A Fed boom or a Fed bust for stocks?

ZH has a couple of good wraps. First, bearish:

For the past year BofA Chief Investment Strategist, Michael Hartnett, has been one of Wall Street’s gloomiest strategists (perhaps just below Albert Edwards and Michael Wilson on the permabear scale) warning that global markets are on the precipice of a very ugly turn of events, and predicting that 2022 will unleash a “rate shock” that will hammer risk assets, and as 2022 gradually rolls out, doling out major pain for the bulls, his predictions are finally coming true.

But for all the complaints from stock investors, nowhere is the pain more acute than in the White House, because as Hartnett writes in his latest weekly Flow Show note, US inflation is up from 1.4% to 7.0%, while Biden’s approval rating is down from 56% to 42% past 12 months. One can almost imagine what Biden told Powell during that renomination phone call…

As Hartnett explains for the cheap seets, inflation = economic and political problem, writing that Joe needs 50bps from Jerome at Jan FOMC. And while Biden won’t get it, the BofA strategist notes that the Fed will be very hawkish next 9 months, “so short the winners of Fed’s liquidity supernova – tech, IG, private equity.”

The take home from the above is that after a decade of Fed desperation to hike inflation, the central bank finally got what it wanted… and is now trapped because, as Hartnett lists:

  • inflation is off-the-charts,
  • oil prices strong,
  • supply bottlenecks remain, with China freight prices at all-time highs…

… and the less-acknowledged G7 unemployment rate (@ 4.5%) close to 40-year lows = wage growth..

And while it is like beating a dead horse by now, Hartnett – who has written about this topic extensively – notes that the coming “rates shock” will be global in ’22, while the deflation of long duration bonds (Austrian 100-year bond -34% in price terms) is leading deflation of long duration equities (biotech, software, solar, ARKK…).

Which brings us to the core of Hartnett’s note, which is his explanation of the market’s latest “conundrum” – the drop in the dollar, which as the BofA strategist writes is getting smoked despite 7% inflation, <4% unemployment, and a behind-the-curve Fed. Why? Because global investors’ belief is US fading fast; dollar debasement = yields up & dollar down = 1970s, when cash/commodities outperformed stocks/bonds. That, in a nutshell, is ’22 thus far).

Yet a dropping dollar doesn’t mean “cash is trash” – just the opposite (curiously, every time Dalio says Cash is trash, the market crashes within 3 months): as Hartnett explains in a section on “asset allocation”, cash outperforming stocks and credit rare, and has happened just twice in past 30 years – 1994  and  2018 – both “Fed-shock” years…  but the stagflation era of 1966 to 1981 saw cash outperform stocks & credit 7 out of 16 years (Table 1).

And like every stagflation, we see a furious response from central banks which Hartnett dubs simply “The Tightening”: as of this moment, EM leads largest global tightening wave since 2011 past 6 months 49 global rate hikes vs 7 cuts (here one can note that the big story is not the coming tightening cycle from the Fed but the biblical easing that will follow).

But before we get the easing, we need to hike…a lot: inflation YoY in US, UK & Europe is currently 7%, 5%, 5%, and if inflation continues to rise 0.4-0.5% MoM (the average pace in ’21) over the next 6 months, then inflation will hit 6% in US, 7% in UK, 6% in Europe “making total mincemeat of Fed/BoE/ECB inflation forecasts 2.6%/3.4%/3.2%.”

So while the tightening is coming, the inflation is already here, and as Hartnett puts it simply, inflation always precedes recessions:

  • late-60s recession preceded by consumer price inflation,
  • 1973/4 by oil/food shocks,
  • recession of 1980 by oil,
  • 1990/91 by CPI,
  • 2001 by tech bubble,
  • 2008 by housing bubble

… and the slower the Fed reacts – here Hartnett again notes that the Fed should hike 50bps on Jan 26th – on fears of upsetting Wall St, the more inflation & recession risks grow, and the more likelihood US dollar debasement scars 2022.. albeit great for EM/commodities.

To be sure, the coming recession won’t be just in the markets, it will hit consumers especially hard.

Why? Because the best consumer news are now behind us – as we noted this morning, retail sales are 22% above pre-COVID levels while payrolls up 18mn from lows but still well below pre-covid levels.

