The few smartest gentlemen in the room worthy of the title are back today with grisly new warnings. BofA is still the grizzly:
The Metacurse: world of extreme inflation,rates shock just beginning(“75bpsisthenew 25bps”), secular flip from QE-winners to QT-winners (see natural resources vs biotech–Chart3) well-underway as era of higher global rates begins(Chart4);“rates shock”=techtrauma…social media stocks back at spring 2018 levels (Chart2).
The Charge of the Hike Brigade: 75 global rate hikes YTD–highest net % centralbanks hiking since 2008 (Chart5)…era of higher volatility has begun; but Charge of Hike Brigade follows >1000 cuts since Lehman and $23tn of QE; asset, housing, consumer, commodity, consumer inflation of 2022 demands that coming Quantitative Tightening is draconian.
Das ist mir Inflation: Russia-Ukraine is 488th European military conflict of past 2000 years; GermanPPI up 30.9% YoY (Chart6) = highest since 1923 (aftermath WW1) & 1948 (aftermath WW2), double “peak inflation” rates of 1974 when Bundesbank deposit rate was 7%; ECB repo rate won’t remain-0.5% for long.
Miami Heat: house prices in Miami up 28% YoY in Jan (Chart7), Miami rents up 58%past 2 years, US house prices up 19% YoY, strong US housing activity Q1 (the lead indicator for US consumer), strong US labor market (the lagging indicator)…zeitgeist shifting from Fed 25/50bps to 50/75bps each meeting;homebuiilders-25% & banks down, yields up combo (Chart8) hints necessary rate hikes won’t be positive for growth.
BofA Global EPS Model: driven by PMI’s, Asian exports, China FCI, US yield curve model predicts deceleration in global EPS growth from 21% into negative territory by year-end (Chart 9); note recent resilience of Asian exports & global PMIs mean more moderate deceleration in EPS growth next 6 months.
Shoichi Yokoitrade: BoJ the last central bank left fighting the last war; BoJ Kuroda continues to vow unlimited bond buying in order to achieve…?…since BoJ introduced Yield Curve Control in 2016 Japan GDP growth has been 0.0%, CPI 0.2%; it’s always the unintended consequences that are the most consequential…
AsianFX War:…Japanese yen has been devalued to cheapest level vs Chinese renminbi in almost 30 years (Chart10); and in lockdown China 2022 new orders are contracting, retail sales are down 3.5% YoY, and most ominously of all, the Chinese unemployment rate has jumped to 5.8% (Chart11); China now responding to weak Japanese yen & Korean won via currency weakness; FX war in Asia could see super-spike in US dollar and signal temporary break in commodity fever (overbought, overloved).
Trading bear markets: bear sentiment, waning war fear (see Russian ruble), inflation“peak”, set-up for bear rally not bad; but central banks the oncoming freight train, and will tighten until credit and/or consumer break; technicals to confirm SPX floor of 4200 tested before SPX ceiling of 4800…MOVE (Treasury volatility) index >150 & DXY >105 means “credit event” imminent, while copper breaking down, oil <$95/b & semiconductors (SOX) closing below 200-week moving average (2996)would imply growth taking turn for the worst, and incite rotation from last cyclical holdouts (resources) to defensives of utilities, staples, healthcare, low volatility, high quality, cash; note inability of the new FAANGs…US value (SPYV), resource rich indices (UK, Canada, Australia) to confirm new highs this week.
It is not yet clear to me that we have entered an era of structurally higher inflation courtesy of MMT. I can see the possibility that the current inflation bout kills that off among policymakers. I am, therefore, much less certain of any long-term commodity bull market. Anyway, what is clear is that any and all of these arguments are being swamped by the cyclical tightening underway in the US combined with the war and energy shock in Europe and OMICRON plus property shock in China. Commodities are going to puke with everything else.
Morgan Stanley is also still bearish:
Harder to hide… Over the past year, equity markets have provided plenty of opportunity to investors who were nimble and traded it with the major averages flat to down. With defensives the latest big outperformer, they are now expensive, leaving very few places to hide. This suggests the S&P500 will finally catch up to the average stock and enter a bear market (-20%).
