Near Term Market View (Sep to EOTY FY22)

L

longandshort

Summary
  • Long-duration assets will likely outperform through end of the year as near-term inflation data supports a Fed terminal rate of ~4% by the Dec meeting
  • Positioning data suggests rapid price moves higher though without sustained increases in volume a tactical approach is best (rallies will be fast because of bad positioning, but lack of new volume would mean high chance of mean reversion)
  • Inflation path next year hinges upon the dynamic within the US labor market (tightness) and housing (prices and rent) -- recent data points to a softening in both areas
  • Simple ETF ideas: long QQQ short XLF, long IEO short XHB, short FXC
Thesis changes if:
  • Wage data accelerates for at least two periods: NFPs / JOLTS (I'm wrong about near-term path of wages)
  • Market rents / housing prices accelerate: Zillow rent data, CoreLogic Home Price Index (I'm wrong about near-term path of housing situation)
  • New shock (crystal ball limitations)


Market Insights:
  • The stock market is down this year driven by the Federal Reserve raising interest rates to combat inflation. Over the next 1 year, the policy stance will shift from being aggressive to being neutral (& maybe dovish), which will support the stock market recovery in Q4 this year and through next year
  • Interest rates have jumped from 0.00 – 0.25% to 2.25-2.50% on the short end, and we expect those to stabilize around 3.50-4.00% by the end of this year and early next year
  • The economy is doing okay for now given how strong employment is—this might slip a little, but we don’t see a major recession or downtrend because of how strong consumer and corporate balance sheets are (people have cash, assets are doing okay)
  • The interest-rate sensitive parts of the economy are where there is risk – in housing/real estate we expect a very modest decline, though don’t see a big risk because supply is tight…However, between now and the end of the year, we see mortgage rates peaking, somewhere around 6-6.50% though it’s possible for mortgage rates to hit 7%-8% before Dec FOMC meeting+
Drivers
  • Markets are pricing in the midpoint between 3.75-4% fed funds rate by year end, driven by a Federal Reserve that is bent on getting the fed funds rate into restrictive territory by end of this year (as detailed in recent fedspeak events)
    upload_2022-9-9_13-6-34.png
  • Yield curve is shifting higher, showing that the market is "listening" to the Fed
    upload_2022-9-9_13-10-59.png

  • By the end of the year, the yield curve should finally experience true inversion (my forecast in red lines):
    upload_2022-9-9_13-12-38.png

  • The ramifications of this is a pause in Fed policy with potential easing by the end of Q1 (~ May meeting), which is what the market is pricing in:
    upload_2022-9-9_13-14-30.png
Risks
  • The underlying assumption is that inflation has peaked and will come down... how fast it will move lower depends on the tug-of-war between goods disinflation (drop in commodity prices, bottlenecks, etc.) and services inflation (returning to work is drove rents up dramatically this year, pushing wages higher too)... should services inflation, driven by wage growth and rents (OER in CPI), continue to accelerate into next year, then the Fed will not ease and we could see a move into a real recession with unemployment rate exceeding 4.5%.
  • If services inflation actually continues to slow down, however, then the progress to reality through time will significantly improve the market outlook... this is because everyone and their mother is short and/or hedged for a hard landing
  • You can see this in positioning data such as SPX Index options
    upload_2022-9-9_13-22-12.png

  • In COT/TFF reports, positioning shows that speculators and managed money is massively short -- this will accelerate moves higher (especially with low volumes!)
    upload_2022-9-9_13-26-12.png

  • EPS estimate data has moved lower since the middle of this year -- however, next year EPS is starting to improve
    upload_2022-9-9_13-29-34.png

  • Interest sensitive sectors such as homebuilders are seeing a decline:
    upload_2022-9-9_13-31-0.png

    Which is being offset by a ramp up in earnings from oil & gas:
    upload_2022-9-9_13-38-44.png

  • Next year estimates will really depend on the path of inflation over the next 3-6months because a drop in inflation will result in much higher real wages, which can significantly drive up earnings potential

Inflation Review
  • Yes inflation right now is high, old news -- currently the big drivers of inflation have been (recently) goods disinflation (falling prices thanks to excess inventories due to bullwhip effect), rent inflation (driven by tight supply and high home prices), wage inflation (driven by tight labor markets), and food inflation (driven by a mix of wage, rent, and agri variables)
  • Recent data points to improving labor dynamics (Canada results, job hiring survey, etc.) which will slow down wage acceleration and decrease the odds of sustained higher inflation next year
  • Housing prices have already peaked and (due to lagging effects) will start to show up in rents within the next 1-2 months
  • Food inflation has come down, with wheat prices stabilizing post-Russia invasion
Improving inflation dynamic reduces the risk of both a hard landing and of sustained or increasing interest rate hikes next year.
 

