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Bonds

Bulls Remain in Charge As Rebound Continues

Futures are slightly lower this morning after two strong days of gains as bulls remain in charge but the rebound continues. Treasury bonds and the dollar sold off as the risk-on sentiment took hold. The S&P 500 gained 1.2% to close above its 50-day…

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Futures are slightly lower this morning after two strong days of gains as bulls remain in charge but the rebound continues. Treasury bonds and the dollar sold off as the risk-on sentiment took hold. The S&P 500 gained 1.2% to close above its 50-day moving average for the first time since last Friday. The 10-Year Treasury yield rose by roughly 7 bps to 1.41%, and the dollar lost 0.46%. Based solely on the sharp rise in bond yields, it appears the initial reaction to the FOMC meeting is signaling that the Fed may be too late to curb inflationary pressures.

Index futures are pointing slightly down this morning, while the longer end of the yield curve is flat to slightly higher. Cryptocurrencies and crypto-related stocks are struggling in response to a new policy out of the Peoples Bank of China that makes all crypto-related transactions illegal, according to Bloomberg.

What To Watch Today

Economy

  • 10:00 a.m. ET: New home sales, month-over-month, August (1.0% expected, 1.0% in July)

Earnings

  • No notable reports scheduled for release

Politics

  • The Federal Reserve will host a virtual Fed Listens event at 10:00 a.m. ET, called “Perspectives on the Pandemic Recovery.” Chair Jerome Powell will provide opening remarks and other Fed governors will moderate the conversation among leaders in the private sector.

Market Trading For Friday, Sept. 24th.

Heading into September, we spilled a lot of ink about us raising cash, increasing bond duration, and rebalancing equity risk. With our previous “sell signal” beginning to reverse, we have spent the last couple of days putting that excess cash back to work.

With the market reclaiming the 50-dma and buy signals close to triggering, the bulls are back in charge. It will be important for the market to hold the 50-dma by the close of trading today. There is still some downside risk short-term with the “debt-ceiling” debate, China, and markets still processing the Fed’s announcement.

Maintaining some risk hedges, for now, is logical until the market clears the 50- and 20-dma moving averages successfully.

Buybacks Are Surging And That’s Good For Stocks

Buybacks have been a major contributor to stock market returns over the last 5-years. With corporations flush with cash after pandemic-related bailouts, they are putting that cash to work. However, they are doing that in the one area that benefits insiders the most.

As opposed to the mainstream narrative, stock buybacks are NOT a return of capital to shareholders. We dig into the reasons why in this article.

PMI

The PMI composite index fell slightly as growth is “hampered by severe supply chain hold-ups and capacity shortages.” Both manufacturing and services sectors continue to signal solid economic expansion. Inflation however remains a concern. The following paragraph from the report leads to concern the recent stabilization in headline inflation data may not be lasting: “

On the price front, input costs rose at a sharper pace during September. The rate of cost inflation was the quickest for four months, and the second-highest on record, as supply chain disruptions and material shortages pushed prices and transportation costs up. Meanwhile, output charges continued to increase markedly, continuing to rise at a pace far outstripping anything seen in the survey’s history prior to May, as firms sought to pass on higher costs to clients where possible.

The Evergrande Saga

Evergrande is required to pay $83 million of interest on a dollar-denominated bond today. Per Newsquawk, they have a 30-day grace period as part of an existing agreement before the debt is classified as a default. It appears as if Evergrande may give a preference to paying off Yuan-denominated debt and obligations over foreign-held dollar-denominated debt. They have another $47.5 million dollar-denominated interest payment due next week.

Is Now the Time to Buy Stocks?

Fed Rate Projections

The two graphs below are the “dot plots” from the Federal Reserve showing Fed member expectations for where the Fed Funds rate will be in the coming years. The graph on top is the set of projections from June. At the time only 5 members thought they would raise rates four times or more by the end of 2023. As shown on the bottom graph, with yesterday’s projections, that number stands at 9.  There are also 2 more Fed members that think the Fed will hike rates in 2022 compared to three months ago.

June

September

All Ears on the Fed

With the Fed meeting behind us, Fed members can now speak publicly. We expect a deluge of speeches and interviews over the coming days as members try to clarify the Fed’s views as well as their personal opinions. We are on the lookout for dissension in the ranks by the members that are overly concerned with higher inflation. While Powell clearly set out a time frame for taper, the Fed might get cold feet if the equity markets turn lower. If that were to happen some of the hawks may become even more vocal about the need to taper and ultimately raise rates. In The Fed Speaks Loudly and Carries a Feather, we decompose the Fed members by their voting status and degree of influence. The chart below and the article provides some context for their latest thoughts on the economy and policy.

