There is almost nowhere to hide if we dive into the recession plunge pool for a long time, notwithstanding that the first six months of 2022 have been a challenging time to be a stock market investor.
The most important question we are getting from clients is to re-frame the potential hit to SPX EPS and de-rating the P/E. Valuations have wholly driven the entire mess rather than the result of diminished earnings estimates. So, in line with several giant Wall Street Shops, we expect consensus profit margin forecasts to fall, which will lead to downward EPS revisions whether or not the economy falls into recession.
Last week hallmarked a significant regime shift in the market: we pivoted away from higher inflation to weaker global growth while pricing in an imminent but short-dipped recession, which is now the dominant market driver in the forever spinning carousel of buy and sell inputs.
Recession market dynamics are relatively straightforward, although nothing is simple with capital at risk while trying to make money for jam. The recession cycle produces a toxic brew of weaker equities, commodities and sagging EM, lower long-term bond yields, and wider credit spreads. And those dynamics were playing in real-time last week.
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Then, historically, comes the moment of a Federal Reserve pivot. And as growth risks are acknowledged, the policy stance becomes more dovish, and risk assets start pricing at the cycle’s turn.
The one glaring problem in this cycle is sticky energy-driven inflation. And no if and or buts, the keen policy objective of central banks is to slow down growth and drive energy and other commodities lower, which is what they are explicitly trying to engineer, even if it means stagflation.
A positive thing, though, is that financial markets are far less fearful of inflation than central banks. They are far more concerned about economic growth, suggesting the central banks are still three or four months behind the market narrative. Just as central banks hit maximum hawkishness, the markets have priced inflation back down.
The US 5y5y inflation forward is under 2.50, down from 2.80% a month ago, and now in line with the high it reached in mid-2018 at the peak of the government’s fiscal stimulus.
Friday’s US data releases bode well for the story of weaker spending and recessionary probabilities. Last week we flagged that the CPI fixes had moved the peak of headline CPI back to June. And the peak in the core is still in September. Hence, July FOMC is now pricing in 63bp, between 50 and 75 bp market debate points.
Much of this has to do with the move lower in oil, which is still a key input on any rates directional probability model, and so is the global core goods inflation that should start easing materially in the coming months. Yet it is evident in recent quarters that inflation drivers are shifting to a domestic source: the labour market.
So, putting it all together, we think the labour market needs to slow down with oil prices expected to remain at historically higher levels this year. It may be a matter of time, but that is likely to be the critical variable in the Fed dovish reaction function.
This week’s holiday-shortened economic calendar will primarily focus on the labour market, with Friday’s June employment report the main event. On the monetary policy front, Wednesday’s release of the June 15 FOMC meeting minutes will likely be the focal point amidst a relatively light Fedspeak lineup.
With the 2-year Treasury yield having fallen 30bps last week and now unwound all of the moves after the June 10 CPI release, it does confirm the market’s shift from the inflation outlook to the growth outlook, making this week’s employment data all the more important for near-term market developments.
Macro investors still take the opportunity to liquidate length across the complex, even with no precise supply and demand catalyst to spark any sell-off. However, this is not unusual as pressure builds across risky asset portfolios; risk managers typically lower traders’ exposure limits and ask them to raise hedges across many assets. Hence, we think this current oil market malaise is as much about risk aversion as anything else.
Oil traders 100 % agree that when the economy is in a recession for long enough, demand destruction hits, and prices fall. Yet we are not at that stage yet.
A few things that make oil investing less attractive are patchy liquidity and high volatility but a very tight range.
It is common knowledge that the dollar strengthens into growth slowdowns. Still, there is no consistent dollar pattern in a US slowdown, with the USD behaving very differently in each cycle. Still, the dollar is packing a ton of rate risk premium; it may stay supported over the short term due to the stagflation poster children, the EUR and GBP. The market hit the poster children via the Yen crosses hard on Friday, as we suggested in our pre-Asia Open.
With downside growth risks building again, ECB communications last week did not leave much room for accelerating rate hikes, which was a near-term negative for EUR. We have been running hot and cold on the EUR because moving out of the negative interest rate regimen will help coax back some of the EUR 3tn in fixed income outflows since the start of the negative rate era. On the flip-side, the ECB’s more careful approach to policy normalization medium-term risks for the Euro, especially if the Fed holds the course.
However, the next significant move is likely to be down, not up, for the US dollar as we inch closer to the two-month US dollar reversal window that we forecast will open sometime in September. Of course, we do not expect the Fed to cut interest rates; instead, we expect them to move back to the usual 25 bp regime or even pause as they step back into inflation reassessment mode, but we would likely reassess that timeline if the Fed moved to 50 bp in July.
A tough week for FX, with themes clouded by month-end flows. Equities are showing signs of cracking again, with cyclical names dragging indices lower. Sintra re-emphasized central banks’ focus on inflation at all costs and a potential front-loading of rate hikes. And complicating matters, the market focus has shifted from inflation worries to the building downside economic risks, with breakevens sharply lower over the week.
On Friday, There was a surprise in import duties for refined gold into India. The news caught the market off guard and provided the catalyst to push gold below 1800; when the dust settled, gold rebounded as short tern US rates continued to fall. Although there is zero chance of printing paper money or the Fed cutting interest rates this year, the primary long-term drivers for investing in gold are the gold. We will likely need to keep an eye on how two-year yields impact the US dollar, given gold’s strong inverse relationship to the greenback as a primary signal that the market thinks the Fed may tap the rate hike breaks a touch.
Published by Stephen Innes, Managing Partner, SPI ASSET MANAGEMENT