Ok, What Now? Wall Street Looks Around And Ahead

It’s “Ok, what now?” time. Both for equities and the economy.

The summer stock rally stalled amid options-related flows and ahead of Jackson Hole, where Jerome Powell will presumably say something meaningful, although it’s not clear what.

It was notable that the S&P’s efforts to climb out of 2022’s bear market were frustrated at the 200-day moving average (figure below). I’m not much for “magic” lines, but as former Lehman trader Mark Cudmore put it, “if we do fall back now, you’ll see lots of armchair commentators get excited by that, creating a self-feeding bearish narrative.”

There’s a summer beach joke in there somewhere — something about a “line in the sand.” I can’t make it work, though. It feels too obvious.

Speaking of obvious, everyone knows the risks. They’re well socialized. Earnings revisions are bound to turn lower. The trajectory of Fed policy could be more hawkish than traders expect. The US consumer could falter. Stimulus in China could be too little, too late. And so on.

Even the black swans aren’t black swans anymore. Would anyone really be that surprised if Russia cut all gas flows to Europe, for example? How bad would August’s CPI report in the US have to be to constitute a true “shock”? Pretty damn bad, if you’ll forgive the casual cadence.

The biggest and most underappreciated risk is probably prolonged inflation. So, inflation that moves down to, say, 4.5% in advanced economies and then just sits there. Even that, though, isn’t properly “underappreciated.” There’s always been something paradoxical about BofA’s “biggest tail risk” list (figure on the left, below). The more people who identify something as a tail risk, the less of a “tail risk” it is, almost by definition.

Note in the figure on the right (above) that a full-on meltdown in the Chinese property sector is seen as the most likely source of a credit event. And “systemic credit event” held onto the fourth spot on the tail risk list.

It’s conceivable that authorities in Beijing will finally fall off the tightrope they’ve successfully walked for as long as I can remember — that it’s no longer possible for the Party to juggle every competing priority without at least one ball hitting the floor. I’m just tossing that out there, so it can drift away into a hot summer evening.

As you ponder an exceptionally uncertain future, I thought it might be useful to present a compendium of recent quotes from analysts. Readers hear enough from me, after all. While I certainly intersperse plenty of voices during any given week, I’m not famous for brevity in my own musings, and my editorial voice can be overbearing.

Below, find a compilation of opinions and musings about the outlook for markets, the economy and geopolitics from a handful of the folks I read every week. Some of the excerpted passages are poignant, some are colorful, some are analytical and some are all three.

The near-consensus buy in to the “past peak inflation” story is at risk of being caught flat-footed by ongoing “fits and starts” of structural supply-side inflation issues, which cannot be solved by central bank policy, despite the comfort which has been provided locally by the recent roll-over in Commodities / Goods, as well as forward survey data. Simply put, inflation is not going to roll over in a smooth, linear fashion, and likely stays “sticky higher” above target, keeping central banks in the uncomfortable “restrictive for longer” territory. And bigger picture, this is another reminder that even a seemingly idiosyncratic or isolated situation (UK inflation Wednesday, Thursday’s German PPI) can elicit a butterfly effect: Flapping its wings locally, but risk causing a chaotic “tornado” outcome elsewhere, in a future state. — Charlie McElligott, Nomura

We are often asked about the overall market multiple and how it can justify further market upside. While we ultimately believe positioning is a more important variable than multiples (multiples being a reconciliation factor between earnings and positioning) — we agree that it doesn’t make sense to chase some of the large cap tech stocks or ‘recession proof’ stocks trading near all-time highs. However, on the same argument of valuation there are market segments such as energy trading at mid-single digit P/Es (below recession multiples), and even some broad markets such as the S&P 600 small cap index trading at recession level multiples. We remain of the view that the 2020s will look nothing like the 2010s, and many of the investment trends — be it in commodity, tech, ESG, or low vol investing — will be turned upside down. — Marko Kolanovic, JPMorgan