As a result, in 2022 consumers face inflation annualizing 9% (food 23% YoY, heating 50%, rents 13%, house prices 18%), real earnings falling 2.4%, synonymous with recession – see 1974, 1980, 1990, 2008, 2020…

…  while stimulus payments to US households evaporating from $2.8TN in ’21 to just $660bn in 2022, meaning there is no more buffer from excess US savings (savings rate = 6.9%, lower than 7.7% in ’19…and as we repeated all the time, the “rich” hoard the savings), and as we said this morning, a record $40bn MoM jump in US consumer borrowing in Nov’21 sign to us that consumer starting to feel the pinch.

But while consumers patiently await for purgatory, Small Business are already in recessionary hell: the number of small businesses saying inflation/labor costs/poor sales the #1 problem is highest since 2010; this has historically coincides with recession.

Finally, there is the Profit Recession, where things get funny, because while all predict multiple contraction, few predict EPS contraction, and yet…the BofA global EPS model predicts marked deceleration from 40% last summer to 5% next summer (model driven by China FCI, Asia exports, global PMI, US yield curve), and could turn negative in the second half!

Hartnett is certainly right that nobody is prepared for what’s coming: the latest weekly fund flows showed a massive $30.5bn inflow to stocks (“nobody is short the equity market”), $0.1bn from gold, $2.9bn from bonds, and the largest outflow from cash since Sept 21, at $43.5BN.

Rounding out his apocalyptic views, Hartnett continues to think the S&P will test 4000 before 5000, delivered by <$200 EPS & <20x PE

Finally, this is how Hartnett is trading the coming apocalypse: bearish, negative credit & stocks returns in ’22 driven by “rates shock” H1 & likely “recession panic” in H2.

  • Longs:
    • 1. volatility, high quality, defensives on tighter financial condition;
    • 2. oil, energy, real assets on inflation (Chart 6);
    • 3. EAFE/EM banks on reopening;
    • 4. Asia credit on (very) distressed yield (Chart 8).

Shorts:

1. IG & HY bonds on Quantitative Tightening;

2. short private equity & broker dealers on wider credit spreads;

3. short tech/Nasdaq on higher rates/less capital flow from Europe/Asia.

Second, bullish:

Rate hikes are now just right around the corner and traders are freaking out, but not so fast according to Goldman.

Following the FOMC meeting in mid-December, and especially last week’s FOMC minutes and the subsequent jawboning by various Fed officials,, it has become clear that the Fed will not only double the pace of tapering but also signaled three hikes in 2022. As a result, virtually all sell-side economists – even stern holdouts such as Morgan Stanley and Bank of America – have raised their forecast from three hikes in 2022 to four – with the first hike now expected to occur in March. Their forecast reflects the greater sense of urgency on behalf of FOMC participants towards quelling inflation, which rose to a four-decade high of 7% as measured by the latest year/year CPI. Why this urgency? Because as one can imagine, Biden was very clear in what Powell’s mandate was when he was renominated: “crush inflation as it is crushing my approval ratings”, because as BofA’s Michael Hartnett noted on Friday, “US inflation is up from 1.4% to 7.0%, while Biden’s approval rating is down from 56% to 42% past 12 months.”

But why is the Fed rushing to hike when a growing chorus of economists now agrees with us that the Fed is hiking right into a recession (or alternatively, hiking to create a recession) an observation that was validated by Friday’s dismal retail sales data… and even without validation, the endgame is clear: as David Rosenberg noted recently, every time the US has had 5%+ inflation, it ended in recession.

Well, according to Goldman’s David Kostin, the unprecedented strength of the labor market has made the Fed more sensitive to high inflation and less sensitive to slowing growth. Alongside rising inflation, the Fed has also cited strong employment data as a catalyst for earlier liftoff and balance sheet reduction. The unemployment rate now stands at 3.9%, falling slightly below the FOMC’s 4.0% median estimate of its long-term level (although looking ahead, Kostin notes that surveys of workers and businesses indicate wage growth is expected to slow to about 4% this year).

To be sure, the market already reflects this and real and nominal rates have both jumped in anticipation of the upcoming tightening cycle. Since the December FOMC meeting, the 10-year US Treasury yield has surged by 26 bp to 1.77%. Consistent with historical experience, equities have struggled amid this rapid rise in yields, and the fastest-growing and longest-duration pockets of the market – i.e., the biggest bubbles such as profiless tech names, the ARKK ETFs, SPACs and so on – have de-rated most.

