The S&P 500 index is now in a bull run and investors have also turned bullish. Can equtiy markets go even higher from their current levels? Crossbridge Capital CIO, Manish Singh, CFA shares his views in this month’s MVP…

Summary

The S&P 500 index is now in a “bull run.” With the onset of a new bull market now confirmed, investors have also turned bullish.

The most recent sentiment data released by the American Association of Individual Investors (AAII), indicates a significant surge in optimism. In contrast to the average of approximately 25% of respondents reporting as bullish over the past year and a half, this week, saw a remarkable increase, with 44.5% reporting as bullish.

Meanwhile, the US Federal Reserve is considering a slowdown in its pace of interest rate hikes, as evidenced by their plan to skip an increase this month. This decision aligns with the latest US ISM Services data released last week, which indicated that the sector is on the verge of a contraction.

Nvidia surprised the market two weeks ago by announcing its sales projection of $11 billion for the three-month period ending in July. This figure surpasses the previous estimate by more than 50%. Such substantial revenue surprises are rarely witnessed among mega-cap companies. Its stock has since surged.

It appears highly likely that we are witnessing the dawn of a significant new AI-driven technological era, comparable to the advent of the PC, the internet, mobile devices, and cloud computing.

The looming risk of a US recession continues to hang over equity markets, akin to the sword of Damocles. However, the surge in construction spending on manufacturing projects and the low unemployment rate in the US, could propel equities even higher from their current levels.

S&P 500 Index in a “Bull Market”; US Federal Reserve set to pause

As summer approaches and the allure of a vacation beckons, let us take a moment to examine the market, before basking in the sun. Fortunately, there is plenty of positive news to share.

Cast your mind back to March 16, 2022, when Jerome Powell, the Chair of the US Federal Reserve (Fed), initiated a tightening cycle by raising interest rates, which has resulted in the fastest pace of tightening in over four decades.

Despite concerns that this tightening would harm the stock market, as of yesterday’s closing, the S&P 500 index (SPX) has experienced a total return increase of +0.22% since that date. It seems that the fears that a Fed tightening would crush the stock market, have been proven wrong.

I consistently emphasize in my newsletters, the importance of patience and long-term thinking when it comes to investing. Market fluctuations are to be expected, and it is crucial to stay the course. The wise American investor, Shelby Davis, captured this sentiment perfectly when he said: “History provides a crucial insight regarding market crises: They are inevitable, painful, and ultimately surmountable.”

Looking at the price chart of the SPX and the Fed Funds Target Rate (FDTR) over the past 18 months, we can observe the market’s resilience.

S&P 500 index (SPX) and Fed Funds Target Rate (FDTR): 18-month price chart

Source: Bloomberg

Remember the turmoil surrounding the failure of Silicon Valley Bank (SVB) on March 10, or the recent concerns about the US debt ceiling? Despite these events, the SPX has risen over +11% since March 10.

The SPX is in a “bull run,” defined as a rally of over +20%, following a decline of -20%. Since reaching its lowest point on October 12, 2022, the SPX has now risen by +20.2%.

Within less than a year and a half, we have witnessed the SPX bouncing back. If you are not engaged in short-term trading or leveraged strategies, you have less to worry about and less to lose. As a rule: Always establish a solid investment strategy and resist the temptation to make emotional decisions driven by market noise. Discipline is key to avoiding unintended failures.

Meanwhile, the Fed is considering a slowdown in its pace of interest rate hikes, as evidenced by their plan to skip a hike this month. This decision aligns with the latest ISM Services data released last week, which indicated that the sector is on the verge of a contraction.

The ISM Services index declined to 50.3 (yellow line in chart below), indicating it is barely in expansionary territory (a reading below 50 signals a contraction). Components such as new orders, prices paid, and employment, all experienced drops, with employment reaching 49.2, signifying a contraction in the job market.

5-year price chart: US ISM Manufacturing PMI and ISM Services PMI

Source: Bloomberg

Over the past months, while the ISM manufacturing data slipped into contraction, the ISM Services data remained relatively stable, bolstering the Fed’s confidence in raising rates.

However, with the ISM Services index at 50.3, it is highly unlikely that the Fed will maintain the same stance.

The recent ISM Services data strongly suggests a “Fed pause.” Additionally, when we consider the average prices paid component of both the ISM Manufacturing and ISM Services, the prices paid index has returned to pre-COVID levels (see chart below). It disproves the narrative that the US economy is expanding rapidly and needs rates to stay high, let alone take in more rate hikes as some have even suggested.

5-year price chart: ISM Manufacturing and Services prices paid index and US inflation

Source: Bloomberg

The decline in ISM prices paid aligns with the significant drop in wage growth reported in the recent jobs report. Month-on-month US wage growth has cooled to +0.3% (down from highs of +0.6%)

Wages are by far the biggest expense for services firms, and the Fed has made it clear they want to see slower wage gains bear down on core inflation, ex-rent.

Therefore, the Fed will be comfortable to “pause” and not raise rates when they next meet June 13-14.

Markets and the Economy

The markets are evidently factoring in a return to an inflation rate of +2% to +3% in the US, with the expectation that other major economies will follow suit, in due course. This anticipated inflationary trend, is likely to materialize before the end of the year in the US.

One compelling indicator of the market’s confidence in managing inflation, is the trading behaviour of the 10-year US Treasury.

Despite headline inflation reaching +6%, the 10-year Treasury has remained relatively stable within a tight range of +3.5% to +3.7% over the past six months. Additionally, the downward slope of the yield curve, further supports the notion that concerns about inflation have diminished.

Consequently, the performance of equities (as illustrated in the table below), aligns with this perspective. While the potential for a recession in the US remains a challenge, the low employment rate acts as a mitigating factor, preventing it from gaining significant traction.

Benchmark Global Equity Index Performance (2022; 2023 YTD)

Another factor that could potentially help the US avoid a recession this year, is the significant construction spending on manufacturing projects.

The latest data on US Construction Spending for April shows a robust increase of +1.2% (compared to the estimated +0.2% and the previous +0.3%). Notably, spending on construction for manufacturing projects (represented by the yellow line in the chart below) remains strong, compensating for declines in residential building (represented by the green line).

The resilience of the manufacturing sector’s construction spending is particularly encouraging, because it is typically among the first to suffer declines in spending and job losses, when interest rates rise. This unexpected strength has been a pleasant surprise, contributing to job creation and supporting GDP growth.

The Infrastructure Investment and Jobs Bill enacted in 2021, along with last year’s climate, tax, and healthcare legislation, all are injecting substantial funds into industrial projects. These include the expansion of manufacturing facilities, renewable energy initiatives, and railroad expansions. Such investments promise to keep workers engaged for years to come. Additionally, the computer/electronic manufacturing sector is experiencing a renaissance in the US, thanks to the $53 billion CHIPS and Science Act, which offers direct financial assistance for the construction and expansion of manufacturing facilities.

This program has already sparked an investment boom, with both domestic and foreign manufacturers announcing over 40 projects, totalling investments close to $200 billion, according to the Semiconductor Industry Association. Industry giants like Intel, TSMC, Samsung Electronics, Micron Technology, and Texas Instruments, have unveiled substantial investment plans, totalling billions of dollars.

It would be prudent for the Fed to avoid hindering this growth, by maintaining high interest rates for an extended period or even by further increasing them.

Census Bureau US construction spending (Manufacturing and Residential): 20-year price chart

Source: Bloomberg, Census Bureau

In my March Newsletter, I wrote: “Semiconductor stocks, long seen as a cyclical play, may be turning into a secular growth story, particularly if the AI-driven revolution stacks up well over the next few years. One to watch.”

Recent events have swiftly validated this prediction.

The rally in semiconductor stocks has been remarkable since then. The Philadelphia Stock Exchange Semiconductor Index (SOX) has surged over +20%, while the share price of US chipmaker Nvidia (NVDA) has skyrocketed by more than +70%.

Nvidia surprised the market two weeks ago by announcing its sales projection of $11 billion for the three-month period ending in July. This figure surpasses the previous estimate by more than 50%. Such substantial revenue surprises are rarely witnessed among mega-cap companies.

It appears highly likely that we are witnessing the dawn of a significant AI-driven technological era, comparable to the advent of the PC, the internet, mobile devices, and cloud computing.

