Inflection Points Aplenty: Looking For Confirmation Signals And Upcoming Narrative Shift
Softer-than expected inflation prints in both the PPI and CPI data this past week set off a relief rally in everything: S&P 500 +2.4%, Nasdaq Composite +3.3%, Dow +2.3%, Russell 2000 +3.6%, MSCI EAFE +4.9%, MSCI Emerging Markets +4.9%, 2-year T-Bill +0.45%, 10-year T-Note +2%, U.S. Aggregate Bond +1.5%, Bloomberg Commodity Index +2.74%, and Gold +1.74%. The market’s logic is as follows: headline inflation of 3.0% is only a stone’s throw away from the Fed’s 2% target and while the progress from here to there will not be easy the pressure is off the Fed to continue its tightening campaign. Bottomline, buy everything in this nirvana period of peak Fed Funds rate, inflation has been tamed, and the economy didn’t need to be wrecked to accomplish it. I’ll dig in a little deeper on this below, but for now all is well as both the capital markets and the economy embrace a ‘goldilocks’ setup.
When penning these weekly missives, I get much more fulfillment out of thinking through various scenarios and their market implications as the setup evolves, than I do just reporting what happened in the past. With that said let us get into a meandering expedition across a wide swath of market related topics that have been on my mind of late.
Let’s start with inflation and last week’s print on headline CPI of 3.0%. Since June of 2022, inflation has declined from 9% to 3% (an unprecedented fall within experiencing an economic contraction), but market pricing via the inflation swaps market indicates that 3% is about as low as we’re going to go for the next four months. In fact, according to the chart below from Kevin Muir (author of the awesome MacroTourist Substack) the implied forward CPI print will increase over the next three CPI reports: 3.2% in August, 3.35% in September, and 3.06% in October. Ceteris paribus, we won’t see an inflation print sub-3% until November where the swaps market is implying a 2.69% reading.
Always keep in mind when looking at and interpreting market price signals about the future; forward prices are reflective of current data and forecasts for current data in the future. They will change as incoming data, sentiment, expectations, and positioning change. What I think is important for investors to take away from the inflation backdrop at this moment is that the inflation prints over the next several months are more likely to move higher than lower. By next Spring markets are expecting inflation prints to be stable in the mid-to-low-2’s, but we have to traverse a bump higher before then. So, over the next several months you shouldn’t get caught up in the headlines about inflation risks on the rise, markets are already anticipating this path and won’t be caught off guard by it. Now if the actual prints are wildly different or things change in a significant fashion between now and then (oil price spike for example) then that’s a different story. Just know that markets will be adjusting along the way.
Fueling the rally in everything last week was a substantial easing of financial conditions (yields fell, U.S. dollar declined, equities rallied, credit spreads compressed) as markets priced in two more Fed cuts in 2024. Forward markets are priced for the Fed Funds rate to peak in November and fall (expected rate cuts) throughout 2024.
The market implications of a potential peak in Fed Funds rate for this tightening cycle is pivotal if in fact we have reached that point. I think we have, but it needs further confirmation and if so, this sets the table for an important inflection point in interest rates and the U.S. dollar. Prior to Friday’s rally the U.S. dollar had declined for six straight days (longest stretch since 2020) and slipped below the 100.0 mark.
Before I go on with any more comments on the U.S. dollar, I want to be clear that my view is completely agnostic when it comes to any directional move in the worlds reserve currency. I see validity in Brent Johnson’s “dollar milkshake” theory where the U.S. dollar sucks up capital flows from the rest of the world and I also see validity in the dollar bears view that due to policy misteps, abuse of power, and rapidly rising sovereign debt levels “the U.S. dollar will lose its world reserve currency status and hyperinflation is inevitable”. That being said, my directional lean towards one view or the other (most of the time I’m firmly planted in the middle) is dependent on an amalgamation of other variables where the importance of these variables shifts through time. At this moment, in addition to interest rate differentials and central bank actions, the most important variable in my dollar view is global capital flows. For the past fifteen years U.S. financial assets have become the piggy bank for global savings. As a result, the U.S. stock market has handily outperformed global equity markets and increased the weighting of U.S. equities in the MSCI All-Country World Index (ACWI) to over 62% - the U.S. weighting has increased roughly 12% in just the past decade.
At its core what it is most interesting to me about this U.S. equity market weighting dominance is how overweight investors (and Central Banks) around the world are to U.S. assets. By extension, global investors have bid up the relative value of the U.S. dollar (to buy dollar-based assets you have to sell your local currency and buy the dollars to acquire dollar based assets) where even a marginal reversal in these capital flows going forward will have significant implications on the relative value of the U.S. dollar and U.S. asset prices.