As a quick aside, perhaps the main reason for the equity puke in the past two weeks is not so much the jump in absolute yield in the past month, but the speed of the move. As Goldman showed in a separate report earlier this week (also available to professional subs), regardless of the level of interest rates, equities react poorly to sharp changes in the interest rate environment, and the past week has been no exception: “Historically, equity prices have declined when interest rates rose by two standard deviations or more. This is true for both nominal and real interest rates across both weekly and monthly periods. The two standard deviation threshold was exceeded on both horizons last week, and the accompanying equity weakness followed the usual historical pattern.”

But while that may explain short-term moves, surely higher rates will lead to longer-term weakness no matter what. And while the answer is yes, the next table shows the sensitivity of the S&P 500 forward P/E multiple to various interest rate and ERP scenarios. Goldman’s interest rate strategists forecast a continued rise in real interest rates that will lift the nominal 10-year Treasury yield to 2% by year-end 2022 (more below), however they also expect the ERP to compress modestly from current levels as the pandemic recovery continues and economic policy uncertainty surrounding potential reconciliation legislation passes. In this base case scenario, the S&P 500 P/E multiple would remain roughly flat this year, allowing earnings growth to lift the index price level. But, if the ERP were to rise to its 10-year median and the Treasury yield rises to 2.25%, the P/E multiple would compress by roughly 15% to 17x, and not even Goldman can spin that as positive.

In any case, as Kostin writes in his latest Weekly Kickstart, market pricing and client conversations indicate investors are braced for a string of hikes in 2022, and as a result, questions from Goldman clients during the past two weeks “have focused on the relationship between equities and interest rates, indicating that the hawkish FOMC pivot is being actively assessed by equity investors.” Moreover, the overnight index swap (OIS) market is currently pricing 3.6 rate hikes in 2022 and 2.6 in 2023, just below the 4 and 3 hikes, respectively, that Goldman forecasts (spoiler alert: the total number of rate hikes will be far less once stocks crash).

And this is where Goldman enters the bullish spin cycle, because the bank makes much more money when its clients buy (only to sell in the future), than selling now. So to ease client concerns that the bottom is about to fall off the market, Kostin writes that “historically” (because clearly we have had many “historical examples” when the Fed’s balance sheet was 45% of US GDP), the S&P 500 index has been resilient around the start of Fed hiking cycles, noting that “although the index has returned -6% on average during the three months following the first hike of recent cycles, the weakness has been short-lived as returns average +5% during the six months following the first hike.” Moreover, as Goldman shows in exhibit 3, the S&P 500 P/E is typically flat during the 12 months around the first hike.

Drilling down into segments, Goldman notes that cyclical sectors and Value stocks outperform around the first Fed hike. The reason: the start of Fed hiking cycles (usually) tends to coincide with a strong economy, which can help to lift cyclical sectors (Materials, Industrials, Energy). However, this time around it is starting as the economy is rapidly slowing yet inflation remains stubborn due to supply-chain blockages, and as such anything Goldman suggests you should do, please ignore it.

Which is probably also true for factors. According to Kostin, at the factor level, Value stocks tend to outperform in the months before and after the first hike: “High quality factors (e.g., high margins, strong balance sheets) underperform in the strong economic environment preceding hikes and outperform in the months following the initial rate increase. Growth is the worst performing factor in the 6 months around the first hike.” Here too, we would flip this 180 degrees because the Fed is now hiking to effectively start a recession (or as the US is already en route to one), so what one should be selling is value while buying growth ahead of the next rate cuts/QE which are now just a matter of time.

Next, Kostin brings out the heavy artillery and urges his skittish clients to consider that “surprisingly” equities have historically performed well alongside rising expectations for Fed hikes. Here, the bank examines the six-month periods since 2004 when OIS pricing of the 5-year-ahead fed funds rate increased by 25 bps, excluding episodes when the Fed was cutting rates.