Attachments

  • upload_2022-9-9_13-44-55.png
    upload_2022-9-9_13-44-55.png
    25.1 KB · Views: 4
Some additional notes:

  • Goods disinflation
    upload_2022-9-9_14-31-0.png

  • Hiring plans are slowing:
    upload_2022-9-9_14-31-52.png

  • 2year breakevens are pricing inflation below 2.2%:
    upload_2022-9-9_14-33-32.png

  • Home prices are selling below list price:
    upload_2022-9-9_14-35-3.png

  • CTAs are super short:
    upload_2022-9-9_14-35-44.png
 
Another thing: jumbo rate hikes are old news. The Fed wants to get to 375-400bps by end of the year. It's currently at 250. So that's another 125-150bp of tightening over 3 FOMC meetings. It can do that via 75+50+25, 50+50+50, 100+50, etc., etc. What matters is what rate they are trying to get to.
 
Would you mind explaining how a near term inflation rate of over 8% supports a ff rate of only around 4%? How do you bring down inflation with that? Especially given that we have hardly seen any balance sheet reduction. And what if inflation nudged even higher?

longandshort said:
Summary
  • Long-duration assets will likely outperform through end of the year as near-term inflation data supports a Fed terminal rate of ~4% by the Dec meeting
  • Positioning data suggests rapid price moves higher though without sustained increases in volume a tactical approach is best (rallies will be fast because of bad positioning, but lack of new volume would mean high chance of mean reversion)
  • Inflation path next year hinges upon the dynamic within the US labor market (tightness) and housing (prices and rent) -- recent data points to a softening in both areas
  • Simple ETF ideas: long QQQ short XLF, long IEO short XHB, short FXC
Thesis changes if:
  • Wage data accelerates for at least two periods: NFPs / JOLTS (I'm wrong about near-term path of wages)
  • Market rents / housing prices accelerate: Zillow rent data, CoreLogic Home Price Index (I'm wrong about near-term path of housing situation)
  • New shock (crystal ball limitations)


Market Insights:
  • The stock market is down this year driven by the Federal Reserve raising interest rates to combat inflation. Over the next 1 year, the policy stance will shift from being aggressive to being neutral (& maybe dovish), which will support the stock market recovery in Q4 this year and through next year
  • Interest rates have jumped from 0.00 – 0.25% to 2.25-2.50% on the short end, and we expect those to stabilize around 3.50-4.00% by the end of this year and early next year
  • The economy is doing okay for now given how strong employment is—this might slip a little, but we don’t see a major recession or downtrend because of how strong consumer and corporate balance sheets are (people have cash, assets are doing okay)
  • The interest-rate sensitive parts of the economy are where there is risk – in housing/real estate we expect a very modest decline, though don’t see a big risk because supply is tight…However, between now and the end of the year, we see mortgage rates peaking, somewhere around 6-6.50% though it’s possible for mortgage rates to hit 7%-8% before Dec FOMC meeting+
Drivers
  • Markets are pricing in the midpoint between 3.75-4% fed funds rate by year end, driven by a Federal Reserve that is bent on getting the fed funds rate into restrictive territory by end of this year (as detailed in recent fedspeak events)
    View attachment 294713
  • Yield curve is shifting higher, showing that the market is "listening" to the Fed
    View attachment 294714
  • By the end of the year, the yield curve should finally experience true inversion (my forecast in red lines):
    View attachment 294716
  • The ramifications of this is a pause in Fed policy with potential easing by the end of Q1 (~ May meeting), which is what the market is pricing in:
    View attachment 294717
Risks
  • The underlying assumption is that inflation has peaked and will come down... how fast it will move lower depends on the tug-of-war between goods disinflation (drop in commodity prices, bottlenecks, etc.) and services inflation (returning to work is drove rents up dramatically this year, pushing wages higher too)... should services inflation, driven by wage growth and rents (OER in CPI), continue to accelerate into next year, then the Fed will not ease and we could see a move into a real recession with unemployment rate exceeding 4.5%.
  • If services inflation actually continues to slow down, however, then the progress to reality through time will significantly improve the market outlook... this is because everyone and their mother is short and/or hedged for a hard landing
  • You can see this in positioning data such as SPX Index options
    View attachment 294718
  • In COT/TFF reports, positioning shows that speculators and managed money is massively short -- this will accelerate moves higher (especially with low volumes!)
    View attachment 294719
  • EPS estimate data has moved lower since the middle of this year -- however, next year EPS is starting to improve
    View attachment 294721
  • Interest sensitive sectors such as homebuilders are seeing a decline:
    View attachment 294722
    Which is being offset by a ramp up in earnings from oil & gas:
    View attachment 294723
  • Next year estimates will really depend on the path of inflation over the next 3-6months because a drop in inflation will result in much higher real wages, which can significantly drive up earnings potential

Inflation Review
  • Yes inflation right now is high, old news -- currently the big drivers of inflation have been (recently) goods disinflation (falling prices thanks to excess inventories due to bullwhip effect), rent inflation (driven by tight supply and high home prices), wage inflation (driven by tight labor markets), and food inflation (driven by a mix of wage, rent, and agri variables)
  • Recent data points to improving labor dynamics (Canada results, job hiring survey, etc.) which will slow down wage acceleration and decrease the odds of sustained higher inflation next year
  • Housing prices have already peaked and (due to lagging effects) will start to show up in rents within the next 1-2 months
  • Food inflation has come down, with wheat prices stabilizing post-Russia invasion
Improving inflation dynamic reduces the risk of both a hard landing and of sustained or increasing interest rate hikes next year.
More...
 