The post Bulls Remain in Charge As Rebound Continues appeared first on RIA.

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Economics

Two Quick Notes: Inflation and the Stock Market Plunge

Sorry folks, I’m back!!!! Anyhow, I was following the news the last few weeks and was struck by a couple of items that seem to have gotten little attention….

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Sorry folks, I’m back!!!! Anyhow, I was following the news the last few weeks and was struck by a couple of items that seem to have gotten little attention.

First, on inflation, we have seen a sharp fall in the breakeven inflation rate for inflation-indexed 10-yearTreasury bonds compared with conventional Treasury bonds. This breakeven rate had been rising through the fall and winter, peaking at just over 3.0 percent on April 21.

Anyhow, it has since fallen sharply, and stood at 2.6 percent on Monday. This is still somewhat higher than the Fed’s 2.0 percent inflation target, but not by much, since everyone expects higher inflation in 2022 and there is around a 0.3 percentage point gap between the CPI, which is the basis of the index and the PCE deflator than the Fed targets.

The drop in this breakeven rate deserves more attention than it’s getting. As someone who warned of both the stock bubble in the 1990s and the housing bubble in the 00s, I am well aware that markets can be wrong, but it is still worth paying attention to what they are telling us.

Rather than seeing a story of spiraling inflation, actors in financial markets seem to be expecting that the inflation rate will quickly fall back to more moderate levels. That is worth noting.

 

 

The other issue is the plunge in the stock market that has upset many people, including some self-identified liberals. There all sorts of factors, both rational and irrational, that can explain stock market movements, but in principle, the stock market is supposed to represent the discounted value of future corporate profits.

Many of us have noted that the pandemic inflation has been associated with a sharp shift from wage income to profit income, with the latter rising by roughly two percentage points of corporate income. The immediate trigger for the latest plunge was reports from Target and Amazon that they are seeing increasing pricing pressure, and therefore lower profit margins, on a wide range of goods.

Let’s suppose that this is the beginning of a reversal in profit shares, with the possibility that they will return to their pre-pandemic level. This is what many of us had been hoping for.

But what would be the predicted effect on stock prices of a drop in profit shares of roughly 2 percentage points, or 10 percent of current profits? That’s right, we would expect a plunge in stock prices. The good news for workers here (lower prices mean high real wages) is bad news for the stock market.

Too early to say if this is in fact the story, but if it is, progressives should be happy.

The post Two Quick Notes: Inflation and the Stock Market Plunge appeared first on Center for Economic and Policy Research.

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Spread & Containment

What Did Other Term Spreads Do? And What Does the US Spread Mean for Foreign Economic Activity?

As noted in the post by Rashad Ahmad, foreign yield curve developments helped predict US growth. What did those spreads do? And, turning the question on…

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As noted in the post by Rashad Ahmad, foreign yield curve developments helped predict US growth. What did those spreads do? And, turning the question on its head, what does the US spread mean for those economies’ recession prospects?

Figure 1 depicts 10yr-3m sovereign spreads over time — so before the 2007 recession and during the run-up to  the 2020 pandemic.

Figure 1: 10yr-3mo Treasury spread (bold black), 10yr-3mo government bond – 3 month interbank spread for Canada (blue), for France (brown), for Germany (green), for Japan (red), for UK (dark gray). Source: Treasury via FRED, OECD Main Economic Indicators via FRED, and author’s calculations.

A cleaner measure for the foreign countries would’ve used sovereign yields for the short rate, to make comparable to the US spread (and to control for default risk), but I couldn’t get that easily.

While Chinn and Kucko (2015) examined cross-country evidence for own 10yr-3mo term spreads predicting recessions, we did not examine whether US term spreads had predictive power for foreign recessions. Mehl (2009) examined the usefulness of US spreads for predicting other-country economic activity and inflation rates — but using the 5yr-3mo spread. See the (brief) review of predicting recessions cross-country in this post.

A quick and dirty look at the data shows that the US term spread does not help much in adding to the 12 month predictive power of own-term spread for recessions during the 1970-2022M05 period for the countries shown above (recession peak-to-trough dates from ECRI). The probit regression involves the local economy recession indicator on the LHS, and the local term spread on the RHS, alone and augmented with the US term spread, along with a constant. (Of course, results might change with the addition of other covariates like oil price, equity prices and some measure of financial conditions).

Note that I only examined recessions; I didn’t examine growth or inflation. More for later.