During these episodes, nominal 10Y yields typically rose by 52 bps with roughly even contributions from real yields and breakevens. Despite this, the S&P 500 returned 9% (vs. its unconditional 6-month average of 5%). Higher earnings expectations drove these rallies as increases in fed funds pricing usually coincided with improving expectations for economic growth. However, as we have repeatedly warned and as even Kostin concedes, “the current inflation-led hiking cycle may prove more challenging for equities.” We are not sure this will boost the confidence level of Goldman clients who are on the fence to just BTFD…

After the initial stage, when markets price more eventual rate hikes, cyclical sectors typically outperform while bond proxies lagged according to Goldman. Industrials, Consumer Discretionary, and Materials outperform the S&P 500 on average during these episodes, with financials especially sensitive to the long-term interest rate outlook and also outperforming. Meanwhile, bond proxy sectors such as Utilities and Consumer Staples underperformed sharply.

As noted above, value has typically outperformed alongside rising market expectations for Fed hiking, but only in cases when the the hiking cycle was led by growth expectations, not to crush inflation, so this time one can argue that everything will be flipped. And while traditionally, small-caps also outperformed, as “quality” factors underperformed, the recent weakness in small-caps confirms that this is anything but an ordinary rate hike cycle.

Curiously, even in his bullish pitch to clients, Kostin – perhaps hoping to preserve some credibility- admits that this is not a typical rate hike cycle, and the recent hawkish pivot has been driven not by “improving growth expectations but by inflation risks” yet even so Goldman’s economists expect growth to remain above-trend in 2022 because, of course, what else can they do: start sounding like Zero Hedge and admit that the Fed is hiking into a recession.

And indeed, Kostin admits that “fading expectations for fiscal stimulus and the hit from Omicron have led our economists to downgrade their growth outlook in recent weeks” however – perhaps unwilling to piss off Biden too much – they still forecast 3.4% GDP growth this year, a stepdown from the 5-6% pace in 2021 but still above their 1.75% estimate of trend growth. Translation: the US will be in a recession by the midterms, courtesy of the Fed.

So after all that, if Goldman clients aren’t running for the hills, maybe the will BTFD after all, and for them, Kostin writes that investors “should balance their exposures to Growth and Value” as Goldman’s rates strategists expect yields will continue to rise, a dynamic that should support Value over Growth, unless of course we enter stagflation at which point all is lost (incidentally, as noted last week, Goldman expects nominal 10-year yield to hit 2.0% by year-end 2022 (with real rates rising to -0.70% almost where they are now) and 2.3% by the end of 2023).

From a growth perspective, Goldman economists expect the waning of the Omicron wave to lift GDP growth from 2% in 1Q to 3% in 2Q, supporting Value stocks. But they expect growth will slow to a 2% pace by 4Q 2022, the type of environment that generally supports Growth stocks. Translation: yes, growth stocks are getting crushed now, but as soon as the current whisper of a recession/stagflation becomes a chorus, watch as “growth stocks” (i.e., the bubble/bitcoin baskets) explode higher and surpass their previous all-time highs.

In short, Goldman’s current recommended sector overweights reflect a barbell of Growth and Value:

  • Info Tech remains the bank’s long-standing overweight due to its secular growth and strong profit margins.
  • Financials should benefit from rising interest rates
  • Health Care combines secular growth qualities with a deep relative valuation discount.

Finally, from a thematic perspective, Goldman continues to recommend investors own highly profitable growth stocks relative to growth stocks with low or no profitability. To this, all we can add is that with low growth stocks having been absolutely nuked by now, the highest convexity when the recessionary turn comes, will be precisely in the no profitability growth sector, which will double in no time once the coming recession/easing cycle becomes the dominant narrative.

I sit between these two analyses but that effectively makes me bearish. I still view inflation as temporary (even with a boost from OMICRON) largely because I expect US goods demand to slow pretty quickly into Fed tightening. For me, therefore, the Fed chasing today’s inflation will turn pro-cyclical in due course.

This comes with a secondary bust in the commodity space which is very inflated by a stagflationary narrative despite there being no underlying shortages of anything. Where there is scarcity it is OMICRON impacts or speculative frenzy.

With the end of the Biden stimulus, I am even more convinced that secular stagnation will be back before this year is out and the Fed is tightening directly into it.

Therefore, the Fed and markets are heading into a rerun of the mid-cycle corrections we witnessed in 2015 and 2018 which will anticipate (and force) the end of Fed tightening before very long.

We remain quite underweight equities with a quality tilt and overweight cash plus long DXY.

Houses and Holes

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