Roger [00:00:00] 2022 will be remembered as the year of the price shock, leading to one of the worst declines in global bond markets on record. There are, however, now mounting signs that the worst of the inflation shock might be behind us. But is that because we're now headed towards a growth shock?
Roger [00:00:16] That's the 150th episode of The Big Conversation. They are the ones that don't go out!
Roger [00:00:34] Although the US equity market has spent most of 2022 in a downtrend, it has remained an orderly decline with very few of the high volume capitulation lows, that have typically punctuated previous classic bear markets. If anything, we've seen the unusual activity in the countercyclical rallies led by high volumes of very short dated options, often with less than a day to expiry.
Roger [00:00:57] Market participants have become impatient, having become used to the very short-term capitulation events that were experienced during the volmaggedon event of early 2018, the Fed induced sell-off at the end of the same year, and of course the COVID shock in 2020. People had been looking for a quick buck on the way down and then a rapid rebound.
Roger [00:01:17] But this year has been fundamentally different from those experiences. The downtrend has lasted for most of this year, and we've still not seen a classic low. There are many reasons for this. And amongst them are sequencing and sentiment.
Roger [00:01:32] In terms of sequencing, the price shock has created a clear response from the professional community. Whilst there was much debate about the potential for inflation to be either transitory or sticky, the magnitude of the price shock meant that many investors became very cautious, very quickly.
Roger [00:01:48] Rates, expectations increased, and yields rose sharply. Based on the experience of late 2018, when yields were rising during the last rate hiking cycle. Professional investors had expected the equity markets to fall. As a result, many of them bought put protection in anticipation of the Fed's policy response. But this was never panic buying of options.
Roger [00:02:09] This pre-emptive buying of options meant that when the equity market did fall, investors were able to take profits on their put protection.
Roger [00:02:17] And this selling of puts, meant that many fund managers were placing a bid in the market, whilst also helping to keep a lid on volatility because the selling of puts supplied volatility to the dealers. Volatility of volatility has generally been declining this year compared to rising during the other major sell offs in the last five years. Most of the short-term lows this time around, have been relatively sedate affairs.
Roger [00:02:42] In recent weeks, short dated options have further fuelled the rallies. When put, options have been bought and then the market has moved lower, short-term traders have been quick to sell those puts before the paper profits evaporate, and that has helped drive a number of sharp rallies off the short-term lows. Which have then been chased higher by short dated, call buying.
Roger [00:03:03] But we can see from open interest, however, that most of these positions are only being traded intraday. Open interest has not been exceptional, suggesting that these positions are not being bought and then held. This also implies that some of the extreme intraday puts call ratios that are usually a contrarian indicator for sentiment may now have little value because they're not reflecting a view on the long-term market. But a view on short-term intraday opportunities.
Roger [00:03:33] And although the Fed has now taken up the challenge of higher prices and committed to a higher for longer outlook on rates, these mini shocks from the Fed have been spread out over the whole year.
Roger [00:03:45] The market may have been looking for a pivot like those that was seen in the 1970s, but the market is now increasingly settling for a pause and perhaps a plateau in which rates stay elevated for an extended period of time. If higher inflation and higher interest rates have already caused significant damage to asset prices, then it's unlikely that the Fed will now step back before their job on inflation is properly done.
Roger [00:04:11] So what does that mean for 2023? Can we shift from a price-shock, to a plateau in interest rates without creating a significant slowdown in the economy? Or does the Fed need to create a downturn in the economy, to be sure that they have properly capped inflation?
Roger [00:04:28] Well, they have said that it's easier to put back together a broken market, than it is to put inflation genies back in the bottle once they've escaped.
Roger [00:04:37] And there are clear signs globally that commodity price inflation has turned; the year-on-year change in the Refinitiv Commodity Index has reversed most of the prior gains. Brent Crude futures are 30% below the intermediate spike of 2022.
