It might be a sign of the times that over the past half year or so I have been less focused as of late on my investment research looking at individual companies, and more about playing the role of “closet macroeconomist”, hence the focus of my posts being mostly about macroeconomics lately.
I am not intentionally trying to hide secrets (although there are a couple picks here and there in the non-oil and gas space that are still sitting on my research queue after passing my initial smell test) but in an environment where my baseline investment criteria is that it can earn 25% free cash flow to enterprise value, what’s the point in looking for other stocks?
The answer of course is there will be a time that fossil fuels will become politically correct once again (perhaps when all the lights and crypto farms shut off) and one will then have to dip into the watchlist bucket for other suitable investment candidates. That said, fossil fuels are still going very strong and hence why bother when the thesis I wrote back in 2020 (roughly summarized as being long anything ‘real’ and avoiding anything ‘financial’) is still very much intact?
The reason for the macro focus is simply because it is increasingly a dominant variable in today’s investing climate. To give an analogy, let’s say your choice was investing in established large cap gold miner X and gold miner Y. Ultimately you can talk about mine reserves, operating practices, all-in sustainable costs, capital structure, and on and on, but the dominant variable is much more simpler – the price of gold.
Likewise, the macro situation is creating a dominant variable environment where if you cannot get on board with the correct solution, it doesn’t matter what else you invest in – for instance, back in November 2021, it did not matter one bit which portfolio component of ARKK you invested in – you would have lost money no matter what. Perhaps the magnitude of loss would have been different had you chosen wisely, but it would have been a loss nonetheless.
The macro focus that requires meticulous attention is monetary policy and energy economics. Both right now are more dominant than ever as we are experiencing ‘the turn’ that has caught people flat-footed (including Covid, and the sudden realization of geopolitical instability in eastern Europe), coupled with an incredible amount of monetary mismanagement and dismissal of energy physics that has all translated into really terrible policy. Playbooks that worked in the past will not be working in the future.
One of these playbooks is a sacred tenant of portfolio management. It states that a correctly managed portfolio will have an equity and bond split, say 60/40. If you are young and want to take more risk, then 70/30 or even 80/20, but the point is there is some bond component. The notion is that when equities fall, bonds will rise, and if you maintain a consistent percentage, you will be able to rebalance and extract better value in the process.
We insert in the new macroeconomic reality where inflation is running hot and fast, and your bond portfolio is still trading at a negative real yield. This means that the bond component of the portfolio is losing purchasing power for the investor and only depends on other people purchasing bonds to keep its capital value in the event of an equity drawdown.
With the Bank of Canada, US Federal Reserve, and soon the EU engaging in quantitative tightening, coupled with increasing yields (that would also be impacted by QT in addition to inflation), bonds are going to be terrible investments if the next logical conclusion comes. What is this?
Continued monetary debasement. Amazingly despite everything, because the US dollar is the last one standing, it still wins by default. For now.
This brings up a rather interesting quandary for most institutional fund managers. You can’t hold cash (real negative yield, not to mention that you are hired as a portfolio manager to deploy cash and not stuff it in your mattress). You can’t hold bonds (take a look at the idiots that bought Austria’s 100 year bond with a 50bps coupon for twice par!). You can’t hold equities (take a look at the S&P, for example) although this is the least worst of the three options. Don’t even get me started on cryptocurrency as an asset class – although I do see that Luna is CAD$0.000101 a piece, so perhaps you want to buy one of these as an inflation hedge.
There is no escape at an institutional level. One workaround has been to shovel money into private assets and real estate and infrastructure, but these asset classes are very sensitive to rate increases although of course they do not mark them to market until it is too late. Private assets are a brilliant way to defer those losses, however!
Interest rates themselves are another matter. There has never been a point in history where we have seen such monetary manipulation to the point where real rates of interest have been driven this low without massive reverberations. The “consensus” scenario is that we’ll get a 50bps rate hike in July and then some more minor tightening before things ‘normalize’ and are back to normal.
But consider that your baseline input to the economy (energy) is at sky-high levels with no real material notions that more capacity is being brought online – what if this input to inflation keeps rising further? Everybody cites ‘demand destruction’, and indeed there will be a point where energy inputs will become so expensive that collectively we will be forced to stop using them, but until that point, we will see the trickle-down (or perhaps rain torrent) effect of these costs getting baked into everything we consume.
Likewise, salaries will be escalating, and inflation will start on its trajectory of a self-fulfilling prophecy – labour costs will rise because of inflation, and inflation will drive up the cost of labour supply. Already in British Columbia, we are seeing the seeds of this with the upcoming strike vote by the main BC Government Union – they are apparently miles apart from the government. This is one of many cases that will be resulting in significant wage increases going forward.