Just two days following the ground-breaking quarterly earnings announcement, Jensen Huang, the CEO of Nvidia, delivered an inspiring commencement speech at Taiwan’s prestigious National Taiwan University. During his address, Huang shared valuable insights on entrepreneurship, humility, and perseverance. The entire speech is highly recommended, and you can watch it in its entirety at this link

Allow me to highlight one principal section from his speech, (which dates back to 2010, when the mobile phone industry was maturing) that particularly resonated with me:

Huang said:

“The phone market is vast. We could have competed for market share. However, we made a difficult decision and chose not to pursue that market. Nvidia’s mission is to construct computers capable of solving problems that ordinary computers cannot. We should dedicate ourselves to realizing our vision and making a unique contribution.

Our strategic retreat turned out to be a wise move. By leaving the phone market, we opened our minds to creating a new one. We envisioned developing a new type of computer for robotics, equipped with neural network processors and safety architectures capable of running AI algorithms.

At that time, this market was worth zero billion dollars. By withdrawing from the massive phone market and venturing into the zero-billion-dollar robotics market, we now have a thriving automotive and robotics business worth billions of dollars, essentially pioneering a new industry.

Retreat is not an easy choice for the brightest and most successful individuals, such as yourself. However, strategic retreat, sacrifice, and determining what to give up lie at the very core of success.”

Nvidia has played a pioneering role in the development of Graphics Processing Unit (GPU) technology, which has become essential in the realms of gaming and digital production. In order to maintain a strong focus on advancing GPU chips, Nvidia made the strategic decision to sacrifice market share in other areas of the semiconductor chip industry. The chart below vividly demonstrates Huang’s visionary leadership at Nvidia, highlighting the lack of similar leadership at rival Intel.

The advent of AI is set to generate entirely new job opportunities that never existed before. Roles such as data engineering, prompt engineering, AI factory operations, and AI safety engineers are emerging as a result. Automated tasks may render certain jobs obsolete, but AI will undoubtedly transform every profession, empowering programmers, designers, artists, marketers, and manufacturing planners to enhance their performance significantly. The prospects are incredibly exciting, I must admit.

As we navigate the AI age, I firmly believe that Huang’s speech will eventually be regarded on par with Steve Jobs’ iconic 2005 Stanford commencement address. Given Nvidia’s visionary CEO and its continued involvement in shaping the AI future, the company remains a solid investment despite its lofty valuations. Huang’s propensity for making bold bets, further adds to the allure.

Benchmark US equity sector performance (since Oct 12, 2022; 2023 YTD and 2023 YTD relative to S&P 500 Index)

Technology and Communication sector stocks have experienced a notable upward trend, as indicated in the table above.

With the interest rate cycle approaching its peak, it is expected that growth stocks will reap greater benefits as rates begin to decline but the looming risk of a US recession continues to hang over the market, akin to the sword of Damocles.

However, as mentioned earlier, the flourishing manufacturing sector and low unemployment rate could propel US equities even higher from their current levels.

Instead of waiting for a market correction to adopt a long position, which has proven unfavourable for equity bears for the past nine months, it is advisable to utilize structured products for investment purposes. Structured products offer the opportunity to implement such a view while providing a degree of capital protection. They also facilitate the identification of favourable entry points in the market and offer avenues to earn coupons, even in a flat or negative market environment.

I consistently emphasize the usefulness of structured products for equity investments. They present a valuable combination of capital preservation and strategic market entry.

For specific stock recommendations and ideas related to structured products, please feel free to reach out to me or your relationship manager.

 
Best wishes,

Manish Singh, CFA

US Economic data continues to disappoint. Fed officials are increasingly looking out of touch, as they raise rates focusing largely on lagging indicators instead of focusing on the leading indicators.

Summary

US Economic data continues to disappoint. Leading indicators are flashing red and there are clear signs that the US economy is on the verge of a recession (if not in one already), whilst over the past nine months, US inflation is annualising at +3.2%, down nearly two-thirds from its highs of +9.1% in June of last year

It’s hard to imagine how anyone could, credibly, make the argument that the US economy can endure more interest rate increases. Well, there are some, and crucially (or unfortunately), they’re all on the Federal Reserve Open Market Committee (FOMC). The FOMC is set to raise interest rates by +0.25% at its meeting next week, taking the Federal Funds Target Rate (FDTR) to a range of +5.0% to +5.25%. That’s a cumulative increase of 5% over 14 months, the fastest pace of tightening since the 1980s.

Fed officials are increasingly looking out of touch, as they continue to act and sound hawkish, focusing largely on lagging indicators instead of focusing on the leading indicators. When reality hits, rate cuts will inevitably follow.

May is upon us and the “Sell in May and go away” commentary – weaker returns during May to October compared to the period from November to April – has started to pour in. However, like every other market maxim, “Sell in May” is not a hard and fast rule, and the reality is more nuanced.

In the first full quarter free of its Covid restrictions, China’s GDP grew by +4.5% in Q1. Given the size and importance of the Chinese economy, the growth marked a bright spot for a global economy facing various headwinds. Very encouragingly, the growth was driven in large part by retail sales, which jumped more than +10% in March from a year earlier. If this trend were to continue, we could easily see China’s Q2 GDP growing by of over +6%. This would please the global economic sentiment no end.

“Fool in the Shower“ moment

Over the past nine months, the headline US Consumer Price Index (CPI) is annualising at the rate of +3.2%, this is down nearly two thirds from its highs of +9.1%, in June of last year.

US Economic data continues to disappoint, and there are signs that the US economy is on the verge of a recession (if not in one already):

• The US Conference Board leading Economic Index (LEI) is now contracting at -7.8% p.a. (see chart below). During recessions in the early 1970s and early 1980s, the annual decline was never this negative.
• The Philadelphia Fed Manufacturing Index, released last week, came in significantly weaker than expected, falling to -31.3 versus an already pessimistic forecast of -19.3. April’s report was also the 8th straight month, where the general business outlook was negative and there has never been another streak of eight or more months that didn’t occur during a recession
• In the last eight recessions going back to 1970, in the twelve months leading up to the recession, the US initial jobless claims rose by an average of 52,000 (or +20%) from their lowest point in that period up to the start of a recession. Following the revisions earlier this year, the US initial jobless claims have now risen by 65,000 from their low of 182,000 in September 2022 i.e. a +36% change
• While economists were forecasting a decline of -0.5% for March US Retail sales, the actual decline was much larger at -1.0%
• The prices paid component within the Dallas Fed Manufacturing Index continued to tick lower in April, now down to 19.4, its lowest since July 2020. Price pressures have faded quickly, considering the index was at 60.3 one year ago
• In growing signs of slowdown, the US GDP grew at the rate of +1.1% p.a. in Q1, down from +2.6% in Q4 2022, and lower than the +1.9% expected

US Leading Economic Index (white) and US Real GDP growth (orange)

Source: Bloomberg

Last week, there was a flurry of US Federal Reserve (Fed) commentary (see summary below from Bespoke Invest, our research providers), updating us on the thinking of the Federal Open Market Committee (FOMC).

It’s hard to imagine how anyone could credibly make the argument that the US economy is “resilient” and can take more interest rate hikes. Well, there are some, and crucially (or unfortunately), they’re all on the Federal Reserve board.

Only Philadelphia Fed President Patrick Harker sounded the most realistic – “we need to slow it [rate hike] down.. we need not just respond to the current level of inflation, but where we think it’s going,” and that is down to the ugly manufacturing sector report in his Philadelphia district that was released earlier that day.

The FOMC remains set to raise interest rates by +0.25% at their May 2-3 meeting next week. This will bring the Federal Funds Target Rate (FDTR) to a range of +5.0% to +5.25%. That’s a cumulative increase of 5% over 14 months, the fastest pace of tightening since the 1980s (and nearly twice as fast as the rate hike cycle of 1988-89).

In my opinion, the FOMC is at risk of behaving like the “Fool in the Shower” in Milton Friedman’s metaphor – where Friedman likened a central bank that acted too forcefully to a fool in the shower who finds the water too cold. The fool turns up the hot water, but doesn’t realize that hot water takes a while to arrive. He turns up the hot tap even higher and ends up getting a scalding.

Fed officials are increasingly looking out of touch, as they continue to act and sound hawkish, focusing largely on lagging indicators such as CPI, and failing to look at leading indicators such as the –Leading Economic index (LEI) and the Philly Fed manufacturing data, amongst others as outlined above.