Roger [00:04:52] In the US domestic commodities such as lumber, have also fallen precipitously. Whilst the NAHB housing index has been dropping at the same rate that it fell during the GFC and COVID crisis.
Roger [00:05:05] Even in Europe, when many measures of producer price index were soaring, look like they have now turned. German PPI has dropped from 46% year-on-year to under 35%.
Roger [00:05:17] And the month-on-month decline in German PPI of 4.2% was the biggest decline on record. And global shipping and freight prices have been dropping for a lengthy period of time.
Roger [00:05:29] So can prices drop independently, and quickly enough for policymakers to ease off on their hiking commitments? Or are prices dropping because the inflation shock has already led to a growth shock that's going to play out in 2023?
Roger [00:05:45] Well, there have been some clues in the US yield curve.
Roger [00:05:48] The spread between the U.S. 10 year and the 2-year yield has reached a new low, having inverted by over 70 points. This has once again highlighted the relationship between inverted yield curves, and recession. Over the last 30 years, the yield curve has inverted before a recession, but, it has also started to re-steepen into positive territory before the recession started.
Roger [00:06:12] This inversion and then a re-steepen into recession has historically taken between 9 and 30 months. But this has always taken place during the period of moderation, in which rates were raised to combat an expansion in growth, not a rise in inflation.
Roger [00:06:30] If we go back to the late 1970's and early 1980's, we see a different picture. Although the causes of inflation may be very different today, the policy response may not. Today's 2Y10Y inversion is the deepest since that period.
Roger [00:06:48] Policy makers raised interest rates until they got a handle on inflation in the past, either rampant inflation or at a rapid policy response, eventually capped price by breaking the economy, usually by higher unemployment. The long end of the government yield curve takes note, by dropping below the yields at the front end, therefore creating a deeper inversion.
Roger [00:07:12] Policymakers maintain their hawkish stance, growth and therefore longer dated yields fall more, and this can happen right into the teeth of a recession, as it did at the end of the 1970s.
Roger [00:07:24] So how far will the Fed go this time? Well, the current conundrum is the labour market.
Roger [00:07:30] Now, anecdotally, there are signs that it is downshifting, with significant job losses across many of the large cap tech names.
Roger [00:07:38] But at this stage, we have not seen the sort of pickup in initial jobless claims that usually preceded a historic recession. The recession has usually occurred when claims are clearly on the rise, even with lags and revisions, that could still be months away at the moment.
Roger [00:07:54] But will the Fed want to take a chance and hope that inflation can drop rapidly back towards interest rates?
Roger [00:08:00] Well, historically, the Fed has taken policy rates above the level of core CPI. Given that the time it takes for CPI to drop back to 2% once it has exceeded 5%, can be four years or longer, and the Fed may not be prepared to wait and see.
Roger [00:08:17] They may feel it is better to generate some weakness in employment now, rather than let the wage rises take hold that are currently being negotiated in many of the public and old economy sectors. Which then may require an even more draconian response further down the road.
Roger [00:08:34] And given the level of financialization in the US economy, where the performance of the equity market is often defined, the level of employment, pay and CapEx, the Fed may feel they have to see further weakness in the stock market before they really feel that the economy is under control.
Roger [00:08:52] And as we've shown before, recessions are usually defined by rising unemployment and major lows in the equity market. If unemployment and a recession are still ahead of us, then the equity market lows probably are as well.
Roger [00:09:06] Does that mean we're going to have a period of transition in market leadership? Well, so far the US sell-off has primarily been tech related, based on the inverse relationship between high yields, and growth stocks.
Roger [00:09:17] And another reason why the equity market has been relatively well behaved, is because we've seen primarily rotations from tech to value, rather than outright liquidations. Liquidations tend to be indiscriminate and occur during recessions, amidst the fear of job losses and declining earnings.