In a recent Bank of Canada speech (one day after the June 1st 50bps rate hike), we had the deputy governor talk about inflation. They’re now now talking about “avoiding entrenchment” of inflation. Note that derivatives of the word “entrench” is like the new “transitory”.
You don’t avoid entrenchment with small steps. You need shock and awe – something that goes beyond letting the market guess whether the next rate increase will be 50bps or 75bps. An example would be having an unplanned rate announcement with a 150bps increase “to get things back to the neutral rate”. The current short-term policy rate of 150bps is still at near-record lows (historically), and still below the ambient level the Bank of Canada had before Covid-19 (which was 175bps). The big mistake that people can make is this natural assumption of the “regression to the mean”, and currently that scenario right now is the bank will raise to 300bps and keep things there.
Consider the scenario where they will need to raise even further, to around 600 to 700bps to achieve the destruction of this “entrenchment”, and figure out the financial consequences. I am not saying this will happen, but it is definitely something that one should keep in their minds going forward – that inflation will be running away, just like how global warming activists claim that an increase in the Earth’s CO2 beyond a threshold point will cause a run-away greenhouse effect. Ask yourself what components of your portfolio get killed in a world where short-term rates are 700bps, we live in an inverted yield curve where the 5-year mortgage rate is 600bps and almost every asset out there is slashed in half. It isn’t pretty – practically everything other than cash loses in such a scenario (yes, including fossil fuels).
I am not entirely sure what is going to happen. Things are incredibly fluid right now, and I continue to remain very cautious. If there is any general prescription I could give to people, it is the following – if you’re leveraged, get at least flat.bonds yield curve covid-19 equities stocks cryptocurrency crypto real estate us dollar crypto gold oil
Where Are Interest Rates Headed? Is The Fed Correct Or The Eurodollar Curve?
Where Are Interest Rates Headed? Is The Fed Correct Or The Eurodollar Curve?
Authored by Mike Shedlock via MishTalk.com,
The Eurodollar curve…
The Eurodollar curve implies four quarter-point cuts are on the way starting in 2023. The Fed believes otherwise. Let's discuss stock market implications.
Data from CME and Fed via Wall Street Journal.
The eurodollar curve has nothing to do with euros or dollars. Rather it is an interest rate curve and one of the world's most widely traded futures.
After peaking at about 3.9% this year, eurodollar betters believe the Fed will then cut rates all the way down to 2.8%.
Five Not-Quite-Impossible Things the Market Believes
Wall Street Journal Contributor James Macintosh discussed the above chart in Five Not-Quite-Impossible Things the Market Believes
Inflation is transitory.
The Fed realizes this in time.
The jobs market cools enough to slow wage rises.
But not so much it means falling household spending.
So consumer spending rises in real terms.
In reference to the led chart, Macintosh says "The first assumption is the hardest to believe."
I disagree. The hardest thing to believe is the overall goldilocks scenario and that the current rally makes any sense at all.
Inflation may easily come down if the Fed tightens too much too fast causing a severe recession. What would that do to corporate profits?
But assume otherwise, that inflation does not come down more. What would that do to corporate profits?
While any of the first three points may easily be correct, the combination of all five being correct and that stocks will rise in a goldilocks scenario is what I find hard to believe.
Is the Market Forward Looking?
Goldilocks proponents will tell you that the market is forward looking.
The market isn't forward looking and never was. It is a coincident indicator of current sentiment, wildly wrong at major turns.
If the market was forward looking, what precisely was it looking forward to at the November 2007 peak with recession starting the next month?
What was it looking forward to at the 1929 peak, the 1933 bottom, the 2009 bottom or any other top or bottom?
The Fed Will Hike Until It Breaks Something
I believe the eurodollar curve is more likely to be correct than the Fed. When has the Fed gotten much of anything correct?
The eurodollar view has two ways to win. The first is the Fed actually does tame inflation to the degree that it wants.
That's possible in a severe enough recession. And the global picture is easily weak enough for that to happen.
The second way the eurodollar curve might be correct is if the Fed breaks the credit market.
The Fed would immediately reverse course, regardless of inflation, should that happen.
Neither a credit event nor strong recession would be good for the stock market.
The least likely thing is that the Fed achieves a goldilocks soft landing. Yet, assume that happens.
Macintosh says, and I agree, "The bull case that stocks and corporate bonds are pricing requires the combination of low joblessness and wage rises to allow spending to rise faster than inflation even after pandemic savings run out. But not so much faster that it hits capacity constraints and accelerates inflation."
The problem with goldilocks is stocks are priced so much beyond perfection that they may decline anyway.
Good luck with goldilocks, especially with the Fed still hiking.