Defensives still a good relative trade, we prefer large cap Pharma/Biotech… Large Cap Pharma & Biotech’s defensive attributes make it a consistent outperformer in the type of macro backdrop we expect in 2022—slowing EPS growth, decelerating PMIs and tighter Fed policy. On top of that, it offers a relatively attractive dividend yield at a compelling valuation level. As the US economy moves to a late cycle phase and GDP/earnings growth rates decelerate for the overall economy and market, we think Pharma/Biotech’s defensive properties will outweigh policy concern and drive relative performance higher—a dynamic that has started to play out since November of last year. On this score, this morning, we also published a joint note with our Biotech and Pharma analysts, reiterating our OW strategy view on the space (Large Cap Pharma & Biotech: Defensive Exposure at an Attractive Price).
Margin expansion is slowing and companies thatareguidingfora2021 repeat are at risk… We track incremental operating margins for a sign of where the profit cycle is heading. Incremental margins peaked in 1Q 2021, which is one of the major reasons we made our mid cycle transition call at that time and downgraded small caps. Since then, we’ve witnessed a sharp deceleration, supporting our current late cycle view. Looking ahead, consensus expectations are pointing to margins expanding again even though incremental margins are likely to fall further and cost pressures are likely to persist—a poor setup for revisions, in our view.
Even Goldman is starting to sound chastened:
Financial conditions tightened this week as nominal 10-year US Treasury yields neared 3%, reaching their highest level since late 2018, and real yields verged on turning positive. Year to date, the Goldman Sachs Financial Conditions Index (“FCI”) has tightened (risen) by 138 bp (see Exhibit 1). The index, which combines interest rates, equity prices, corporate credit spreads, and the US dollar, has been driven in roughly equal proportion by the 138 bp YTD increase in the 10-year USTreasury yield and the 8% YTD decline in the S&P 500 (see Exhibit 2).
Despite the recent tightening, our economists believe financial conditions need to tighten further for the Fed to successfully combat inflation. Each 100 bp tightening in the FCI slows real US economic growth by roughly 100 bp during the subsequent four quarters. Due to the historically extreme current mismatch between the numbers of jobs and workers, our economists estimate the Fed will need to generate another 75 bp of FCI tightening in order to slow wage growth to the pace of roughly 4% that would be consistent with the Fed’s overall inflation target of 2%.
Concern that Fed tightening will trigger a recession has recently been a major focus of client conversations. Our economists assign a 35% likelihood of recession in the next two years. However, they note that monetary policy soft landings are historically rare,and have described the outlook for the Fed as a “hard path.” TheS&P 500 has fallen by a median of 24% from peak to trough during 12 recessions since WWII, a drawdown magnitude that would bring the index to 3650.
Because financial condition tightening typically involves lower equity prices, even a relatively good outcome for the economy may be a poor one for equity investors. Equities are the most volatile component of the FCI. Based on the typical historical relationship, a 75 bp FCI tightening would include a 9% fall in the S&P 500 to 4000. However, equity bears point out that stocks have driven most of the FCI easing in recent years and argue that equities should therefore account for most of the tightening going forward. The US FCI currently ranks in the 6th percentile since 1990 while the FCI excluding equities ranks in the 59th percentile, slightly tighter than the historical average. For equities to drive the entire 75 bp FCI tightening described by our economists, the S&P 500 would have to decline by 15% to 3700.
Equity bulls point out the possibility that FCI could tighten without the participation of stock prices, or that it might take place later, after further equity appreciation. Recent Fed hiking cycles (1999, 2005-2006, and early 2018) represent periods when equities continued to climb despite overall FCI tightening, although each of these episodes eventually resulted in sharp equity downturns. Within the equity market, the FCI has recently been strongly correlated with the relative performance of Growth vs. Value. Growth stocks lagged as financial conditions tightened in early 2022, rebounded alongside FCI easing in March, but have trailed since then as the FCI has tightened further (see Exhibit 4).
Orderly FCI tightening calculations do not account for the likelihood of credit events that spike the index. Nor can it capture tipping points in sentiment.
My base case is now for the Fed to tighten until both break, even into the European war and energy shock plus China and OMICRON and property shocks. All three thus lead to a global recession and major deflationary shock exacerbated by collapsing supply chain tightness and an old-fashioned commodities puke.
MB Fund remains very underweight equities, moderately long bonds and very long cash.