Roger [00:09:34] Well, if long dated bond yields start to fall, should tech stocks start to rise? Well, I think that would be unlikely, unless we're in the recovery phase where yields are finding a base, because in that scenario, the growth scare is receding. Tech may outperform, but a true recessionary slowdown with job losses should see the majority of equities struggle.
Roger [00:09:54] But some of the biggest risk in 2023 may be amongst the relative winners of 2022, because it's the old world and value stocks that will be the last to get hit.
Roger [00:10:04] Now, the long term outlook for sectors like energy and resources is still very promising because of their massive underinvestment over the last decade and the uncertainty of the green transition. And they have relatively cheap valuations, but in the shorter term they could come under pressure because investment plans get shelved during a genuine slowdown.
Roger [00:10:23] And the US energy ETF, the XLE, is at the levels that have been seen at major resistances on previous occasions. Some investors may be looking at taking profits and replacing long positions with call options to lock in some of the big gains off the COVID lows.
Roger [00:10:39] And in Europe, the basic resources sector look like a head and shoulders top is forming. There is still some way to go, but the 520 level is a line in the sand that investors should have on their radar. A break of this level would suggest that global growth is under significant pressure.
Roger [00:10:57] And the European industrial goods and services sector, has been in a very distinct uptrend versus the broad based Stoxx600 markets. If global growth falters, then this trend should be breached.
Roger [00:11:09] Also, the UK's benchmark index, the FTSE 100, is a global defensive and remains only marginally off its all time highs. This is the sort of index that could be one of the last shoes to drop. Energy and materials make up about 25% of the index, and this index benefits from a weaker pound because of its overseas earnings. Therefore, if we get a US dollar rally during a global slowdown, the UK could still outperform, but there will still be downside risks, in absolute terms.
Roger [00:11:42] And one of the biggest questions is whether the bond yields have peaked?
Roger [00:11:45] The deep inversion of the U.S. 2Y 10Y curve suggests the long end is now starting to price for a weaker growth outlook.
Roger [00:11:52] If the Fed remains more aggressive and raises rates even further than anticipated, which would be beyond the current 5% level that is priced by the May 2023 Fed funds future, then the outlook for growth will be compromised further and the risk are that longer dated yields move into a deeper inversion, versus their short dated equivalents.
Roger [00:12:13] And the risk to this view on yields, is if the Fed chooses to pause much earlier than expected and the market sees this as supportive of inflation, if the Fed's stance eases, then inflation expectations may rise and push longer, dated yields higher. But it's unlikely that the Fed would allow this to happen for long. In fact, if longer dated yields rise too much, they put more pressure on U.S. mortgages and the housing market, increasing the potential for a deeper slowdown later on.
Roger [00:12:41] In terms of currencies, the Yen may well have a decent run, even if we get a broad based risk-off move higher, in the US dollar against most other currencies. And this potential strength in the Yen is because the major pressure on the Yen has been their yield curve control policy and rising domestic inflation. A drop in global yields would remove this pressure and a global slowdown would reduce domestic inflation. Energy prices would also fall if there is a slowdown, and this would reduce Japan's import bill.
Roger [00:13:13] So to summarise at the moment, the US and the global economy appears to be in transition. The price shock this year has led to an economic slowdown, but not a true recession, except where energy costs have spiralled out of control.
Roger [00:13:27] Inflation appears to have peaked, but policymakers will want to make sure that it's permanent and not just an intermediate peak, and to make sure that the Fed will still want to see a pickup in unemployment. And that might require more pain in the equity market to force the hand of boardrooms.
Roger [00:13:43] So far, the equity market has had an orderly decline focussed on tech. But if we shift towards a growth shock, then the winners of the rotation in 2022 could also come under pressure because the selling generally becomes more indiscriminate during a true recession.
Roger [00:14:00] But a recession is not yet baked in the cake. A strong contrarian view is building that a recession won't occur, but that might actually be the biggest fear for a Fed that is determined to focus on inflation and price so that they can eventually create a sustainable path towards true growth.