* * *
Futures Tumble After UK Double-Digit Inflation Shock Sparks Surge In Yields
Futures Tumble After UK Double-Digit Inflation Shock Sparks Surge In Yields
Futures were grinding gingerly higher, perhaps celebrating the…
Futures were grinding gingerly higher, perhaps celebrating the end of the Cheney family's presence in Congress, and looked set to re-test Michael Hartnett bearish target of 4,328 on the S&P (which marked the peak of yesterday's meltup before a waterfall slide lower when spoos got to within half a point of the bogey), when algos and the few remaining carbon-based traders got a stark reminder that central banks will keep hammering risk assets after the UK reported a blistering CPI print, which at a double digit 10.1% was not only higher than the highest forecast, but was the highest in 40 years.
The print appeared to shock markets out of their month-long levitating complacency, and yields - both in the UK and the US - spiked...
... and with yields surging, futures had no choice but to notice and after trading at session highs just before the UK CPI print, they have since tumbled more than 40 points and were last down 0.85% or 37 points to 4,271.
Nasdaq 100 futures retreated 0.9% signaling a selloff in technology names will continue. The dollar rose as investors awaited the minutes of the Fed’s last policy meeting for clues on policy makers’ sensitivity to weaker economic data.
In US premarket trading, retail giant Target slumped 4% after reporting earnings that missed expectations despite still predicting a rebound. Applied Materials and PayPal dropped at least 1.3%. Tech stocks are the forefront of the growing pessimism over equity valuations on the back of Fed rate increases. The S&P 500 had posted a small gain on Tuesday, aided by earnings reports from retailers Walmart Inc. and Home Depot. Here are some of the other biggest U.S. movers today:
- Manchester United (MANU US) rises as much as 17% in US premarket trading before trimming most of the gains, after Tesla CEO Elon Musk said he was buying the English football club but later added that he was joking.
- Hill International (HIL US) shares rise 61% in premarket trading hours after it announced Global Infrastructure Solutions will commence an all-cash tender offer for $2.85/share in cash, representing a premium of 63% to the last closing price.
- BioNTech (BNTX US) was initiated with a market perform recommendation at Cowen, which expects demand for Covid-19 vaccines to mirror annual flu trends as the pandemic enters its endemic phase.
- Bed Bath & Beyond (BBBY US) shares surge 20% in premarket trading, putting the stock on track for its sixth day of gains. The home-goods company has helped reinvigorate a wave of meme stock buying
- Agilent (A US) saw its price target boosted at brokers as analysts say the scientific testing equipment maker’s results were strong thanks to growth in biopharma and a recovery in China, while the company’s guidance was on the conservative side. Shares rose .
- Jefferies initiated coverage of Waldencast Plc (WALD US) class A with a buy recommendation as analyst Stephanie Wissink sees 29% upside potential.
- Sea Ltd. (SE US) ADRs slipped as much as 2.1% in US premarket trading, extending Tuesday’s declines, as Morgan Stanley cut its PT on expectations of slowing growth at the Shopee owner’s e-commerce business in the third quarter.
- Weber (WEBR US) downgraded to sell from neutral at Citi, which says there are too many concerns to remain on the sidelines, including a decline in point-of-sale traffic and macro factors like inflation weighing on consumer demand
In the past two months, US stocks rallied on signs of peaking inflation and an earnings-reporting season that saw four out of five companies meeting or beating estimates. Boosted by relentless systematic (CTA) buying and retail-driven short squeezes, as well as a surge in buybacks, stocks recovered more than 50% of the bear market retracement. Yet, continuing rate hikes and the likelihood of a recession in the world’s largest economy are weighing on sentiment. Meanwhile, concern is growing that Fed rate setters will remain focused on the fight against inflation rather than supporting growth.
“We expect the FOMC minutes to have a hawkish tilt,” Carol Kong, strategist at Commonwealth Bank of Australia Ltd., wrote in a note. “We would not be surprised if the minutes show the FOMC considered a 100 basis-point increase in July.”
In Europe, the Stoxx 600 fell after a strong start amid signs the continent’s energy crisis is worsening. Benchmark natural-gas futures jumped as much as 5.1% on expectations the hot weather will boost demand for cooling. In the UK, consumer-price growth jumped to 10.1%, sending gilts tumbling. Real estate, retailers and miners are the worst performing sectors. The Stoxx 600 Real Estate Index declined 2%, making it the worst-performing sector in the wider European market, as focus turned to UK inflation that soared to double digits for the first time in four decades and also to today's FOMC minutes. German and Swedish names almost exclusively account for the 10 biggest decliners. TAG Immobilien drops 5.4%, Wallenstam is down 4.7%, Castellum falls 4% and LEG Immobilien declines 3.3%. The sector tumbles on rising bond yields, with 10y Bund yield up 11bps, and dwindling demand for Swedish real estate amid rising rates.