This brings me to the ongoing Cold War between the U.S. and China which started down this path even before Trump was elected in 2016. But without question his policies intensified the Thucydide’s Trap and likely marked the peak in globalization. Then came the pandemic which heightened the senses of nations from around the world in regards to their reliance on global trade for key necessities and resources. As a result we’re seeing terms like onshoring, reshoring, friend shoring, populism, and nationalism everywhere which to me has a lot of commonality with peak globalization.
What’s your point Corey? My point is, that I think the U.S. dollar is highly vulnerable to a sustained period of weakness if/when global savings from other nations are repatriated back home. No, this won’t happen all at once and without question the U.S. will remain one of if not the premiere global destination for excess savings because of its rule of law and economic dynamism. But the U.S. is not without warts, its financial system and Treasury funding in particular are reliant on the generosity of strangers given the U.S. is a debtor nation - requires outside capital to fund its twin deficits. Should such an inflection point be at hand it would mark a regime shift that will have ripple effects that playout over the course of years and impact every asset class.
As for China, without question it’s economy has been weak and unable to find another gear. Real GDP growth in Q2 expanded at a tepid +0.8% (in line with expectations) with the year-over-year growth rate decelerating to 6.3% and well below the 7.1% consensus forecast. The latest trade data showed exports tumbled 8.3% and property investment is down 7.9% YoY. Beyond the growth data we learned last week that inflation in the world’s second biggest economy is down to 0% - that’s not exactly an indictment of a vibrant economy.
The economic weakness in China relative to the U.S. makes it easy for many market participants to forget that China has one attribute that the U.S. doesn’t – it is a creditor nation. Before getting all excited, I’m not implying that this one attribute dominates all others, but at a particular moment in time where investors are all goosed about U.S. asset prices and the economy can do no wrong its easy to get complacent about risk factors. In this case a major risk to the value of the U.S. dollar, U.S. asset prices, and U.S. interest rates is the fact that China’s foreign currency reserves are the largest in the world (larger than the next 5 nations combined).
Don’t lose sight of how China has built up this stockpile of reserves. U.S. consumers and U.S. companies buy Chinese goods, China receives payment for sold goods in U.S. dollars, and China reinvests those dollars back into U.S. financial assets. If/when the U.S. – China relationship devolves further, I’m not so sure it’s going to be constructive for the U.S. dollar, U.S. interest rates, or U.S. financial assets in the short-term. Over the long-term, I’m of the view that the U.S. has a much stronger hand, but that’s a thought for another day. The below chart from the IMF breaks down world reserve holdings by currency which highlights the long-term strategic advantage of the U.S. – its no accident that over 60% of world reserves are held in U.S. dollars with the Euro being the next closest at a little over 20% (the Chinese Yuan is around 3%). In a nutshell, the world is comfortable holding dollars and dollar based assets with no viable alternative to upend the dollars reserve status.
Moving on to the Fed, interest rates, and the economy. I continue to be pleasantly surprised by how well the economy has held up given how aggressive this tightening cycle has been. And while I admit being wrong in that I thought we’d be slipping into recession about now, I still lean in the direction that the negative repercussions from this tightening cycle lie ahead. I’m going to highlight another piece of Kevin Muir’s MacroTourist write up from over the weekend because I think it brings to light a very important development that has not yet worked its way through the economy or financial system.
The tightening in real rates at the front-end has been massive
Rewind back to March 16th, 2022, when Powell embarked on his first rate hike. A few days earlier, the 2-year TIP yield was -3.00%. This means that over the next two years, a buyer of this TIP would receive inflation minus 3%. If inflation was 2% (the Fed’s target), the buyer would earn a whopping minus 1% (2% - 3%).
To say Fed policy was easy at this point is probably the understatement of this financial cycle.
What’s happened since?
Front-end real rates (as measured by the 2-year TIP yield) have risen 600 basis points to almost +3%.
And the part that many market participants are overlooking is that the last 150 basis points have occurred over the past few months.
There is no way to undersell this tightening. This is the yield an investor will receive after inflation, so it’s guaranteed to provide that return in real terms. Due to the Fed’s tightening campaign, front-end TIPS now offer investors actual positive real yields that are more than just a token few basis points.
I know that 2-year TIPs are not instruments auctioned by the Fed and do not represent the most liquid of markets. However, these are still prices at which investors can transact. We don’t have a ton of historical data to compare, but we are at the tightest non-crisis level since the 2006 tightening cycle.
Back in 2018, Powell only made it to 2% before markets rebelled. In 2006, Bernanke got 2-year TIPs yield to 3.5% before that proved the top.
Will we make it to that level again?