M.W. said:
Would you mind explaining how a near term inflation rate of over 8% supports a ff rate of only around 4%? How do you bring down inflation with that? Especially given that we have hardly seen any balance sheet reduction. And what if inflation nudged even higher?
More...
Couple of things here:
  • BS reduction isn't going to impact inflation much. QT won't occur until after the Fed drains most of the excess reserves (shaded area below).
    upload_2022-9-9_16-39-32.png

  • Should the Fed raise rates to where inflation was last month or where inflation will be? Monetary policy doesn't hit overnight....High energy prices contributed a significant amount to CPI -- remember that CPI is a lagging indicator (Sep CPI will tell us about Aug inflation), while energy prices can tell us about inflation today:
    upload_2022-9-9_16-30-59.png
 
With full decoupling of the West from China an inflation rate of 4% will be remembered to be low. There is no way we can continue to have it both ways, battle China and keep it within control and at the same time continue to consume cheap products. We already see massive price increases even in the smallest of items on Amazon, not 4%,not 8%,mostly 50-200% more expensive year over year. Don't believe me? Go back in memory and remember what you bought a year or 2 years ago, try to find the same or similar item on Amazon. Check what you pay today. Then we have under invested in commodities for decades. Those missing investments are gonna hurt now for years. With liberal policies and more immigration from the rest of the world property prices will continue to point upwards in the medium and long term. Please explain how we get back to 2% inflation anytime soon? I don't see that happening. And this is the scenario without war or serious power struggle. At that into your calculation and there is a very good chance we see yields climb to over 10% in the next 2-3 years.

longandshort said:
Couple of things here:
  • BS reduction isn't going to impact inflation much. QT won't occur until after the Fed drains most of the excess reserves (shaded area below).
    View attachment 294738
  • Should the Fed raise rates to where inflation was last month or where inflation will be? Monetary policy doesn't hit overnight....High energy prices contributed a significant amount to CPI -- remember that CPI is a lagging indicator (Sep CPI will tell us about Aug inflation), while energy prices can tell us about inflation today:
    View attachment 294737
More...
 
M.W. said:
With full decoupling of the West from China an inflation rate of 4% will be remembered to be low. There is no way we can continue to have it both ways, battle China and keep it within control and at the same time continue to consume cheap products. We already see massive price increases even in the smallest of items on Amazon, not 4%,not 8%,mostly 50-200% more expensive year over year. Don't believe me? Go back in memory and remember what you bought a year or 2 years ago, try to find the same or similar item on Amazon. Check what you pay today. Then we have under invested in commodities for decades. Those missing investments are gonna hurt now for years. With liberal policies and more immigration from the rest of the world property prices will continue to point upwards in the medium and long term. Please explain how we get back to 2% inflation anytime soon? I don't see that happening. And this is the scenario without war or serious power struggle. At that into your calculation and there is a very good chance we see yields climb to over 10% in the next 2-3 years.
More...
What are your odds of inflation being within these ranges in 2 years:
10%+
6-9%
3-6%
2-3%
0-2%
< 0%
 
I assume you ask in 2 years not within? I meant within, but if I had to guess what it's like in 2 years...

8%
16%
35%
25%
15%
1%



longandshort said:
What are your odds of inflation being within these ranges in 2 years:
10%+
6-9%
3-6%
2-3%
0-2%
< 0%
More...
 
I notice one thing missing from your assessment and the presumed "causes".

Fiscal policy. The Fed controls monetary policy. Congress and the President control fiscal policy.

It's like everyone is sitting in traffic and there's a tree across the road. Your analysis is that no one can pass because the tree is too large and heavy to be moved and it's blocking everything. What caused this? The tree falling. Except one thing...you aren't mentioning that if you walk over into the woods you will see that someone cut the tree down which caused it to fall across the road.

The Fed can do lots of stuff but they are largely reacting to trees in the road. If the fiscal policy people decide to put another trillion into the hands of the favored voters at the moment, then the Fed has another large tree to deal with. The people working to clear the trees need some help from the people putting them there in the first place.
 
Just got back from a trip to the Seattle area and all I saw were "Now Hiring" signs. Even saw one on a toll booth! It's obvious that there has been no real demand destruction, and why should there be with real rates deeply negative?

I reckon we have much further to go in both price and time, and at some point the mechanical effects of liquidity reduction will body-slam a market lulled into a false sense of security by the apparent resilience of share prices. At any rate, I'm keeping my eyes open for good trade setups predicated on this thesis.
 
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