Fed officials appear to have little concern over the state of the economy, despite forecasts from Fed staff released last week, which suggested a recession in the second half of the year. For Fed officials to continue to say – “inflation is still too high and proving to be stubborn,” “we are looking for further, sustained improvement in inflation”, the US economy is “resilient,” “we’re still seeing strong economic conditions”…and use that as an excuse to raise rates even further, is negligent and speaks of the lack of “private sector” experience among the current Federal Reserve officials.

Of the 18 members on the FOMC – six members of the Board of Governors of the Federal Reserve and the twelve Presidents of the Regional Federal Reserve Banks, only four have ever worked in the private sector. Of these, only Chairman Jerome Powell and Minneapolis Fed President Neel Kashkari, have private sector experience of over seven years.

To put it numerically – on average an FOMC member has 30 years of post-grad career history. Simple maths tells me that of the 540 years of post-grad career history of the 18 members on the FOMC, only 30 years i.e. 5% of the experience is in the private sector. The rest, 510 years since graduation, has been spent in academia or government positions. That’s not to say they aren’t qualified, however, wouldn’t you want more members on the FOMC with private sector experience i.e. those who have “participated” in the real economy, rather than just “watched”, or “spoken” about it at conferences, and “written” about it in academic papers?

I would.

The recession probability model (see chart below) from the New York Federal Reserve, continues to move up and is now at its highest since 1982.

New York Federal Reserve, probability of recession in the US – 12 months ahead

Source: Bloomberg

We’ve already seen the mistakes of such a group think – the Fed sticking with “zero rates” for longer, saying “inflation is transitory” and so on – and we may be seeing another one in the making as the Fed raises rates to a higher level than warranted.

Quantitative Easing (QE) wrecked the market’s ability to determine prices and interest rates and the stimulus that followed in the wake of Covid-19, distorted things even further. Under the “fiat money” regime that we have, “group think” can just add fuel to the fire.

It’s hard to imagine that Friedman would look at the current Fed and its bloated balance sheet favourably.

When reality hits, rate cuts will inevitably follow. The FOMC focus should return to preserving (and indeed encouraging) growth, and hence avoiding a “credit crunch” and preventing a recession.

Markets and the Economy

This week is all about “big tech” earnings. On Tuesday, we had a biggie from Microsoft (MSFT), which reported 3Q revenues of $52.9 billion, a +7% increase, thanks to beats across all its segments, led by personal computing. Everything from LinkedIn to Office 365 grew more than +10% in constant currency terms as the $2 trillion software juggernaut continued to roll. Microsoft’s shares, which were up +15% year-to-date (YTD), jumped more than +9%, in after-hours trading.

Microsoft expects the integration of Artificial Intelligence (AI) tools into the MSFT suite of products, to be the new growth area for revenues. It has invested billions of dollars in OpenAI, the company behind ChatGPT, and it owns 49% of the company. Will AI be the new revenue driver? Are programs like ChatGPT doing the “thinking” or merely faking it?

We seem to have forgotten about the “Metaverse” craze and the billions Facebook threw at it, only to recoil and correct course.

I use ChatGPT, but it is still just a fancy search engine/word processor with an easy-to-use front end. Despite the buzz and billions being spent on AI startups, we are not in sight of a breakthrough that can impart actual “human feelings” to a computer. Adding GPT to Word and Excel would however enhance the productivity of the MS Office suite, just as adding a motor to a manual screwdriver, can turn it into a power screwdriver and drive productivity.

While Alphabet’s (GOOGL) earnings were not as strong as MSFT, they still topped revenue estimates with $69.79 billion for the quarter, up +3% on the year, and beating expectations of $69 billion. Management kept a lid on costs, including capital expenditures with free cash flow of $17.2 billion coming in well ahead of the $13.5 billion expected by analysts.

Resilient demand for cloud computing and digital advertising together with cost cutting, has helped shore up “big tech” earnings overall.

US tech companies had been expected to produce little growth this quarter, if any, owing to difficult comparisons with the strong start they had to the quarter in 2022 and a spending slowdown that has hit many parts of tech service and product businesses. Therefore, seeing revenue growth is a piece of welcome news and points to the fact that big tech has been on a relentless drive of cost-cutting, increased efficiency and sound execution. We’re now seeing the results

America’s largest technology companies – Microsoft, Apple, Meta, Amazon etc. have all scrambled to identify efficiencies, cutting tens of thousands of jobs, amid heightened anxiety over the state of the US (and the world) economy. We are only one-third into the year and the tech sector layoffs in Silicon Valley for the year, have already surpassed the whole of last year. Almost 169,000 people have been let go since January this year, compared to 164,411 that were let go in the whole of 2022.

Despite the strong rally in equities since the market bottomed on Oct 12, 2022 (table below), Technology (XLK) and Communication services (XLC) stocks are still down between -15% to -27% from their December 2021 highs.

Benchmark US equity sector performance (2022, 2023 YTD and 2023 YTD relative to the S&P 500 Index)

May is upon us and the “Sell in May and go away” commentary – weaker returns during May to October compared to the period from November to April – has started to pour in.

Historically the adage does hold.

Post WWII, the S&P 500 (SPX) median performance during the winter months has been a gain of +6.2% with positive returns 75.6% of the time. During the summer months, however, the SPX’s median return has been less than half this, at +3.0%, with positive returns at 65.4% i.e. 10 percentage points weaker than the winter period.

However, like every other market maxim, “Sell in May” is not a hard-and-fast rule and the reality is more nuanced.

The charts below show that the performance and consistency of positive returns of both the SPX and National Association of Securities Dealers Automatic Quotation System (NASDAQ) during the summer months, is largely based on each index’s YTD performance through April 30.

• In the years the indices were significantly down (more than -5%) through April, the median returns during the summer months were negative for the indices – a decline of -6.3% for the SPX and a decline of over -10% for NASDAQ
• In all other scenarios when the index was down a little (less than -5%) or indeed positive YTD through April, the index median returns were positive during the summer months

Source: Bespoke Invest

With one trading day left until the end of April, the SPX is currently up +5.7% and the NASDAQ is up +13%.

Here’s another reason why it doesn’t make sense to be bearish -positioning. Market consensus is bearish and equities are under-owned. Investors are 27.2% Bullish and 35.1% bearish, per the American Association of Individual Investors’ (AAII) stock sentiment survey. Bearish reading on the survey is above average for the 69th time out of the past 74 weeks. It’s hard to get a sustainable market crash when everyone is looking for it

• Furthermore, the Conference Board’s ‘bull-bear’ spread remained negative for 16 consecutive months. Going back to 1987, the current streak ranks as the second longest on record, trailing only the 18-month streak during the Financial Crisis that ended in April 2009. It reflects the prolonged consumer pessimism towards equities that started in Q2 2021. In the year following previous streaks of nine months or more with negative sentiment, the S&P 500’s performance was consistently positive, suggesting that pent-up demand for stocks may emerge, once pessimism subsides
• Despite the rally we have seen from the October 2022 lows, the SPX and NASDAQ are still -15% and -24% below their December 2021 highs

Benchmark Global Equity Index Performance (2022, 2023 YTD and 6 months)

Meanwhile, in the second largest economy in the world – China, consumer spending is playing a stronger-than-expected role in driving its recovery, after the country lifted its stringent zero-Covid measures. Beijing’s National Bureau of Statistics said Tuesday that the economy grew by +4.5% in the first three months of the year, when compared with a year earlier, the fastest such rate of growth since the first quarter of 2022, and a marked improvement from the +2.9% rate in the last three months of last year.

The strength of China’s economic recovery in Q1, free of its Covid restrictions marked a bright spot for a global economy facing various headwinds – inflation, higher interest rates and fallout from instability in the financial sector.

Very encouragingly, China’s growth in Q1 was driven in large part by retail sales, which jumped more than +10% in March from a year earlier. That was the fastest pace in nearly two years, and helped to offset a sharper-than-expected slowdown in real estate, infrastructure and other private-sector investments. This is a welcome change from the past quarter where the economic boom had been largely built on an investment-driven model which often leads to malinvestments and bubbles in the economy. Since this sharp rebound in consumer spending is largely organic and not driven by government stimulus, Q2 growth could easily get to +6% or more. That would be a bright spot for global economic sentiment.