Who knows, but make sure you keep this quote on your screen. The move from 1.44% to 3% likely surprised a lot of market participants and reflects an increasingly tight Fed stance in real terms.
The point I think Kevin is trying to accentuate is how much tightening has worked its way into the system over the past three months of which the economy has yet to feel the full impact. I find it humorous that at the moment I’m typing this point I overhear a discussion on CNBC where the bullish participants are adamant that recession was priced in last year and therefore there is no need for anymore repricing. WHAT!! A recession that didn’t even occur yet? So we priced in a non-recession, therefore we don’t need to price in the real thing if it were to happen. Come on! You can call out those who were adamant that a recession was coming in the first half of 2023 as being wrong, but in the interest of intellectual honesty and objectivity lets refrain from the certainty that there will be no recession. No one knows that, but because the stock market is within 5% of its all-time highs it gives the bulls the cover to abandon prudence and risk management.
Let me state plainly – I am neither bullish or bearish at this moment in time – consider me a patient, content, and well diversified observer until something changes my mind. I will say this, all the bulls taking victory laps should revisit the last couple cycles where it’s the stock market that is the last to know before a recession hits. Other indicators with a good track record at predicting recesions - like yield curve inversions (lead the turn by twelve months on average) or the Leading Economic Indicator (leads on average by fourteen months) are still flagging elevated recession risk. Then there is the contraction in GDI (gross domestic income) which typically coincides with the onset of a recession.
Here's another history lesson for overconfident bulls from the ever-insightful David Rosenberg:
Lags. Lags. Lags. In the two years before the Fed tightening cycle, real GDP growth has averaged +3.5%. During the Fed tightening cycle, the economy typically expands at its fastest pace of the business expansion, as it feeds off the lagged effects of the prior period of policy accommodation. But look at what happens in the two years after the peak of the Fed tightening. The historical record shows that, without exception, the economy slows down and does so precipitously in the two years that follow the END of the Fed tightening cycle. Not only that but by an average and median haircut to real GDP growth of roughly 3 percentage points. Problem is, the current baseline growth is 1.8% — so the odds we make it through without an outright contraction are next to nil.
Don’t forget what the objective of Fed tightening is: slow growth and curb inflationary pressures. They have been so good at it throughout history that 11 of the last 14 tightening cycles have ended in recession. If they don’t succeed, they will continue to tighten until they do. They have made it abundantly clear over the past twelve months that their resolve in achieving their objective will not fizzle. One variable that I think many of us skeptics overlooked in this tightening cycle is the size of the fiscal impulse working its way through the economy. Over the past 12 months the U.S. government has spent $6.7 trillion (up 14% year-over-year) and the fiscal year 2023 federal deficit is up more than $1 trillion from the prior year. Tough to get a recession with a deficit-to-GDP of 9% and an unemployment rate below 4%. Fiscal dominance is here to stay and this is not a U.S. centric policy as world debt is setting new record highs - $227 trillion or 250% of GDP (see below chart).
Ultimately the bills must be paid, and as a result interest payments are set to jump in coming years - could rise to as high as $4 trillion should the average coupon level on outstanding debt rise from 2.5% to 4.3%. One other item the bulls need to take note of on the policy front is the oncoming liquidity drain set to ratchet higher in the back half of the year. Balance sheet reduction (QT) from the Fed and ECB combined will equal more than $100 billion per month going forward and then there is the increased Treasury issuance to account for.
As for the stock market the S&P 500 is priced at historically rich 19.5x on 12-month forward EPS. Over the last several weeks forward 12-month EPS estimates have held pretty firm at just over $230 which means that the appreciation in price is all a matter of expanding valuations. However, its worth noting that outside of the highest-flying stocks, the forward P/E multiple is trading at a normal 15x (vs 27x for the tech sector or 29x for the Nasdaq 100). Perhaps this is something investors are gravitating towards of late as the character of the market has definitively changed and broadened out. More than 140 stocks have made fresh 52-week highs since the end of May with all 11 sectors in the green over this period. Over the past three weeks, the equal-weight index has gained 5% and outperformed the cap-weighted index by roughly 1.5%. The expanding market breadth is underlined by the fact that more than 80% of the index has moved above their 50-day moving averages, the first time this has happened this year.
Furthermore, positioning as measured by the National Association of Active Asset Managers (NAAIM) is nearing a full equity allocation. Historically, when this metric gets to this level it has traditionally served as a contrarian signal – in this case a signal that everyone is in the pool (and why not with how bloody hot it is outside).
So, we have the bulls taking victory laps, valuations stretched, peak tightening yet to work its way through the economy, equity allocations nearing peak levels, and goldilocks becoming the consensus view. What could go wrong?
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