 

 

 

 

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Bonds

Too Early To Get Bullish: Mike Wilson Sees S&P Tumbling To 3400 In Less Than Three Months

Too Early To Get Bullish: Mike Wilson Sees S&P Tumbling To 3400 In Less Than Three Months

A curious trend has emerged in Bank of America’s…

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Too Early To Get Bullish: Mike Wilson Sees S&P Tumbling To 3400 In Less Than Three Months

A curious trend has emerged in Bank of America's monthly Fund Manager Survey: with every passing month, as the S&P grinds lower and lower until it finally briefly dipped into a bear market on Friday, the prevailing consensus among Wall Street investors for where the "Fed put" is has also declined with every passing month...

... and is currently at just 3529, down from 36347 in April, and from 3698 in February.

None of that is a surprise to Morgan Stanley's Michael Wilson (the second most bearish "Michael" - and strategist - on Wall Street after BofA's Michael Hartnett) who one week after saying that the S&P will likely drop to 3,400 as "that is where valuation and technical support lie" before rebounding to his base cae target of 3,900, picks up where he left off and in his latest Weekly Warm-up note, says that bearishness is spreading fast and "de-rating is now a consensus view" but the magnitude is still up for debate (as the above shrinking Fed Put trends show).

As Wilson elaborates in his latest note (available to pro subscribers) while most clients agree P/Es should be lower than last year, there is still some debate around how low P/Es should fall. In this context, many MS clients believe that the de-rating is now over with the S&P 500 NTM P/E having fallen to 16.5x from 21.5x last November. Here Wilson agrees, but is not so sure that earnings forecasts are correct.

In fact, Wilson adds, the S&P 500 reached a reasonable level last week when ERPs traded as high as 345bps which is right in line with Morgan Stanley's current fair value target. However, according to Wilson, 345bps is too conservative now given the likely fall in earnings forecasts and PMIs over the next 6 months, not to mention the greater than average geopolitical risks. Indeed, P/Es typically lead EPS revisions and this time should be no different.

Meanwhile, just to make sure he continues to lead the market on the way down as all of his peers scramble to catch down to his year-end forecast, Wilson again lowered his target P/E on both a normalized (16.5x) and short term (14.5x) basis "given the risk to earnings growth that is more visible and less deniable, particularly for consumer and technology oriented companies. Or as he puts it:

"... the S&P 500 P/E will fall toward 14x ahead of the oncoming downward EPS revisions. ~14.5x, which assumes an ERP of ~400bps, mutiplied by the current NTM EPS of $237 is how we arrive at our near term overshoot of fair value scenario of 3400- which we have discussed in recent reports."

Meanwhile, energy - a sector we have been pitching since the summer of 2020 - has officially emerged as the most favored sector by generalists, and inflation expectations remain high. As such, Wilson warns that investors view the hawkish Fed as appropriate and since he expects the S&P to drop at least another 550 points to 3,400, Wilson cautions that "the Fed put strike price is now below 3500."

Furthermore, while bearishness is now pervasive, Wilson notes that this is a necessary condition for a sustainable low, but an insufficient one. Indeed, as we pointed out in last month's Fund Manager Survey, "while sentiment and positioning for active institutional investors is low, asset owner clients remain heavily exposed to equities. As they reallocate, this should further weigh on equity prices."

Continuing his trek through Wall Street's bearish underbelly, Wilson next pays a visit to the biggest question mark facing the US economy - the health of the consumer - which according to Walmart and Target is far worse than career economists and Fed talking heads will have everyone believe.

As Wilson puts it, while COVID has been a terrible period in history, many consumers, like companies, actually benefited financially from the pandemic: "Between the combination of record amounts of stimulus provided directly to many households and asset price inflation for homes, stocks and crypto currency, most consumers experienced a one time windfall in wealth." But coming into 2022 Wilson's view, just like ours, was that "this gravy train was about to end for most households as we anniversaried the stimulus, asset prices de-rated and inflation in non-discretionary items like shelter, food and energy ate into savings."

And indeed, consumer confidence readings for the past 6 months supported the view that things aren't so great anymore for the average household. Yet, many investors have continued to argue erroneously the consumer is likely to surprise on the upside with spending as they use up excess savings to maintain a permanently higher plateau of consumption (this, as we noted last October, was the core premise behind Goldman's cheerful late 2021 GDP forecasts which the bank crucified last weekend).

The shift from goods to services has been the other rallying cry for the US consumer, a theme which as Wilson has frequently noted, is a net negative for the stock market given the much higher contribution of consumer goods versus services companies to the overall market cap of the consumer discretionary sector.

If that wasn't enough, over the past few weeks more nascent weakness has emerged as the consumer sector has been pummeled by bad news from the largest US retailers (WMT, TGT, ROST, etc) all of whome cited weaker demand and profitability. This is in line with Wilson's that the consumer will remain a positive contributor to the overall economy this year but the slowdown in consumer activity will contribute to negative operating leverage. It's effectively the reversal of the over earning that many consumer oriented companies experienced over the past few years.