S&P 500 Index – 12-month price chart

Source: Bloomberg

The SPX has been flat for the last 12 months (see chart above) and we may get more sideways moves in the months ahead. In such circumstances, clipping a 10%-12% p.a. coupon on a basket of large-cap stocks using income-Structured Products is still my favourite play.

For specific stock recommendations and Structured Product ideas please do not hesitate to contact me or your relationship manager.

 
Best wishes,

Manish Singh, CFA

Market expects rate cuts. The US Federal Reserve has ruled out rate cuts this year. However, failure of more smaller banks could lead to rapid emergency easing of rates by the Fed.

Summary

The US Federal Reserve has maintained a moderately hawkish tone and ruled out any interest rate cuts this year. The markets, however, have a different view and seem ready to call the Fed’s bluff. At least, the one thing that the markets and the Fed agree on – no more dramatic increases in interest rates from here.

Over, the last two weeks, the shock of Silicon Valley Bank’s (SVB) failure, delivered a massive blow to the US short-term interest rate markets. Just over three weeks ago, the two-year US Treasury yield was +5.1%, it dipped to +3.7% last week and this morning, the yield stands at +4.15%. These moves provide another example of something that’s “broken” in the aftermath of the Fed’s most aggressive tightening cycle in forty years.

The Fed is banking on generalized strength, a robust economic backdrop, as well as systemically important US banks having robust balance sheets (unlike the holes they had in 2008), in order to stay on its rate path.

However, any broadening of the turmoil in US banking sector due to the failure of more smaller banks, that cuts credit expansion and jams economic activity, could lead to rapid emergency easing by the central bank. Fed Funds futures tend to under-shoot policy rates at inflexion points. In other words, they price too few hikes during tightening cycles (we saw that this cycle too), and too few cuts during easing cycles i.e. you could see well over 100bps rate cuts this year.

For now, however, US economic activity is not collapsing, and growth is still positive. Therefore, the S&P 500 continues to stay in the range it has been in for the last six months, while the Nasdaq has also outperformed.

I continue to be risk positive and even though I expect interest rate cuts this year, a no-rate-cut outcome, wouldn’t bother me, if the economy grows well and rate cuts were delayed for that reason.

US Fed stays hawkish…markets don’t care

US Federal Reserve Chair Jerome Powell to Mr Market: “[FOMC] participants don’t see rate cuts this year. They just don’t. Rate cuts are not in our base case.”

Mr Market to Chair Powell: “Yes you are cutting rates this year.”

On March 22, the Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) approved another +0.25% increase in interest rate. This is the Fed’s ninth consecutive rate increase and brings its benchmark Federal Funds rate to a range between +4.75% and +5%, the highest level since September 2007.

The Fed changed the language regarding the outlook for future rate hikes, replacing “ongoing increases in the target range will” be appropriate, with “some additional policy firming may” be appropriate. The Fed, however, maintained a moderately hawkish tone and ruled out any rate cuts this year.

The markets, however, seem to have a different view. As the chart below shows, the markets seem ready to call the Fed’s bluff on rate cuts this year.

Current market pricing reflects a +0.75% to +1.00% interest rate cut by December. The Fed Fund Futures market is pricing in more than a full 25 bps cut, by the July meeting. This is despite Chair Powell’s and the FOMC’s repeated insistence not to expect a rate cut this year. I’ve been in the financial markets since 2004, I can’t remember a time when there was more of a disconnect between what the Fed is forecasting and what the market is expecting.

At least, the one thing that the markets and the Fed agree on – no more dramatic increases in rates from here. The Summary of Economic Projections (SEP) released by the FOMC reflected that view, with the median Fed Funds forecast for this year unchanged at +5.125% i.e. close to the current upper bound of +5%.

Implied Overnight Fed Funds policy rate and Number of Hikes/Cuts

Source: Bloomberg

Over, the last two weeks, the shock of Silicon Valley Bank’s (SVB) failure, delivered a massive blow to the short-term interest rate markets.

Traditionally, the 2-Year Treasury has been one of the least volatile areas of financial markets, but over the last month, the average daily move in the two-year yield, has been over +17 basis points (bps), the most volatile trading since 1983. Many days saw yields fall by over 50 bps, intraday.

Just over three weeks ago, the two-year yield was +5.1%, it dipped to +3.7% last week and this morning, the yield stands at +4.15%.

We are talking about a US Treasury bond here and not the price of Adele concert tickets!

These moves provide another example of something that’s “broken” in the aftermath of the Fed’s most aggressive tightening cycle in forty years.

Source: Bespoke Invest

The Fed is banking on generalized strength, a robust economic backdrop as well as systemically important US banks having robust balance sheets (unlike the holes they had in 2008), in order to stay on its rate path. A broadening mess in the US banking sector, due to the failure of numerous smaller banks, that cuts credit expansion and jams economic activity, could lead to rapid emergency easing.

Powell emphasized the uncertainty, saying the banking situation “could have very modest effects” on the economy, while also noting the opposite could also be true, thereby leaving the door open for rate moderation. Powell created clear grounds for changing the trajectory of policy conditional on broader pain in the banking sector hitting the real economy.

Small banks play a crucial role in the US economy and, if they fold, the big banks couldn’t fill the gap quickly enough (let alone fill it over time). Small and medium banks account for about 50% of US commercial and industrial lending, 60% of total residential lending, about 80% of total commercial real estate lending, and about 45% of total consumer lending in the US.

The easiest way the Fed can contain regional banks from folding, is by moderating rates lower over time.

The post-Covid world has already reduced the need for commercial real estate, as many employees choose to work from home. Businesses that have still kept office space, in the hope of using it in the future, will have to think hard. If rates stay high, as leases come up for renewal, they may just not be renewed, leaving a stack of non-performing loans on the books of the regional banks. This will force the Fed’s hand very quickly.

On Friday after the close, the Federal Reserve released its weekly snapshot of national bank balance sheets for the week ending March 15, capturing the failure of SVB and Signature Bank. The report shows evidence of deposits flowing away from smaller banks and towards large banks, which is a concern that could imperil regional banks more generally. Large banks saw deposits rise $67bn. Small banks lost $120bn in deposits (the most ever, and a 2.2% decline, the second-largest ever). As for loan growth, the data showed no slowdown for the week across lending categories. That may come later, but at least credit creation hasn’t yet ground to a halt.

Historically, Fed Funds futures tend to under-shoot policy rates at inflexion points. In other words, they price too few hikes during tightening cycles (we saw that this cycle too), and too few cuts during easing cycles i.e. you could see well over 100bps rate cuts this year.

Regular readers of this newsletter will know that I do not see inflation as a problem. On the contrary, disinflation will be a bigger problem, as was the case pre-Covid. Also, given the level of debt in the US economy, a Fed Funds Rate higher than +3 to +3.5%, is unsustainable over the medium to long term.

Markets and the Economy

The key event since last month’s newsletter, is the collapse of SVB, the second-biggest bank failure in US history, with total assets and deposits equalling $212 billion and $173 billion, respectively.

SVB failed because the bank’s management did not effectively manage its interest rate and liquidity risks, and the bank then suffered a devastating and unexpected run by its uninsured depositors, in less than 24 hours. Welcome to the other benefits of online banking – bank runs will happen not at the gates of bank branches, but overnight when branches are closed. Vast sums moved with a few taps on a smartphone.

SVB failed on March 10, 2023. The S&P 500 index is up + 5% since that day.

This “banking crisis” is not your 2008 crisis or Lehman 2.0, as alarmists like to call it. Back then, it was not just a liquidity but also a solvency crisis. Systemically important large US banks were undercapitalised and had too much bad debt on their books. The Fed and lawmakers were slow to realise this problem.

Bear Stearns went under on March 16, 2008, and it was almost 7-month later that the Troubled Asset Relief Program (TARP) – to help stabilize the US financial system, restart economic growth, and prevent avoidable foreclosures – was signed into law by President George W. Bush on October 3, 2008. The first allocation of TARP money was primarily used to buy preferred stock and proved ineffective in stalling the contagion.

On November 12, 2008, US Treasury Secretary Hank Paulson indicated that reviving the securitization market for consumer credit would be a new priority, in the second allotment of TARP and on December 19, 2008, Bush used his executive authority to declare that TARP funds could be spent on any program that Paulson deemed necessary, to alleviate the financial crisis. It was only then that the crisis abated. The hesitation and delay meant S&P 500 index (SPX) kept falling and between March and November 2008, the SPX was down over -40%.