It’s compelling… to suggest that one of the enduring fallouts from the pandemic is structurally higher inflation that would require higher long-dated yields in the form of an inflation premium. It’s an open debate and one that this year’s Jackson Hole Fed conference would offer an ideal forum to further explore. Suffice it to say, if the Fed suggests a revisit of the potential for structurally higher inflation and/or studying the appropriateness of its 2% inflation target, that would make a strong case for shifting to a core short Treasury bias with a steepening undertone. Alas, this is an unlikely message to come from Wyoming and, if anything, we’d expect Powell & Co. to reinforce the necessity of containing forward inflation expectations and ensuring consumers have confidence in the central bank’s commitment to price stability over the long-run. — Ian Lyngen, Ben Jeffery, BMO

The best approach is for the FOMC to remain on message with its forecast until that forecast changes. Failure to do so allows the market to run wild with its own imagination. The central bank has spent the past three weeks trying to reel the market back from the dovish pivot speculation. It is clear that markets have yet to feel the full effect of tightening, otherwise Bed Bath & Beyond would not be the most active name in the stock market this week. The economy and the financial markets will still have to grapple with the headwinds of recent and future tightening. Instead, they have already fast forwarded to the next easing cycle. With the notable exception of Chairman Powell, there have been material attempts by Fed officials to drive home the policy message, but they have been unsuccessful. It is Powell’s time to lead. When the time is right to pivot, then pivot, but in the meantime greater risks are being nurtured by Powell’s absent assertiveness. Markets will embrace the good news when its appropriate, but by letting mixed messages grow, the Fed is making the same mistake of the 1970’s Fed. — Mike O’Rourke, JonesTrading

Having done this job for 40 years now, it takes a lot to shock me these days, but the latest Chinese data showing youth unemployment hitting 20% did! The Chinese youth unemployment data threatens the very social stability that has always been the number 1 priority for the ruling Communist Party. My late mother used to say “the devil makes work for idle hands” — a phrase which apparently has been around at least since the famous English author Chaucer used it in 1405. The unemployment situation has been made much worse by the vigor with which the Chinese authorities have pursued a zero COVID policy. — Albert Edwards, SocGen

Things are really happening, and fast. And the West is really in deep trouble on many fronts — many self-inflicted. Frivolity has been the order of the day for far too long. Yet if coloring in countries on maps was the key to success then the Soviets would have won the Cold War. Making geographical connections work economically is the key. As covered in ‘Why Bretton Woods 3 Won’t Work,’ the countries lining up to forge an [alliance] are largely large, sparsely populated places that sell the same stuff. Turkmenistan can export gas to Kazakhstan, which can export gas back in return: Both can export gas to Russia, in exchange for more gas. Only China stands out as a producer of things — and yet it still relies on Western markets to prop up its own economy and currency, given it has too little demand and far too much supply. — Michael Every, Rabobank

Less pricing power + higher wages = corporate misery. Our Corporate Misery Indicator, a macro gauge of profits, just deteriorated. In it we use CPI as a proxy for pricing power, average hourly earnings as a proxy for cost pressure and the coincident indicators as a proxy for unit volume sales or demand. All three measures moved the wrong way last month. Lower oil/gas may represent a temporary reprieve on consumers’ wallets, but food and rent remain sticky and high. Beneath the surface, real growth remains weak, and investors’ laser focus on the Fed combating inflation via short rates ignores QT, the elephant in the room. — Savita Subramanian, BofA

What will be the driver of the next leg lower in earnings expectations? We think it’s margins. As we wrote about last week, margin expectations for the out quarters/2023 appear overly optimistic as cost pressures remain sticky and demand slows. While many focused on the impact of the recent jobs and CPI prints from a Fed policy standpoint, we came away with some fundamental takeaways as well. The combination of sustained, higher wage costs and slowing end market/consumer pricing loudly signals margin pressure. This dynamic is at odds with bottom-up consensus, which is still calling for all-time high operating margins next year. We’re skeptical. — Mike Wilson, Morgan Stanley