Goldilocks And Other Summer Stories

There’s talk of an autumn “reaping” following a summer stock rally which, depending on who you ask and what day it is, was either a “classic” bear market bounce or evidence of investor irrationality in the face of the most aggressive Fed tightening campaign since Volcker.

In reality, of course, the rally was a squeeze perpetuated by familiar, self-feeding dynamics, as systematic cohorts re-leveraged and re-allocated with the trend and receding volatility, forcing under-positioned funds to chase the market higher. No more, no less.

There was indeed a touch of the speculative fever that overheated markets in the post-pandemic era. Meme stocks were “back” for the umpteenth time. How many times does something have to “come back” before it’s more accurate to say it never left in the first place?

The Fed could certainly do without the kind of activity “informed” by the “you only live once” mantra retail traders so proudly espouse. But there’s something ridiculous about the notion that a contingent of market participants with no qualms about the equity of bankrupt (or nearly bankrupt) companies, cares about the Fed’s destination. If someone is hell-bent on throwing money at a left-for-dead retailer because of “nostalgia” for an era they’re too young to actually remember or, more likely, something they read on Reddit, they’re not going to be dissuaded by today’s terminal rate pricing. Something like this: “Well, I was going to buy some calls on that mall-based chain store that sold the best latex Halloween masks in 1995, but it looks like STIRs are leaning more Kashkari and less Daly today, so I’m gonna take a wait-and-see approach for now.”

In any event, my view (and I reiterated this at regular intervals early last year, when I begrudgingly dedicated coverage to the GameStop saga) is that the meme stock phenomenon isn’t going away entirely, no matter what the Fed does. The only way to stamp it out is to crack down on online message boards or curtail inexperienced market participants’ access to options. I’m a big believer in benign paternalism where appropriate, but that’s a bridge too far even for me. If people are determined to lose money legally, they’ll do it, and it’s far from obvious that the government should prevent it from happening in this case. By contrast, the casinos of Web3 arguably aren’t legal, and that’s where regulators should probably focus their attention. The “de-gamification” of stock and option trading isn’t going to stop inexperienced investors from speculating. What regulators could do, though, is stop DeFi protocols from perpetuating what some critics view as Ponzi schemes and prosecute the sale of what many argue are unlicensed securities.

I do think there’s an element of collusion to some of the Reddit trades, by the way. When taken too far, that sort of thing can distort the price formation mechanism and forestall creative destruction by allowing enterprises which aren’t viable to retain access to capital markets. But ultimately, it’s self-correcting. All the Reddit traders in the world don’t have enough capital between them to change the long-term fortunes of a failing enterprise. They can engineer gamma squeezes, and they may be able to delay the inevitable by, for example, opening the door to secondaries and indirectly propping up prices for outstanding debt, but most of the companies swept up in the meme trade are destined for some kind of insolvency.

“While history shows Northern Hemisphere autumns are when many rallies die, history has never been faced with retail day traders who are capable of driving rallies in nearly insolvent stocks or pushing the S&P 500 up 9% in a month when the Fed is tightening,” Bloomberg’s Vildana Hajric and Lu Wang wrote, in a Friday piece called “Rowdy Summer Stock Bulls Catching the Scent of an Autumn Reaping.” I assume this is obvious, but “retail day traders” weren’t responsible for the summer rally in US benchmarks. Systematic re-leveraging and short covering was, something Wang surely knows given that just seven hours before “Rowdy Summer,” he published an article called “Massive Short Squeeze Behind Stock Rally Showing Signs of Ending.”

That’s me donning my media critic hat. Bloomberg’s coverage is as good as can reasonably be expected, and both of those linked pieces are worth the five minutes it’d take you to skim them if you’re inclined. One good takeaway from the first is just that seasonality may be irrelevant. This isn’t about whether there are enough dedicated day traders to keep the benchmarks afloat, and although systematic flows will continue to play a role, the next few months will ultimately be about whether inflation continues to abate and monthly payrolls are amenable to a “Goldilocks” interpretation, where that means headline NFP prints and accompanying average hourly earnings figures are robust without being too hot for comfort.