This time around, the systemically important US banks are well capitalised, rules bar them from holding risky assets on their balance sheet (proprietary trading) and the Fed, the Federal Deposit Insurance Commission (FDIC) and the US Treasury, moved quickly in a coordinated fashion, to limit the contagion by guaranteeing all SVB deposits and extending additional support to all banks. Economic activity is not collapsing, and growth is still positive.

Therefore the SPX continues to stay in the range it has been in for the last six months (chart below), while the Nasdaq has also outperformed

1-year price chart: The S&P 500 Index

Source: Bloomberg

There’s another reason why the SPX has held up so well over the last six months – the market is underinvested in equities – as confirmed by the Bank of America (BofA) Fund Managers Survey (FMS) report.

The cash allocation in the report stands above +5.2% in February 2023, whilst the historical average is +4.7%. The cash allocation has remained above the historical average since December 2021.

As rates have risen, cash/deposits have become an alternative but there hasn’t been equity capitulation (chart below from Michael Hartnett of BofA Research)

Data compiled by BofA Research indicate that:

• Since December 2019, there has been a cumulative inflow of $1.6tn into cash, $1.3tn into equities, $440bn into Investment Grade bonds, and $270bn into US Treasuries i.e. in the 2020s, cash has become an alternative
• But there hasn’t been equity capitulation thus far. For every $100 of inflow during the last Bull market, no outflow has happened during the current bear market (vs $113 outflow during the GFC of 2008, $53 outflow during the Eurozone Debt Crisis of 2012 and $61 outflow during Covid-19)
• As you can see, the equity line in the chart below has flatlined since last April– i.e. no net inflow/outflow for over 12 months.

The dry powder packed in deposits will start flowing into equities and other risk assets as we come to the end of the hiking cycle, risk factors abate and sentiments improve.

Yesterday, BofA reported that its client flows to US equities posted their biggest week since October, adding that they bought both single stocks and ETFs, with bigger inflows into stocks. BofA clients were net buyers of US equities for the fourth straight week. BofA is the second largest prime broker, hence their client flows offer useful insights into market sentiments.

Cumulative flows by asset class since December 2019

Meanwhile, the sentiment regarding Emerging Market equities, is already a lot better and keeps improving.

Chinese equities have recouped nearly half their recent losses and the news that Alibaba would likely split into 6 groups- brought additional cheer, with BABA up +10% on the day. The break-up of Alibaba will help unlock value.

The reorganization of one of China’s largest private companies, once valued at more than $800 billion but now worth about a third of that, comes after Chinese authorities signalled in recent months they were winding down a sweeping regulatory clampdown aimed at reining in the country’s powerful tech sector. The return of the government’s supportive stance toward China’s private enterprises is very welcome news.

After more than a decade abroad, Alibaba’s co-founder Jack Ma was spotted back in China on Monday, a co-incidence only if you don’t know how China works. It will be interesting to see if another coincidence is soon announced – Ant’s IPO. Bet on it.

Benchmark Global Equity Index Performance (2022, 2023 YTD and 6 months)

If you are in the pessimist camp, there’s a lot not to like about the market these days, but the performance of the semiconductors, has been an area of optimism.

Last week, the Philadelphia Semiconductor Index (SOX) broke out of a sideways trading range and is not far from its 52-week highs. This, with only 47% of stocks above the 50-day moving average, i.e. there’s more upside to this ETF.

Much of the strength in the semis has been attributed to NVIDIA (NVDA), which has been on fire this year, rallying more than +80% on the explosion of AI-related interest.

Semiconductor stocks, long seen as a cyclical play, may be turning into a secular growth story, particularly if the AI-driven revolution stacks up well over the next few years. One to watch.

3-Year Price chart: The Philadelphia Stock Exchange Semiconductor Index (SOX)

Source: Bloomberg

Another stock-specific news, which indicates earnings are not as weak as some anticipate.

Last week, Nike (NKE), announced a dramatic fiscal Q3 revenue beat of +8% alongside adjusted and diluted EPS +46% higher than forecast. North America and EMEA both grew more than +20% on a constant currency basis thanks to spectacular results in footwear, especially. Very few wanted NKE at $80, now everyone will want it at $120.

Warrant Buffet once said, “be fearful when others are greedy, and greedy when others are fearful.”

At Crossbridge, we chose to be greedy when others were fearful and launched the following product in November 2022 which has an attractive +15.6% coupon, with a Leveraged Put.: 5 Year 15.6% p.a. Decreasing Trigger on Nike, Disney, Pepsi, and Constellation.

The note is currently trading at 101.03, with a carry (coupon) accruing as the product progresses.

My point? You do not have to have a bullish view in order to invest. The beauty of a structured product, is you can “create a product” to suit the prevailing and forecasted outlook.

As I keep reiterating – Structured Products are a very useful means of investing in equities. They offer a degree of capital protection, while at the same time helping pick good entry points in the market, and offering means to clip coupons, in a flat to negative market.

For specific stock recommendations and Structured Product ideas, please do not hesitate to contact me or your Relationship Manager.

I continue to be risk positive and even though I expect rate cuts this year, a no-rate-cut outcome, wouldn’t bother me if the economy grows well and rate cuts were delayed for that reason.

Pessimism makes for stories and WhatsApp forwards, but unattractive for portfolio returns.

If you have a medium to long-term investment strategy and you don’t use leverage then you have little to worry about and build your portfolio with the right selection of products and structures. We are here to help. So, please do get in touch.

 
Best wishes,

Manish Singh, CFA

Inflation peaked last June. The Fed risks killing “aggregate demand” if it doesn’t change course on rates.

Summary

The “Inflationists” won the inflation debate in November 2021, but their victory was “transitory”, as US inflation peaked seven months later in June 2022, at +9.1%. It currently sits at +6.4%, annualising at +3.2% over the last seven months. The US Federal Reserve’s effort to cool inflation, is not only working, but has worked its way through to the point where the focus should now shift from inflation to growth.

Raising interest rates further could easily sacrifice “aggregate demand” and kill the US economy’s clearest bright spot in recent years—a strong job market. A recession leading to inevitable rate cuts would undo the progress made so far by the Fed in coming out of “zero rates.” It would be better to focus on the medium-term trend in data, than to panic with one print which is above expectations.

We all should take heart that in Fed Chair, Jerome Powell we have a person who is less academic and more practical, thus well suited to ignoring the baying mob and staying focused on economic growth, just as much as inflation, and seeing through the “transitory” impact of Covid-19 on the inflation numbers.

We are in the favourite part of the US Presidential cycle. The third year of a Presidential cycle tends to be the most bullish for US equity markets, with a median return of +17% with positive returns an incredible 95% of the time. It’s no surprise then that the equity markets have held up well over the last two months. Easing inflation and seasonality both doing their job to keep getting the dip buyers at every opportunity. Melt-up (with some sideways moves) is the trade, whether the equity bears like it or not.

“Inflationists” won the inflation debate in 2021, but…

Over the past 12 months, as the US Federal Funds Target Rate (FDTR) climbed to +4.75% from +0.25%, inflation sparked a furious debate that turned into an obsession within the commentariat.

Between March and November 2021, the US Consumer Price Index (CPI) rose from +2% (the US Federal Reserve’s target inflation rate), to +6.5%.

At the November 22, 2021, Federal Open Market Committee (FOMC) meeting, Fed Chair, Jerome Powell announced that the Fed would stop characterizing the high US CPI prints as “transitory.” The inflationists, led by the likes of former US Treasury Secretary Larry Summers, took a victory lap, and rightly so.

The “Inflationists” won the inflation debate, but their victory was “transitory,” as US inflation peaked seven months later in June 2022, at +9.1%. It currently sits at +6.4% (annualising at +3.2% over the last seven months – a lengthy enough timeframe to reach such a conclusion.)

The November 2021 announcement by the Fed, was largely symbolic, as the Fed’s job is to manage “expectations.” You don’t expect a central bank to be alarming in its communication. It leaves that to politicians and the talking heads on television, who love sensationalism more than rationalism, and rarely, if ever, have “skin in the game.”

We are now almost in the Spring of 2023. Inflations peaked eight months ago and since then, inflation has been coming down steadily, yet some continue to agitate for a higher Fed Funds Rate.

As recently as last week, Summers doubled down by saying, “the Federal Reserve’s efforts to cool inflation aren’t working as well as hoped.”

