Stocks still in firing line as cycle overheats

Morgan Stanely with more useful warnings for stocks:

For investors, 2022 should be called The Year of theFed with every meetingand communication more hawkish than the last. It’s almost comical how fast the markets’ expectations have changed in the past 4 months. After all, it’s not like inflation was dormant in 4Q21 (Exhibit 1). It’s fair to saytheFed missed the boat on inflation being transitoryand was slow to tighten policy. In fact, Chair Powell has admitted as much. However, it’s also fair to say the bond market completely missed the boat, too. Indeed, many bearish bond bets got run over last fall by a bond market that remained extremely resilient in the face of what was clearly a Fed that was behind the curve of inflation that was unlikely to be transitory. These mis-priced yields helped the S&P remain resilient which also ignored the growing risk of a more hawkish Fed in the fourth quarter of2021.

On that score, the internals of the stock market are once again diverging from the message from the bond market. More specifically, back end rates have had one of it’s largest 1 month moves in history as Fed funds futures catch up to reality. To be clear, we don’t have a bone to pick with this move higher in rates given the state of inflation and the Fed’s persistent attempt to convince the world they are going to do whatever it takes to quash it. However, we do question the bond market’s apparent view that the Fed can do this much tightening without impacting the economy in such a way that this path for rate hikes will be challenging to complete.

Exhibit 3 shows the 10 year Treasury yield is simply a function of where the market thinks Fed funds rate will be at it’s peak for this cycle–the Morgan Stanley Terminal Rate. As already noted, this has been one of the sharpest resets we have ever seen. In prior episodes when the Terminal rate, and consequently 10 year yields, has adjusted so abruptly, it marked a top for both. In short, the bond market does the tightening for the Fed long before it actually raises rates. In that sense, it acts as it’s own governor because higher rates will ultimately slow inflation, and the economy, which is the Fed’s desired goal. Of course, this means eventually lower expectations on how high theFed will be able to raise rates before it has to pause/stop. This is the way it always works and as our rates strategists have recently noted, the bond market is almost probing for what the level of rates is that will ultimately slow growth and subsequently reverse as it always does. In their latest note, they argue bond yields have likely entered the “overshoot” zone with back end rates most likely to consolidate recent gains as growth slows.

The relationship between Fed Funds and 2year notes shows the same thing but 2year yields actually lead the moves in Fed Funds and therefore 10 year yields, too. Looking at the chart we can see that in the past few cycles,2year notes did a fairly accurate job of forecasting where Fed funds would peak. However, when we look at therecoveryin theearly1990s, the2year note overshot to the upside and predicted a Fed Funds rate that was unachievable–i.e. theFed had to pause and even cut rates to keep the expansion going. This was the last time the Fed was so far behind the curve and we find it instructive for this cycle. It’s also the soft landing episode the Fed is hoping for, so it probably makes sense to examine the outcome. In 1994, rates market adjusted quickly to the Fed’s aggressive pivot, similarly to today. However, it got ahead of reality as the economy slowed as the 10 year yield soared to 8% and the Fed was forced to abort the forecasted path of hikes and even cut rates to keep the expansion going.

While this is very plausible outcome and one that is worth shooting for, call us skeptical it is achievable. The main reason we don’t see this as a repeat of 1994 is that this expansion is already much further along in terms of where we are based on the data (Speeding Through a Hotter but Shorter Cycle). If we had to pick just one data point to compare it would be the unemployment rate relative to NAIRU, or the noninflationary rate of unemployment. Here, we can see that there just isn’t anywhere near the amount of slack in the labor market as there was in 1994 when the rates market made such a similar pivot to a more hawkish Fed (Exhibit 5). Based on the CBO’s estimate of NAIRU, we are already close to 1% below that level. This compares to 1994 when unemployment was more that 1% above NAIRU. That 2% spread suggests the Fed has a lot less runway to work with even if they decide to pause prematurely to where the market is now projecting–i.e.Fed Funds Terminal rate of 3.19%.

Bottom line, we continue to recommend defensives even though they have already had a great run of performance. Perhaps the best expression of this view is the relative trade of defensives versus cyclicals which appears to still have a long way to go if we are right to be worried about growth. The recent acceleration here is encouraging in that regard as the cyclicals finally start to give it up. It’s also another warning sign that 10 year Treasuries are potentially in overshoot mode and looking toppy.

The permabullish JPM has joined in which makes me quite uncomfortable:

Cross-Asset Strategy: We retain a pro-risk view and continue to recommend OWs in equities and commodities and UW in bonds. Prior to the Ukraine war, growth was expected to accelerate to well above trend as we reopen from the Omicron wave and see an unleashing of pent-up consumer and corporate demand. Although growth prospects have been downgraded over the past month, much of this impulse remains and we still see supports from strong labor markets, light investor positioning, healthy consumer and corporate balance sheets, easing policy in China, and fiscal supports in several countries to offset part of the drag from high energy prices. However, markets have recovered a majority of their earlyMarch sell-off and thus no longer look oversold, while risks remain elevated around geopolitics, policy tightening and growth. As such, we take profit on the tactical increase to our equity OW initiated last month. While the US appears to be on an aggressive tightening path, China is expected to ease as soon as this month. As such, we increase our OW of EM vs. DM stocks. We also maintain our large strategic OWs of Commodities and Energy stocks given structural supply/demand drivers (see our supercycle thesis) and geopolitical risks.

There is some comfort in there for me. EM and commodities are the last place I want to be as global recession threatens over H2, 2022 and into next year:

  • China is pushing on a string so long as property is out of the reflation.
  • OMICRON is a big problem that Beijing can only beat by killing the economy.
  • An external shock is building as the European war ad energy shock plus US rates shock kill imports.
  • DXY is mounting into a blowoff move.

Beware EM and commods!

Houses and Holes

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