Earlier on Wednesday, stocks rose in Asia amid speculation that China may deploy more stimulus to shore up its ailing economy while Japanese exporters were boosted by a weaker yen. After a string of weak data driven by a property-sector slump and Covid curbs, China’s Premier Li Keqiang asked local officials from six key provinces that account for 40% of the economy to bolster pro-growth measures. The MSCI Asia Pacific Index advanced as much as 0.8%, with consumer-discretionary and industrial stocks such as Japanese automakers Toyota and Honda among the leaders on Wednesday. The benchmark Topix erased its year-to-date loss. Chinese food-delivery platform Meituan also rebounded after dropping more than 9% in the previous session on a Reuters report that Tencent may divest its stake in the firm. Chinese stocks erased declines early in the day, as investors hoped for more economic stimulus after a surprise rate cut on Monday failed to excite the market. Premier Li Keqiang has asked local officials from six key provinces that account for about 40% of the country’s economy to bolster pro-growth measures.
“I believe policymakers have the tools to prevent a hard landing if needed,” Kristina Hooper, chief global market strategist at Invesco, said in a note. “I find investors are overly pessimistic about Chinese stocks -- which means there is the potential for positive surprise.” Asia’s stock benchmark is trading at mid-June levels as traders attempt to determine the trajectory of interest-rate hikes and economic growth globally -- as well as the impact of China’s property crisis and Covid policies. Meanwhile, minutes of the US Federal Reserve’s July policy meeting, out later Wednesday, will be carefully parsed. New Zealand stocks closed little changed as the country’s central bank raised interest rates by a half percentage point for a fourth-straight meeting. Australia's S&P/ASX 200 index rose 0.3% to close at 7,127.70, supported by materials and consumer discretionary stocks. South Korea’s benchmark missed out on the rally across Asian equities, as losses by large-cap exporters weighed on the measure
In FX, the Bloomberg Dollar Spot Index rose as the dollar gained versus most of its Group-of-10 peers. The pound was the best G-10 performer while gilts slumped, led by the short end and sending 2-year yields to their highest level since 2008, after UK inflation accelerated more than expected in July. The yield curve inverted the most since the financial crisis as traders ratcheted up bets on BOE rate hikes in money markets, wagering on 200 more basis points of hikes by May. The euro traded in a narrow range against the dollar while the region’s bonds slumped, led by the front end. Scandinavian currencies recovered some early European session losses while the aussie, kiwi and yen extended their slide in thin trading. EUR/NOK one-day volatility touched a 15.12% high before paring ahead of Norges Bank’s meeting Thursday where it may have to raise rates by a bigger margin than indicated in June given Norway’s inflation exceeded forecasts for a fourth straight month, hitting a new 34-year high. Consumer sentiment in Norway fell to the lowest level since data began in 1992, according to Finance Norway. New Zealand’s dollar and bond yields both rose in response to the Reserve Bank hiking rates by 50bps, while flagging concern about labor market pressures and consequent wage inflation; the currency subsequently gave up gains in early European trading. The Aussie slumped after data showing the nation’s wages advanced at less than half the pace of inflation in the three months through June, backing the Reserve Bank’s move to give itself more flexibility on interest rates.
In rates, treasuries held losses incurred during European morning as gilt yields climbed after UK inflation rose more than forecast. US 10-year around 2.87% is 6.5bp cheaper on the day vs ~13bp for UK 10-year; UK curve aggressively bear-flattened following inflation data, with long-end yields rising about 10bp. Front-end UK yields remain cheaper by ~20bp, off session highs, leading a global government bond selloff. US yields are higher on the day by by 4bp-7bp; focal points of US session are 20-year bond auction and FOMC minutes release an hour later. Treasury auctions resume with $15b 20-year bond sale at 1pm ET; WI 20-year yield at around 3.35% is ~7bp richer than July’s sale, which stopped 2.7bp through the WI level.
In commodities, oil fluctuated between gains and losses, and was in sight of a more than six-month low -- reflecting lingering worries about a tough economic outlook amid high inflation and tightening monetary policy. Spot gold is little changed at $1,774/oz
Looking at the day ahead, the FOMC minutes from July will be the main highlight, and the other central bank speaker will be Fed Governor Bowman. Otherwise, earnings releases include Target, Lowe’s and Cisco Systems, and data releases include US retail sales and UK CPI for July.