I would say:

• US CPI is down from +9.1% to +6.4% (and annualising at +3.2% over the past seven months)
• The US yield curve has inverted to an extent not seen in the last 40 years
• The risk of a recession is rising
• Goods prices are in disinflation
• Housing starts have declined for nine months in a row

All the above, are signs that the Fed’s effort to cool inflation, is not only working, but has worked its way through to the point where the focus should now shift from inflation to growth.

The Fed has raised short-term rates to such a high level that the spread between 2 year and 10 year Treasurys (chart below) at -86 bps, is at a worse level than the one observed in 1987 (Russian default, Asian financial crisis, Long Term Capital Management(LTCM) collapse), in 2000 (the Dotcom crisis) and in 2007-08 (the Great Financial Crisis).

US Treasury 10-year yield minus US Treasury 2-year yield

Source: Bloomberg

Besides, there’s more to the headline CPI number than meets the eye. So, let’s take a closer look at the CPI data:

• The core goods inflation is already negative, and volatile energy prices have collapsed. The only thing keeping headline CPI high is “shelter”. Shelter makes up 34% of the US CPI basket and remains stubbornly high at over +9%. However, crucially, the shelter data lags the actual housing/rental market data by 8-12 months
• The CPI ex-shelter data (chart below) is already in disinflation. as of June 2022 to the current data. From June 2022 to January 2023, CPI ex-shelter, is annualising at i.e. -1.6% p.a. i.e. disinflation

US Consumer Price Index (all items, ex-shelter)

Source: US Bureau of Labour Statistics (BLS)

So, “shelter” should peak and roll over during the March -June 2023 period.

What happens to headline CPI data once its largest component normalises/ goes negative, as the current rental data indicates? Disinflation is the answer. The Fed knows “disinflation” is what it will have deal with for years to come, and it has set in already.

If this is not a sign that the Fed has done enough and the focus should stay on growth, then I don’t know what is. Thankfully, the Fed is not run by the likes of Summers, else we’d be in an economic depression now, due to policies to combat “inflation” brought on by transitionary factors.

Regular readers of this Newsletter will recall my concern that “disinflation” is where we are headed, and the short bout of inflation we have seen, is the result of Covid-19 and the accompanying fiscal spending.

Those still demanding the 1970s “Volcker shock” ought to read this newly published paper. The researchers at the Fed have concluded that Covid caused a “demand reallocation shock,” not a startling conclusion you might say. What’s more interesting is this – the reallocation shock “is able to explain a large portion—3.5 percentage points—of the increase in US inflation, post-pandemic.”

Covid-19 didn’t lead to an increase in “aggregate demand” to a new level. It shrunk “aggregate supply,” as fewer goods were made globally, due to Covid-induced disruptions. As restrictions eased, supply has caught up and inflation declined. Why then still this obsession with inflation you might wonder, even as there’s plenty of evidence that inflation has peaked. There’s a simple explanation.

Last time the world worried about inflation, was in the 1980s when the then Fed Chair Paul Volcker raised rates to +20% to curtail inflation plunging the US economy into its worst recession since the end of World War II. For much of the last four decades, inflation has taken less of macroeconomists’ and policy analysts’ time, so much so, that they are now in danger of overdoing it with their prescription to deal with a short-term burst in inflation.

However, could the inflationists force the Fed’s hands to take interest rates to +6%?

The probability of this happening is low, however, I wouldn’t bet against it, as the market did force the Fed’s hand in June last year.

Last June, as the CPI vaulted to +9.1% and the inflation-is-here-to-stay noise grew, the Fed hiked rates by 75 bps (after hiking 50 bps in May). It was the first of four 75 bps hikes last year. It’s worth noting that the CPI has been in decline ever since that June print.

What I am certain about is that if the Fed Funds Rate gets to +6%, the rate cuts that ensue will be much deeper than currently anticipated – most likely over 200 bps when the cuts start.

Data released on Friday by the US Commerce Department indicate that the Fed’s preferred inflation gauge—the Personal-Consumption Expenditures (PCE) price index—rose +5.4% in January from a year earlier. The PCE core index, which excludes food and energy and is seen as a better predictor of future inflation, rose by +4.7%.

Both readings, were on the higher side of the market’s expectations, so expect the clamour for a 50bps hike at the next Fed meeting on March 14 to grow.

Markets will continue to be in panic mode with every data that prints hotter than expectations.
Importantly, the Fed doesn’t expect inflation to slow down quickly, and they’ve already said so. The Fed’s Q4 2023 core PCE inflation forecast is +3.5% y/y which is very achievable.

The core PCE with new rent data (swapping in new rents for all rents using the Zillow and Apartment List numbers) is already at +3.4% i.e. the Fed will not be in panic mode and they have started using “disinflation” in communication and have guided for a 25bps increase.

We all should take heart that, in Powell, we have a person who is less academic and more practical, thus well suited to ignoring the baying mob and staying focused on economic growth just as much as inflation and seeing through the “transitory” impact of Covid-19 on the CPI prints.

In my opinion, the Fed will see through the noise in the January data. Besides, the Fed has only just locked in one 25bps hike given the language change in its last statements “in determining the extent of the future increase in the target range, the committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation and economic and financial developments.”

As the chart below indicates, whatever the quibbling and noise in the data, disinflation in core CPI (left hand side) and the PCE (right hand side) is happening.

Core US Consumer Price index (CPI), & core Personal Consumption Expenditure (PCE)

Source: Robin Brooks, Institute of International Finance (IIF)

Raising rates further could easily sacrifice “aggregate demand” and kill the US economy’s clearest bright spot in recent years—a strong job market that is delivering higher gains to low – and moderate-wage workers. If the “transitory” inflation of the past 20 months forces the Fed to push the economy into a recession, then it would undo the progress made so far by the Fed in coming out of “zero rates.”

Melt-up (with some sideways moves) is the trade, whether the equity bears like it or not. That’s the reason the S&P 500 has held up so well in face of better-than-expected US Jobs report, a higher headline CPI report and better than expected Retail sales number. It’s better to focus on the medium-term trend in data than to panic with one print which is above expectations.

Markets and the Economy

Did the S&P 500’s (SPX) closing low in October last year, mark the start of a new bull market (20%+ rally on a closing basis without a -20% decline in-between)?

From the Bear’s perspective, it hasn’t been a convincing rally. More than four months past the October lows, the SPX is only up +10.8%, and its maximum gain was +16.9%. Here we are 135 days removed from that October low, and the SPX still hasn’t reached the +20% threshold for a bull market. The Bears do have a point, even if it’s purely observational. To find a bull market, where it took the SPX longer to reach the +20% bull market threshold, one must go back to 1962. The ten bull markets between then and now all reached the +20% point faster.

I am reminded of what the great pragmatist and former Chinese leader Deng Xiaoping, famously said, “it doesn’t matter if a cat is black or white, so long as it catches mice.”

So, as someone who believes we are in an uptrend in SPX, it doesn’t matter if the number of days to get to +20% is 140 days or 200 days, so long as the trend continues and the market keeps ticking up with some sideways consolidation.

Take a look at the chart below. There’s little doubt that the downtrend in place for much of last year has been broken (a very constructive development from a technical perspective) for well over four months, and we are in a steady rally. A well-defined short-term uptrend is in place for the SPX.

The 50-day and 200-day moving averages have held up well. In technical analysis, we like to say “old resistance becomes new support” and we’ve seen a great deal of that since last October.

The economic data backdrop looks steady, as PMI data around the world has started to perk up, China’s reopening offers the hope of a further normalization of supply chains and global activity, and central banks globally seem to be nearing peak hawkishness for the cycle.

S&P 500 Index – 12-month price chart

Source: Bloomberg

You may be sick of politics and political shenanigans. You may not be interested in voting for either the Democrats or the Republicans. However, if you are holding US equities, then you can’t ignore the statistics during the third year of the US Presidential cycle.

We are in the favourite part of the Presidential cycle. As the chart below from Goldman Sachs research indicates – the third year of a Presidential cycle tends to be the most bullish for US equity markets, with a median return of +17% with positive returns positive an incredible 95% of the time. Intuitively, this makes sense, as US Presidents begin eyeing re-election in the third year of their first term, and promote growth and market-friendly policies to boost their chances of re-election.