For me, that really is the key for the balance of 2022. Barring a rapid deterioration in the economy, the Fed will probably deliver 100bps of additional hikes, 50 next month and 25 in November and December. I’d lean towards 50 in December were it not for i) the distinct possibility that headline inflation will be materially lower by then, ii) QT will be biting in earnest, whatever that entails, and iii) activity indicators, both “hard” and “soft,” will betray an uneven economy that’s one exogenous shock and/or one Fed “shove” from a real recession, as distinct from the “technical” recession the US is already in.

If the glide path for inflation is lower through year-end and monthly net job gains are accompanied by above-average, but not scorching, wage growth, it’s conceivable that the inflation-adjusted wage math could become more favorable, especially for those in occupations where pay growth is brisk. Most of those occupations are at the low-end of the pay scale, and those workers tend to have a higher marginal propensity to consume. That consumption could support the broader economy without perpetuating a wage-price spiral. Having the capacity to afford name brand milk again, and the financial headroom to replace an old set of bath towels and buy the kids new backpacks for school, isn’t the same as rushing out to buy new gadgets and a third sofa.

Gauges of input costs, both anecdotal and otherwise, for US firms are falling, and as I’ve tried to emphasize previously, management doesn’t necessarily want to raise prices to consumers. Pricing power is great, but ideally, the economy can find an equilibrium where inflation moderates such that everyone in the equation can call a truce, if you will. Lower prices for gas and food could support the kind of healthy discretionary spending necessary to keep the economy afloat and prevent margin erosion. Faced with less onerous prices for necessities, workers can settle for the wage increases already delivered (or on offer) as opposed to insisting on ever more money due to the ever higher cost of meeting basic needs. That could reduce labor market churn, and help close the wage growth gap between job “stayers” and “switchers,” which is part and parcel of the sky-high quit rate. Job openings could then catch down to slower demand which, thanks in part to the lagged effect of Fed tightening and the psychological impact of this year’s inflation shock (evidenced by, for example, poor readings on gauges aimed at measuring households’ perceptions of their finances), won’t reaccelerate to dangerous levels, notwithstanding various state subsidies aimed at preserving demand when it needs to remain subdued.

Set against such a backdrop, the Fed could very comfortably deliver 100bps of additional rates hikes by the end of the year, almost “in the background,” without causing too much of a stir. Politics is a wild card, but markets aren’t averse to D.C. gridlock. And in all likelihood, that’s what the US will have following the midterms.

So, that’s the Goldilocks scenario. Plainly, there are any number of ways it could go awry, and there’s material “spillover” risk from Europe, where the macro conjuncture is getting worse by the week.

On the geopolitical front, Russia appears to be totally bogged down in Ukraine (who could’ve predicted that, right?) which could, at the least, delay planned annexations and might even compel Vladimir Putin to consider face-saving options. I’ll confess I’m not sure what such options might be, given that Ukraine isn’t going to cede Russian-occupied territory, nor is Kyiv likely to settle for any sort of perpetual occupation on the tenuous premise that it’d be generally peaceful. Russia needs to leave, and it’s not obvious how Putin can do that without looking weak unless he can get new security concessions from NATO along with an agreement to lift some sanctions. The former could be pitched to his domestic audience as a win worth fighting for. Obviously, any Russian withdrawal would be deflationary, as would the reinstatement of a modified nuclear deal with Iran. As for US-China tensions, they’ll simmer, but won’t boil. Xi Jinping isn’t going to seize Taiwan by military force anytime soon. The mainland has enough problems right now, and sending the PLA across the Strait isn’t going to fix any of them.

In any event, take all of the above for what it is: A collection of musings delivered into the summer void.