that. “Yes, this week might see headline US CPI fall back in YoY terms, unleashing the latest bout of incorrect ‘transitory!’ calls and yes, 9% (10%, 13%, etc.) Western inflation might be near its peak [but] anyone thinking we quickly and effortlessly get back to 2% CPI from here to justify a 2.75% 10-year rate and higher stocks, is either a genius or lying to themselves through their teeth.”

He wasn’t done. “The structural problems we now face mean that 4% CPI might be the new 2% for a long time,” Every added. “Or the recession might be deeper than stocks can imagine. Or both.”

That brings us full circle. Good luck making a directional call on equities coming off a bear market rally in the middle of the most aggressive Fed tightening campaign since Volcker, with the 2s10s ~50bps inverted, with the economy in a technical recession and with inflation running so hot that an 8.6% headline CPI print would count as “cool.”

Goldman’s Mariotti did the best she could, bless her. “We think that investors should be wary of both upside and downside risks near-term,” she wrote. “Backtests of our indicator show that from bearish levels of positioning left-tail risks remain elevated (especially against a slowdown in activity) but investors are also likely to face higher right-tail risks in the short term.”