- S&P 500 futures down 0.3% to 4,293.00
- STOXX Europe 600 little changed at 443.30
- MXAP up 0.5% to 163.48
- MXAPJ up 0.2% to 530.38
- Nikkei up 1.2% to 29,222.77
- Topix up 1.3% to 2,006.99
- Hang Seng Index up 0.5% to 19,922.45
- Shanghai Composite up 0.4% to 3,292.53
- Sensex up 0.5% to 60,168.83
- Australia S&P/ASX 200 up 0.3% to 7,127.68
- Kospi down 0.7% to 2,516.47
- German 10Y yield little changed at 1.06%
- Euro little changed at $1.0178
- Gold spot down 0.0% to $1,775.21
- U.S. Dollar Index little changed at 106.50
Top Overnight News from Bloomberg
- More market prognosticators are alighting on the idea of benchmark Treasury yields sliding to 2% if the US succumbs to a recession. That’s an out-of-consensus call, compared with Bloomberg estimates of about a 3% level by the end of this year and similar levels through 2023. But it’s a sign of how growth worries are forcing a rethink in some quarters
- The euro-area economy grew slightly less than initially estimated in the second quarter as signs continue to emerge that momentum is unraveling. Output rose 0.6% from the previous three months between April and June, compared with a preliminary reading of 0.7%, Eurostat said Wednesday
- Egypt became a prime destination for hot money by tethering its currency and boasting the world’s highest interest rates when adjusted for inflation
- Norway’s $1.3 trillion sovereign wealth fund, the world’s largest, posted its biggest loss since the pandemic as rate hikes, surging inflation and Russia’s invasion of Ukraine spurred volatility. It lost an equivalent of $174 billion in the six months through June, or 14.4%
A more detailed look at global markets courtesy of Newsquawk
Asia-Pac stocks just about shrugged off the choppy lead from the US where markets were tentative amid mixed data signals and strong retailer earnings, but with gains capped overnight ahead of the FOMC Minutes and as participants digested another 50bps rate hike by the RBNZ. ASX 200 swung between gains and losses with the index indecisive amid a slew of earnings and with strength in the consumer sectors offset by underperformance in tech, energy and healthcare. Nikkei 225 climbed above the 29,000 level with the index unfazed by mixed data releases in which Machinery Orders disappointed although both Exports and Imports topped forecasts. Hang Seng and Shanghai Comp were somewhat varied with Hong Kong led higher by tech amid plenty of attention on Meituan after reports its largest shareholder Tencent could reduce all or the bulk of its shares in the Co. which a Tencent executive later refuted, while the mainland was less decisive amid headwinds from the ongoing COVID situation and with power restrictions disrupting activity in Sichuan, although reports also noted that Chinese Premier Li told top provincial officials that they must have a sense of urgency to consolidate the economic recovery and reiterated to step up macro policies.
Top Asian News
- RBNZ hiked the OCR by 50bps to 3.00%, as expected, while it stated that conditions need to continue to tighten and they agreed that maintaining the current pace of tightening remains the best means. RBNZ also agreed that further increases in the OCR were required to meet the remit objective and that domestic inflationary pressures had increased since May. Furthermore, the RBNZ raised its projections for the OCR and inflation with the OCR seen at 3.69% in Dec. 2022 (prev. 3.41%) and at 4.1% for both Sept. 2023 and Dec. 2023 (prev. 3.95%), while it sees annual CPI at 4.1% by Sept. 2023 (prev. 3.0%).
- RBNZ Governor Orr stated at the press conference that they are not forecasting a recession but expected below-potential growth amid subdued consumer spending. Governor Orr also stated that they did not discuss a 75bps rate hike today and that 50bps moves have been orderly and sufficient, while he added that getting rates to 4% would buy comfort for the policy committee and that a Cash Rate of around 4% is unambiguously above neutral and sufficient to meet the inflation mandate.
- Chongqing, China is to curb power use for eight days for industry.
- China’s Infrastructure Boom Gets Swamped by Property Woes
- Tencent 2Q Revenue Misses Estimates
- Hong Kong Denies Democracy Advocates Security Law Jury Trial
- UN Expert Says Xinjiang Forced Labor Claims ‘Reasonable’
- Singapore’s COE Category B Bidding Hits New Record
- Delayed Deals Add to Floundering Singapore IPO Market: ECM Watch
European bourses have dipped from initial mixed/flat performance and are modestly into negative territory, Euro Stoxx 50 -0.5%. Stateside, futures are under similar pressure awaiting fresh corporate updates and the July FOMC Minutes, ES -0.6%. Fresh drivers relatively limited throughout the session with known themes in play and focus on upcoming risk events; stocks also suffering on further hawkish yield action. Lowe's Companies Inc (LOW) Q1 2023 (USD): EPS 4.68 (exp. 4.58), Revenue 27.47 (exp. 28.12bln); expect FY22 total & comp. sales at bottom-end of outlook range, Operating Income and Diluted EPS at top-end. Target Corp (TGT) Q1 2023 (USD): EPS 0.39 (exp. 0.72), Revenue 26.0bln (exp. 26.04bln); current trends support prior guidance.
Top European News
- German Gas to Last Less Than 3 Months if Russia Cuts Supply
- European Gas Surges Again as Higher Demand Compounds Supply Pain
- Entain Falls; Citi Views Fine Negatively but Notes Steps by Firm
- UK Inflation Hits Double Digits for the First Time in 40 Years
- Crypto.com Receives Registration as UK Cryptoasset Provider
- Greenback underpinned ahead of US retail sales data and FOMC minutes, DXY holds tight around 106.500.
