SUMMARY: Real US growth prospects have improved (10yr yields higher but inflation expectations anchored and commodity prices lower), but growth is still too strong for the Fed (FOMC remains focused on lowering inflation), expect market headwinds but not a sharp drawdown. Bond and stock Volatility increasing along with Fed funds futures (2023 cuts have been significantly reduced) reflect a bias for the Fed to remain hawkish given still too strong US economic data.
FYI… Financial condition changes usually intensify around Fed meetings/important speeches as volatility increases. Friday will likely be another volatile day. As of last week, 71% of investors expected Powell would try to tighten financial conditions at Jackson Hole. That noted, the VIX has moved rapidly higher over the past few days.
Multiples have expanded during the rally but are about appoint lower over the past week and are still WELL off their highs, even as financial conditions eased. The setup with implied volatility is similar. Equities will move lower during the next round of financial conditions tightening, but the magnitude of that decline will be smaller.
And on Friday, unless Powell signals a higher terminal rate (higher peak fed funds) or a firm signal on 75bp in Sept, his message might not be enough to tighten financial conditions further. Given positioning, another VERY SHORT TERM pain trade run higher is possible. Our call through September is that growth is too firm for the Fed, which biases financial conditions tighter and favors Low Vol and Defensive Sectors & factors. CPI and Payroll are critical for our thesis to work. Both need to be on the firm side. At the end of this repot we highlight the stocks best and worst positioned for further tightening along with John Roque’s technical scores for those names.
Europe Theory: European news has been terrible, but risk assets are holding up ok. The best theory as to why comes from a few macro clients. The combination of an underappreciation of the fiscal offset from European governments to higher energy prices, AND the surge in natural gas storage levels. The increase in nat gas storage levels is consistent with Germany finding more LNG and that helps explain the collapse of the German trade surplus (imports soaring). A shrinking surplus means lower Euro. Which is really good news for tourism in southern Europe (bad for Tech earnings exposed to Europe). Anyway, that is a theory that many have pointed to and along with super bearish positioning (S&P net futures positioning deeply negative) makes it harder to make money on the short side.
Breadth of Data Important: Data yesterday was weak, but when we look at the breadth of economic data, not just cherry pick data points, the US economy still appears to be at an above trend pace of growth. And as Gerard has noted, if the economy is growing above trend and labor markets are tight, the Fed still has work to do in slowing the economy. Both the NY Fed Weekly Economic Indicator and the Chicago Fed’s National Activity index show underlying economic demand as having weakened, but still relatively strong and above trend.
Full report below….
MARKET VIEWS: Headlines from Europe and China have been unusually concerning, and the breakdowns in the Euro and CNY (Chinese Yuan) reflect those concerns. If we had to guess as to why risk assets are not acting worse, it’s the underappreciation of the fiscal offset in Europe to higher energy prices AND the surge in natural gas storage levels. As a few clients have pointed out, the increase in nat gas storage levels is consistent with Germany finding more LNG and that helps explain the collapse in the German trade surplus (imports soaring). A smaller surplus means lower Euro. Which is really good news for tourism in southern Europe. Anyway, that is a theory that many have pointed to and along with super bearish positioning (S&P net futures positioning deeply negative) makes it harder to make money on the short side.
High frequency data in the US has been poor this week with S&P service PMI and housing data very weak. Two important offsets to that data though. High frequency restaurant and TSA crossing data have not slowed, and core retail sales came in higher-than-expected last week.
When we look at the breadth of economic data, not just cherry pick data points, the US economy still appears to be growing at an above trend pace. And as Gerard has noted, if the economy is growing at an above trend and the labor market is tight, which it is, then the Fed still has work to do in slowing the economy. Both the NY Fed Weekly Economic Indicator and the Chicago Fed’s National Activity index show underlying economic demand as having weakened, but still relatively strong and above trend.
Vol Has Increased – How Much More Should We Expect: As we discussed (details here), Volatility has been the major driver of tightening financial conditions this year. The rise of VIX and MOVE this week contributed to the tightening of financial conditions this week. Volatility dropped, and financial conditions eased as the economy looked to be slowing more quickly just a few weeks ago. With real US growth prospects improving (10yr yields higher but inflation expectations anchored and commodity prices lower), but growth still too strong for the Fed (they continue to focus on bringing inflation lower), we expect market headwinds, but not a sharp drawdown. FYI..Financial condition changes usually intensify around the Fed meeting or important Fed speeches as volatility increases. So Friday will likely be volatile. As of last week, 71% of investors thought Powell would tighten financial conditions at Jackson Hole, but vol has already had a decent move.
High volatility and low quality Tech names also face headwinds as financial conditions tightened again and investors embraced risk-off factors. ARKK dropped again since the recent high last week and has lost -26.9%. Meme stocks have following similar trend while dropped only -2.9%.
Why A Drawdown Should Be Less Painful: When the market peaked at the beginning of the year, financial conditions and NTM multiples were at a higher level than the lower peak in March, which were again at a higher level than now. Multiples have expanded during the rally but were still WELL off their highs even before the recent downturn. Equities will move lower during the next round of financial conditions tightening, but the magnitude of the decline will be smaller.
The setup with implied volatility is similar. The S&P PE was more than 3 points higher and implied vol was 3.5 points lower at the start of the year. In addition, earnings growth and margin expectations have both moved lower. Fundamentals are not a stretched today, and that limits the market downside. We still put fair value between 3,800-4,200.
Here are the top 5 stocks by sector benefitting from tightening financial conditions with John Roque’s technical scoring…
…and the top 5 stocks by sector at risk from tightening financial conditions with John Roque’s scoring.