Finally, there is still a strong view from many clients to play a re-opening trade as the consumer moves from goods to services spending. However, as noted above, that trade may be at risk now as airline and other travel expenses become out of reach for many households, and we have in fact noted the drop in airline ticket purchases following the record surge in air fares.  As such, Wilson says that he remains underweight the consumer discretionary sector and believes it will disappoint on earnings this year.

There's more: while the narrative of the "strong US consumer" is cracking, Wilson says that the other big push back he received to his bearish year ahead outlook in recent client meetings, was on the view that technology spending would likely disappoint the aggressive assumptions coming into 2022. Technology bulls argue that work from home only benefited a few select companies while most would continue to see very strong growth from the very positive secular trends for technology spend. In fact, many bulls argued technology spending was no longer cyclical but structural and non-discretionary, especially in a world where costs are rising so much. Companies would spend more on technology, especially software, to become more efficient.

Wilson says he strongly disagreed with that view and argued technology spending is inherently cyclical and would follow corporate cash flow growth and corporate sentiment. There has also been a massive pull forward of many durable technology goods amid covid like PCs, handsets, servers, etc...a trend that would require a period of absorption in 2022.

That said, when marketing his mid-year outlook, Wilson found many technology investors are now on his page and more worried about companies missing forecasts than he has heard in over a decade. While some may view this as bullish from a sentiment standpoint, the MS strategist thinks it's a bearish sign as investors will likely want to wait to buy the dip from here and even sell key core positions which seems to be what's been happening since 1Q earnings season. Bottom line, Wilson believes that "technology spending is likely to go through a cyclical downturn this year and it could extend to even the more durable areas. While clients aren't in denial about this risk anymore, it's not fully priced, in our view. We remain underweight cyclical tech (hardware and semis) and neutral on internet/software."

Shifting the discussion to another topic, Wilson writes that "perhaps the biggest change in the past 6 months is the view that inflation is here to stay and no longer transitory." At the end of last year there was a more balanced view that inflation could come down in 2022 and allow the Fed to take a more modest path on rate hikes to get it under control. But that view is now out the window with the severe move higher in both front and back end rates. As a result, Wilson finds himself much more bullish on long duration bonds than the average equity client; he explains why:

Our more bullish view is even more in contrast to the views of macro and rates oriented clients. This is in stark contrast to year end when we were much more bearish on long duration bonds than the average equity client. As such, we are taking this as a contrarian signal, particularly given our more bearish view on growth which should drive more money into bonds from both retail and institutional asset allocators. In fact, we think part of the move lower in yields and stocks is the direct result of this re-allocation which has further to go.

Which brings us again to the topic du jour, the Fed Put, which Wilson repeats remains below 3,500 mostly due to the hawkish Fed. As the MS strategist notes, "this is another area where equity clients have pivoted significantly since year end. Most are now in the hawkish Fed camp and realize the reaction function has changed from prior decades. This is all due to the inflation genie having escaped from the bottle."

Echoing what we observed up top when looking at the sliding Fed Put estimates by FMS respondents, Wilson writes that many still think there is a Fed put but they acknowledge the strike price is now lower and agree that it's somewhere below 3500 on the S&P 500. This would be down approximately 15% y/y which is a level that will start to have a negative wealth effect - we showed this morning that as of this moment, a whopping $20 trillion in household wealth has been lost, a number which is still not enough for the Fed...

... which will also help slow demand, a necessary condition for the Fed to get inflation under control.

Taking all of this together, Wilson says that "equity clients are bearish overall and not that optimistic about a quick rebound" and while this is a necessary condition for a sustainable low, it is note a sufficient one. And while Wilson's 12 month target for the S&P 500 is 3900, he expects an overshoot to the downside this summer that could come sooner rather than later (sooner, since he expects the S&P to drop by almost 600 points in the next 3 months). Additionally, while sentiment and positioning for active institutional investors is low, asset owner clients remain more heavily exposed to equities, and as they reallocate toward bonds and other assets less vulnerable to slowing growth/recession, "this should weigh on equity prices in the near term."

In conclusion, Wilson thinks that 3400 is a level that more accurately reflects the earnings risk ahead and he expects that level to be achieved by the end of 2Q earnings season, if not sooner. Until then, he urges traders to use vicious bear market rallies to lighten up on the areas most vulnerable to the oncoming earnings reset.

More in the full note available to professional subscribers.

Tyler Durden Mon, 05/23/2022 - 14:01

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