- Pound pegged back after spike in wake of stronger than expected UK inflation metrics, Cable hovers circa 1.2100 after fade into 1.2150.
- Kiwi retreats following knee jerk rise on the back of hawkish RBNZ hike, NZD/USD near 0.6300 from 0.6380+ overnight peak.
- Aussie undermined by marginally softer than anticipated wage prices and lower RBA tightening bets in response, AUD/USD well under 0.7000 vs 0.7026 at one stage.
- Yen weaker as yield differentials widen again, but Euro cushioned by more pronounced EGB reversal vs USTs, USD/JPY probes 21 DMA just below 135.00, EUR/USD bounces from around 1.0150 towards 1.0200.
- Loonie and Nokkie soft amidst latest slippage in oil, USD/CAD closer to 1.2900 than 1.2800, EUR/NOK nudging 9.8600 within 9.8215-9.8740 range.
- Debt retracement ongoing and gathering pace ahead of Wednesday's key risk events.
- Bunds now closer to 154.00 than 156.00 and 157.00 only yesterday, Gilts not far from 114.50 vs almost 116.00 and 117.00+ earlier this week and T-note sub-119-00 vs 119-31 at best on Monday.
- Sonia strip hit hardest as markets price in aggressive BoE hikes in response to UK inflation data toppy already elevated expectations.
- Crude benchmarks are currently little changed overall, having recovered from a bout of initial pressure; newsflow thin awaiting fresh JCPOA developments
- Spot gold is little changed overall but with a slight negative bias as the USD remains resilient and outpaces the yellow metal as the haven of choice.
- Aluminium is the clear outperformer amid updates from Norsk Hydro that they are shutting production at their Slovalco site (175k/T year) by end-September, due to elevated energy prices.
- OPEC Sec Gen says he sees a likelihood of an oil-supply squeeze this year, open for dialogue with the US. Still bullish on oil demand for 2022. Too soon to call the outcome of the September 5th gathering. Spare capacity at around the 2-3mln BPD mark, "running on thin ice".
- US Private Inventory Data (bbls): Crude -0.4mln (exp. -0.3mln), Cushing +0.3mln, Gasoline -4.5mln (exp. -1.1mln), Distillates -0.8mln (exp. +0.4mln).
- Shell (SHEL LN) announced it is to shut its Gulf of Mexico Odyssey and Delta crude pipelines for two weeks in September for maintenance, according to Reuters.
- Uniper (UN01 GY) says the energy supply situation in Europe is far from easing and gas supply in winter remains "extremely challenging".
- China sets the second batch of the 2022 rare earth mining output quota at 109.2k/T, via Industry Ministry; smelting/separation quota 104.8k/T.
- China's military is to partake in a military exercise in Russia, their participation has nothing to do with the international situation.
- Taiwan's Defence Ministry says they have detected 21 Chinese aircraft and five ships around Taiwan on Wednesday, via Reuters.
- Iran is calling on the US to free jailed Iranian's, says they are prepared for prisoner swaps, via Fars.
US Event Calendar
- 07:00: Aug. MBA Mortgage Applications, prior 0.2%
- 08:30: July Retail Sales Advance MoM, est. 0.1%, prior 1.0%
- 08:30: July Retail Sales Ex Auto MoM, est. -0.1%, prior 1.0%
- 08:30: July Retail Sales Control Group, est. 0.6%, prior 0.8%
- 10:00: June Business Inventories, est. 1.4%, prior 1.4%
- 14:00: July FOMC Meeting Minutes
DB's Tim Wessel concludes the overnight wrap
Starting in Europe, where the looming energy crisis remains at the forefront. An update from our team, who just published the fourth edition of their indispensable gas monitor (link here), where they note the surprisingly fast rebuild of German gas storage, driven by reductions in industrial activity, reduces the risk that rationing may become reality this winter. Many more insights within, so do read the full piece for analysis spanning scenarios. Keep in mind, that while gas may be available, it is set to come at a higher clearing price, which manifest itself in markets yesterday where European natural gas futures rose a further +2.64% to €226 per megawatt-hour, just shy of their closing record at €227 in March. But, that’s still well beneath their intraday high from March, where at one point they traded at €345. Further, one-year German power futures increased +6.30%, breaching €500 for the first time, closing at €507. Germany is weighing consumer relief measures in light of climbing consumer prices and also announced that planned nuclear facility closures would be “temporarily” postponed.
The upward energy price pressure and attenuated (albeit, not eliminated) risk of rationing pushed European sovereign yields higher. 10yr German bunds climbed +7.1bps to 0.97%, while 10yr OATs kept the pace, increasing +7.4bps. 10yr BTPs increased +15.9bps, widening sovereign spreads, while high yield crossover spreads widened +10.2bps in the credit space.