Whatever the reason, going back to 1932, when Democrat Franklin D. Roosevelt defeated Republican Herbert Hoover in the race for the White House, the stock market performance in the third year of the Presidential cycle has been impressive. This is a statistic that mustn’t be ignored.

A key point that the table below doesn’t indicate yet is significant:

• The first six months of the third cycle year have averaged a gain of +12.6%, with all 18 of the returns being positive. The second half of the third year has averaged a much softer return of +3.93%. So, if you are still waiting for that market drop then you’ve missed the Jan month impressive return and you might miss the whole of H1 if you don’t act fast

And if you are wondering how the third year performed, after stocks suffered in the prior year? Then the stats are even more impressive.

• The third year of the cycle has seen a big bounce-back. In the eight years that the second year of the cycle was negative for the SPX, the third year averaged a gain of nearly +25%, with all eight returns positive. By comparison, after a positive second year in the cycle, the index averaged a gain of approximately +10% in the third year with a positive return 80% of the time.

It’s no surprise then that the equity markets have held up well over the last two months. Easing inflation and seasonality both doing their job, to keep getting the dip buyers at every opportunity.

What’s even more impressive is the performance of Chinese equities, as China has fully re-opened after the Covid lockdown. China’s central bank, the People’s Bank of China (PBoC), is injecting a record amount of liquidity (chart below) into the market. On the 15th of this month, the contents of President Xi Jinping’s speech at China’s central economic work conference in December last year, were published in the party journal, Qiushi.

Titled “Several Major Issues in Current Economic Work”, the speech emphasises on expanding domestic consumption – “Prioritize the recovery and expansion of domestic consumption this year… consumer credit support should be reasonably increased .. the need to innovate consumption scenarios, and fully release consumption potential. The need to increase the consumption capacity of low and middle-income residents who have a high propensity to consume but are greatly affected by the epidemic. Rolling out policies aimed at stimulating spending on housing and unlocking consumer savings.”

Source: Bloomberg

Unlocking consumer savings is the crucial point. According to figures from the PBoC, Chinese savers had bank deposits totalling US$2.6 trillion in 2022, up a whopping +80% from 2021.
It also bodes well for Chinese equities.

Post-Covid China is a very different China and it is amped for plenty of growth and change. A growing China, with a larger consumer base bodes well for the European economy, particularly one which counts China as its major export destination.

Joe Ngai, Chairman of McKinsey & Co. Greater China put it best – “if China’s GDP grows at a conservative +2% annually for the next 10 years, the total cumulative growth will be equal to India’s GDP today. If China’s GDP grows at +5%, the total cumulative growth for the next 10 years will be equal to todays’ GDPs of India, Japan and Indonesia are put together. If you are looking for growth the answer is very simple – the next China is China.”

It’s not just China that is easing, but Japan too.

The market is failing to consider the scale of easing/liquidity injection in both China and Japan, the second and the third largest economies in the world, respectively.

After an equity market correction of -63% from February 2021 to October 2022, Chinese equities are up +53% since their October lows and the Chinese Yuan is stronger by +7%,

More economic growth lies ahead.

Benchmark Global Equity Index Performance (2022, 2023 YTD and 3 months)

Source: Bloomberg

With short-term rates pricing in Fed Funds at well over +5%, earnings yields are only slightly above 6-month US Treasury bill yields.

With so much return available risk-free at the front of the curve, equities have work to do keeping valuations high enough amidst falling earnings estimates.

This is where Structured Products become a useful means of investing in equities. They offer a degree of capital protection, while at the same time helping pick good entry points in the market, and also offer means to clips coupons in a flat to negative market.

For specific stock recommendations and Structured Product ideas please do not hesitate to contact me or your relationship manager.

 
Best wishes,

Manish Singh, CFA

“The US headline inflation at +6.5% doesn’t convey the full picture of where inflation is headed. Inflation is crashing. The new bull run may already be here”

Summary

The new Bull market is already here – Chinese equities, the EuroStoxx 50 and Emerging Market equities – have broken their downtrend and are up more than +20 to 30% from their recent lows. However, there is no Bull market for US equities yet.

The relaxation of China’s strict zero-Covid policy has boosted the economic growth prospects and the likely export prospects of the Eurozone. Add to this, the warmer weather in Europe, which has helped temper the intensity of the energy crisis feared over the last quarter, and Europe may actually avoid a recession by the looks of things and the US may experience one. How ironic would that be?

After negative returns in 2021, last year, US Treasuries, arguably, the safest asset in the world, returned -17%. Their worst returns since the State of Massachusetts ratified the United States Constitution and became the sixth US State in 1788. In their 250 years history, US Treasuries have never had three consecutive years of negative returns. So, it’s safe to conclude (and history is onside) that 2023 will be a positive year for investment in US Treasuries. The US is nearing the end of the interest rate cycle and rate cuts lie ahead.

Given how negative sentiment is towards economic growth and US equities, the biggest contrarian trade for 2023 would be: The US avoiding a recession as the Fed relents and does not raises rates to +5.25%. The S&P 500 in such a case could have a +20% year.

The US ISM index has continued to drop, the OECD leading indicators have dipped into contractionary territory, yield curves have inverted, recession talk is everywhere…and yet over the last three months, copper prices have risen +28%. Dr Copper seems to be telling us something. China’s re-opening is a big boost to the global economy and copper prices. This, in my view, is the key macro development that will have a profound effect on asset prices this year. So stay tuned!

Skate to where the puck is going to be…not where it has been

Equity markets have started the year on a positive note with European, Chinese and Emerging Market (EM) equities, continuing to build on their rally that began in Q3 last year.

The new Bull market is already here – Chinese equities (ASHR) are up over +30% from their lows, the EuroStoxx 50 (SX5E) is +26%, and the MSCI Emerging Market Index (EEM) is +24%, as they have all broken their downtrend.

However, there is no Bull market for US equities yet. The S&P 500 (SPX) and the NASDAQ (QQQ) are up +12% and +10% respectively from their October lows. The focus in the US still seems to be on inflation and interest rate hikes by the US Federal Reserve (Fed).

If the US does experience a recession, much of the blame will rest with the Fed, which has continued to raise rates, despite all signs that inflation is not only under control, but has collapsed.

Let’s look at the data for US inflation. The chart below lays out the month-on-month change in the US Consumer Price Index (CPI) index, a measure of US inflation.

A glance at the chart will tell you that the six-month prints from July 2022 to December 2022 couldn’t be more dissimilar from the prior six-month prints.

US Consumer Price Index (CPI) month-on-month change – 1 year chart

Source: Bloomberg

The US CPI hit a 40-year high in June last year, after months of sustained price increases. However, since then, the monthly gains have slowed down sharply.

US Inflation has declined over the past three to six months, due largely to falling energy prices and prices of goods, such as used cars. There are certain signs that soaring rents and other housing costs are cooling, amid a sharp slowdown in demand, although this isn’t expected to show up in official CPI measures, until later this year, such is the quirkiness of the CPI calculation.

A simple calculation will reveal:

• The US CPI annualised at +10.4% in the first half of 2022, and
• The US CPI annualised at +1.8% in the second half of 2022 which is close to the average annual inflation rate of +1.7% between 2010 and 2020

Taken together, it left the headline inflation at +6.5%, which still doesn’t convey the full picture of where inflation is heading.

One should be more concerned about where inflation is heading and not where it is. As the ice hockey great Wayne Gretzky once said: “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.”

The “inflation puck” is already below the Fed’s target rate of inflation of +2%.

The Fed has continued to sound hawkish and kept the relentless focus on the headline number, as it seeks to overcompensate for past mistakes. This has led many to stay focused on rate hikes rather than see the impending pause, followed by rate cuts, as data deteriorate.

In my opinion, there is no need for the Fed to raise rates any further. However, I don’t run the Fed and therefore, I reiterate what I wrote in the December Market Viewpoints – “The Fed will be forced into cutting interest rates in Q3 as it responds to recession.”

The more the Fed raises rates from here, the more it begets a recession and rate cuts down the line. The market knows this and as such, you have seen a steady rally in risk across asset classes.

When looking at annual change (chart below), 2022 marked the most aggressive (largest) move for the Fed Funds Rate in the last 50 years.

The US Federal Funds Target Rate (upper bound) – Annual change

Source: Bloomberg

Financial conditions are very tight and the economic data isn’t getting any better.