Equities were resilient, however, with the STOXX 600 posting a +0.16% gain after flitting around a narrow range all day. Regional indices were also robust to climbing energy prices, with the DAX up +0.68% and the CAC +0.34% higher. In the States the S&P 500 registered a modest +0.19% gain, with the NASDAQ mirroring the index, falling -0.19%. Retail shares drove the S&P on the day, with the two consumer sectors both gaining more than +1%, following strong earnings reports from Wal Mart and Home Depot.
Treasury yields also climbed, but the story was the further flattening in the curve. 2yr yields were +7.5bps higher while 10yr yields managed to increase just +1.6bps, leaving 2s10s at its second most negative close of the cycle at -46bps. 10yr yields are another basis point higher this morning. A hodgepodge of data painted a mixed picture. Housing permits beat expectations (+1674k vs. +1640k) while starts (+1446k vs. +1527k) fell to their slowest pace since February 2021. However, under the hood, even permits weren’t necessarily as strong as first glance, as single family permits fell -4.3% with gains in multifamily pushing the aggregate higher. Indeed, year-over-year, single family permits have now fallen -11.7% while multifamily permits are +23.5% higher. So the single family housing market continues to feel the impact of Fed tightening. Meanwhile, industrial production climbed +0.6% month-over-month (vs. +0.3%), with capacity utilization hitting its highest level since 2008 at 80.3%.
Drifting north of the border, Canadian inflation slowed to 7.6% YoY in July in line with estimates, while the average of core measures climbed to a record 5.3%. Bank of Canada Governor Macklem penned an opinion piece saying that while it looks like inflation may have peaked, “the bad news is that inflation will likely remain too high for some time.” In turn, Canadian OIS rates by December climbed +16.2bps.
In other data, the expectations component of the German ZEW survey fell to -55.3, its lowest level since October 2008 at the depths of the GFC. In the UK, regular pay (excluding bonuses) fell by -3.0% in real terms over the year to April-June 2022, its fastest decline on record.
On the Iranian nuclear deal, EU negotiators reportedly found Iran’s response constructive, though Iran still had some concerns. Notably, Iran is looking for guarantees that if a future US administration withdraws from the JCPOA the US will "have to pay a price”, seeking insulation from the vagaries of representative democracy.
Asian equity markets are trading higher after Wall Street’s solid performance overnight. The Nikkei (+0.76%) is leading gains across the region with the Hang Seng (+0.57%), the Shanghai Composite (+0.23%) and the CSI (+0.51%) all rebounding from its opening losses this morning. US futures are struggling to gain traction this morning with the S&P 500 (-0.02%) and NASDAQ 100 (-0.09%) trading just below flat.
The Reserve Bank of New Zealand lifted its official cash rate (OCR) for the fourth consecutive time by an expected +50bps to 3%, a seven-year high, while bringing forward the estimate of future rate increases. The central bank expects the OCR will reach 3.69% at the end of this year and expects it to peak at 4.1% in March 2023, higher and sooner than previously forecast.
Early morning data coming out from Japan showed that exports rose +19.0% y/y in July (v/s +17.6% expected) posting 17 straight months of gains while imports advanced +47.2% (v/s +45.5% expected) driven by global fuel inflation and a weakening yen. With the imports outweighing exports, the nation reported trade deficit for the 14th consecutive month, swelling to -2.13 trillion yen in July (v/s -1.91 trillion yen expected) compared to a revised deficit of -1.95 trillion yen in June.
In terms of the day ahead, the FOMC minutes from July will be the main highlight, and the other central bank speaker will be Fed Governor Bowman. Otherwise, earnings releases include Target, Lowe’s and Cisco Systems, and data releases include US retail sales and UK CPI for July.
S&P 3500 By Year End If QT Continues
"Don’t Fight the Fed" echoes through the financial media, Wall Street, and in the minds of retail and institutional investors. The phrasing pertaining…
“Don’t Fight the Fed” echoes through the financial media, Wall Street, and in the minds of retail and institutional investors. The phrasing pertaining to Fed-generated liquidity is often the sole basis for investors to chase bull markets when the Fed employs easy monetary policy. Unfortunately, some investors forget the phrase is equally meaningful when the Fed is not friendly to markets. As we share in this article, we have developed a model to track Fed liquidity, allowing us to quantify the Fed’s influence on the S&P 500.
Before unveiling our liquidity formula and its forecast for the S&P 500, it’s essential to discuss the three primary drivers by which the Fed is influencing liquidity: Reverse Repurchase (RRP), Treasury General Account (TGA), and the Fed’s balance sheet.