Earlier this week, the crucial Conference Board’s Index of Leading Indicators reading (chart below) dropped -1.0% versus already weak expectations of a decline of -0.7%.

Not only that, but November’s reading was also revised down from -1.0% to a drop of -1.1%

• On a Year-on-Year (YoY) basis, the index of Leading Indicators is now down -7.4%, the weakest YoY reading since the Covid-19 lockdowns and the level we saw during the 2008-09 recession induced by the Great Financial Crisis (GFC)
• The chart below shows the YoY change in Leading Indicators since 1963 with the red line indicating the level as of December 2022. Since 1960, there has never been a time when the YoY reading was as low or lower than it is now and the economy wasn’t in a recession
• There were also two other periods where the economy had a recession, and the YoY change wasn’t even as negative as it is now

December’s decline in the index of Leading Indicators was the third straight month of over -1% drops. In every prior period since 1963, where there were at least two consecutive month-on-month declines of at least -1%, the economy was already in a recession.

Source: Bespoke Invest

Are we already in a recession?

Well, the data is weak across the board. However, in the current President Joe Biden economy, two conservative quarters of negative GDP isn’t considered a recession. Additionally, the employment leg is still holding strong and consumers are still spending the savings they accumulated during the recent lockdown.

That being said, I have no doubt that the Fed must be getting worried about the recessionary indicators turning a brighter shade of red.

The Fed will very likely increase rates by +0.25% next week. That increase would bring the Fed Funds Rate to a range between +4.5% and +4.75%.

Most Fed officials projected in December that rates would rise to a peak between +5% and +5.25%. That would imply two more +0.25% increases, after the likely increase next week.

A Fed Funds Rate at +5.25% is not my base case and rates at that level will make a US recession even likelier. However, I do see a scenario in which Fed does take rates to +5.25%.

The Fed has rightly turned its focus recently toward a narrower subset of labour-intensive services, by excluding prices for food, energy, shelter and goods.

Inflation in this narrow category is running at +4.4%, up from around +2.3% on average between 2010-19. This data will reveal, if higher wage costs are passing through to consumer prices.

If services inflation is high, because pay checks are rising in lockstep with prices, then Fed officials would want to see more hiring slowdown to avoid a 1970s-style wage spiral setting in i.e. rates will have to go higher, possibly to +5.25%, unemployment will rise and wages will moderate. The US jobs market has been tight, with an unemployment rate of +3.5% in December matching multidecade lows.

In such a scenario, a US recession is even more likely than it already is, given a lot of growth data is already flashing red.

I maintain that rates will have to be cut in the second half of this year by as much as 150 bps (if not more), as a recession ensues.

Markets and the Economy

Fashionistas will tell you that Europe sets the trends. This certainly seems to be the case as far as equity markets are concerned, with the Eurostoxx 50 (SX5E) outpacing the S&P 500 (SPX) by a wide margin (see table below). It goes to show what “unloved/oversold” assets can do when they change course.

Benchmark Global Equity Index Performance (2022, 2023 YTD and 3 months)

The relaxation of China’s strict zero-Covid policy has boosted growth prospects and likely export prospects of the Eurozone. Add to this, the warmer weather in Europe, which has helped temper the intensity of the energy crisis feared over the last quarter.

On economic activity front, on Tuesday, S&P Global said its composite output index for the US, a closely watched survey of business activity, was 46.6 in January, a slightly better reading than December’s reading of 45. In Europe, however, the index rose to 50.2 from 49.3. A reading above 50 points to an expansion, while a reading below that level points to a contraction.

Europe may avoid a recession by the looks of things and the US may experience one. How ironic would that be?

One clear explanation for all this – the difference between Eurozone and US monetary policy

In the Eurozone, interest rates didn’t start increasing until July, and we have seen a total increase of +2.5% (see chart below).

In the US, rates started increasing in March, and we saw an increase of +4.5%. The US got to +2.5% rate when the Eurozone was still at 0% in July. If there’s one consolation – rates in Europe have further to rise, perhaps another +0.75% to +1%, while the US may be nearing the end of its rate-increase cycle.

12-month chart – ECB main refinancing rate and US Fed Funds Rate

Source: Bloomberg

As the trade-weighted US dollar (DXY) has pulled back -9.5% from its high in September, Emerging Market currencies versus the US Dollar have risen over +10%, on a total return basis. As a result, over the last three months, Emerging Markets equities (EEM) have outperformed US equities (SPX) by over +20%.

Also, if rates were to go higher in the US, then other markets will have consternation too i.e., no rapid rise in equities to a higher level.

As I wrote in my December Newsletter, I see a +10% year for US equities, and we have seen half of this already.

Technically, a lot is going on for the SPX (see chart below).

A clear break above the 200-day moving average (DMA) will be very positive for the SPX. Also, what we have seen recently are higher lows (filled circles in the chart below), a sign that momentum is building up.

I do not see new lows (barring an inflation spike, and a re-aggressive Fed). A rip-roaring rally can be ruled out as long as recession fears overhang. Not until the Fed indicates it is willing to cut rates, will you see a stable up-trend.

Until then clipping coupons and investing in income strategies on a basket of oversold/attractively priced equities or broad market equity indices are sensible trades to do.

1-year price chart: S&P 500 Index

Source: Bloomberg

US Treasuries’ (10 Year US Govt bond), arguably the safest asset in the world, returned -17% in 2022. This is its worse return since 1788. Yes, you read that correctly, the worse return since Massachusetts ratified the United States Constitution and became the sixth US State in 1788.

2022 was also the second year in a row of negative returns for US Treasuries. In their 250 years history, US Treasuries have never had three consecutive years of negative returns.

So, it’s safe to conclude (and history is onside) that 2023 will be a positive year for investment in US Treasuries. The US is nearing the end of the rate cycle and rate cuts lie ahead.

By the same reasoning investment in investment grade bonds – 2 to 5-year duration – seem to be a sensible trade. The Investment grade yield curve, at the shorter end, is more elevated and offers investors an attractive yield of +4% to +5%. Besides, any future rate cuts will impact shorter end 2y bonds more than the 10y bonds.

Benchmark US equity sector performance (2022, 3 month, 2023 YTD and 2023 YTD relative to the S&P 500 index)

Former UK Prime Minister Margaret Thatcher once said – “Nothing is more obstinate than a fashionable consensus.”

Given how negative sentiments are towards economic growth and US equities, the biggest contrarian trade for 2023 would be: The US avoiding a recession as the Fed relenting and not raising rates to +5.25%. The S&P 500 in such a case could have a +20% year.

Let me give you something to chew on as you, if only briefly, dwell on this constructive/bullish view.

Copper is often described as “the metal with a PhD in economics” as it forecasts economic expansion and contraction. The chart below plots the price of copper alongside the US ISM Manufacturing PMI index, one of the most reliable monthly indicators of US economic activity.

The ISM index has continued to drop, the OECD leading indicators have dipped into contractionary territory, yield curves have inverted, recession talk is everywhere … and yet over the last three months, copper prices have risen +28%.

Dr Copper seems to be telling us something. China’s re-opening, as it abandoned its misguided zero-Covid policy, is a big boost to the global economy and copper prices. It is the key macro development that will have a profound effect on asset prices this year.

Chinese mortgage rates are at record lows, household cash piles are at record highs, and the Chinese government has scrapped its “three red lines” which restricted bank lending to the real estate sector. The resulting demand boost by itself, could explain the sudden rebound in copper prices and hence economic activities.

So, I would caution against too much pessimism.

Price chart: Copper and ISM Manufacturing PMI index (NAPMPI)

Source: Bloomberg

And here’s some data to mull over as you make up your mind:

• The S&P 500 has historically posted stronger gains in February and for the remainder of the year when January has been an up month
• Including 2023, there have been 13 years since WW2 where the SPX gained in January after posting declines in the prior year. Those years have seen a strong rest-of-year return with an average gain of +16% from the end of January through December and positive returns 10 out of 12 times.
• In the eight prior years since WW2 where the SPX gained at least +4% in January, after posting a decline in the prior year, the index rallied at least +10% for the remainder of the year all eight times with an average gain of +21%

The SPX is currently up +4.6% month-to-date after falling -19.4% in 2022. With four trading days to go this month, let us hope this gain is maintained.

For specific stock recommendations and Structured Product ideas please do not hesitate to contact me or your relationship manager.

 
Best wishes,

Manish Singh, CFA