Reverse Repurchase Agreements (RRP)
The New York Fed uses numerous repo programs to manage the supply of cash in the banking system, thereby maintaining the Fed Funds rates within the FOMC’s target range. Currently, they are employing its RRP program to accomplish this task. In an RRP transaction, the Fed sells securities to a counterparty and simultaneously agrees to repurchase them at a future date. The duration is often overnight. The transaction temporarily reduces the supply of money from the banking system. Increasing daily RRP balances results in less system liquidity, and a declining balance reduces liquidity.
As shown below, RRP has been around for 20 years but was scarcely used until early 2021. The various pandemic-related rounds of fiscal stimulus and massive Fed liquidity efforts left banks and money market funds with excessive levels of cash. The excess liquidity would have pushed the Fed Funds rate lower than the target rate without the RRP program. As such, RRP sucks up liquidity, making Fed Funds easier for the Fed to manage.
The Fed has other repo tools, such as repurchase agreements and the standing repo facility, which can dampen money market rates by providing the banking system with liquidity.
The RRP facility has been increasing rapidly and now sits at over $2 trillion daily. Rising RRP balances are a drain on liquidity.
As money market yields rise with Fed Funds and asset markets perform poorly, investors tend to prefer higher cash balances. Such should keep RRP levels elevated for the time being.
Treasury General Account (TGA)
The Treasury General Account is the U.S. Treasury Department’s checking account. The account is held at the Federal Reserve Bank of New York. Like your checking account, the TGA receives deposits (tax receipts and proceeds from debt issuance) and makes payments.
The Fed doesn’t manage the TGA balances, but the surplus cash balance held at the Fed affects banking system liquidity. Fed liabilities (bank reserves) must equal its assets. Bank reserves are fodder allowing banks to make loans and, by default, print money. When the TGA account increases, bank reserves must fall, reducing banking system liquidity. Conversely, a shrinking TGA account adds reserves and liquidity to the banking system.
The graph below shows that TGA balances are elevated versus the pre-pandemic years but have fallen as the banking system normalizes from the massive fiscal cash injections. It will likely drop a bit more, but the TGA will not significantly impact liquidity, barring unusual circumstances.
Fed Balance Sheet
The Fed’s assets, mainly Treasury bonds and Mortgage-Backed Securities (MBS), are the liquidity elephant in the room. Its assets currently account for 75% of total Fed-sponsored liquidity and historically average over 90%.
When the Fed does Quantitative Easing (QE), they remove securities from the bond markets and, in their place, leaves reserves with the banks. Again, bank reserves can lead to loan creation which is the creation of new money. Ergo, QE adds to the system’s liquidity. Conversely, Quantitative Tightening (QT) removes liquidity and reserves from the system and increases the amount of securities in the market.
For this reason, QE tends to be bullish for stocks, and QT is bearish.
Liquidity and Stock Prices
With an understanding of the three key factors driving banking system liquidity, we can create a Fed liquidity model. The size of the Fed’s assets less the sum of the TGA and RRP equals the amount of Fed-generated liquidity in the system. Recent changes in net liquidity shed light on how the S&P 500 trends.
The two graphs below compare the liquidity measure and the S&P 500. The first graph shows how the S&P 500 rose in line with liquidity through 2021, and both reversed simultaneously to start 2022. The dotted lines are quarterly moving averages to help smooth out the data. The moving averages track each other almost perfectly this year. The green dashed line forecasts liquidity based solely on the Fed’s plan to reduce its balance sheet by $95 billion a month. The S&P 500 could be close to 3500 by year-end if they follow through with their QT plans and the correlation holds up.
The second graph shares the same data but in scatter plot form. The correlation between liquidity and the S&P 500 is statistically significant, with an R-squared of 0.57. The orange dot shows the S&P 500 is about 3% overpriced based on liquidity.
The model does have an important caveat. Other factors become the predominant driver of market returns when the Fed is inactive and liquidity is relatively stable.
The Fed is not the only game in town, but they are the biggest game in town. While many other factors account for stock price performance, liquidity may be the most important to grasp.
To drive home this point, recall March 2020, when covid struck the economy. Global economies were shutting down worldwide. Unemployment was soaring, and the economy was careening toward a depression. Despite zero clarity on the economic future, stocks began to rally strongly in late March. Why? Liquidity via fiscal stimulus and a surge in Fed QE purchases drove markets higher. The economic situation was awful, and earnings outlooks were crumbling, but liquidity trumped fundamentals.
By accepting what the Fed does, right or wrong, and closely following its actions, we can quantify how liquidity will steer markets. On top of fundamental and technical analysis, this additional layer of research helps us better navigate the market’s twists, turns, and trends when the Fed is active.depression unemployment default pandemic stimulus treasury bonds bonds sp 500 stocks monetary policy fomc qe fed federal reserve unemployment stimulus
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