SUMMARY: Brainard, who is worth paying attention to, said yesterday, “at some point in the tightening cycle, the risks will become more two-sided.” That’s conveniently consistent with what we wrote a week ago – the Fed’s tone will change once the urate starts to rise, limiting downside (HERE). Tail risk IS lower; the Fed wants to slow growth, not crush it. The nuance is important; we don’t see a reason to call for 3200. This is consistent with downside being more limited by already higher vol, lower multiples, and tighter conditions than earlier episodes of tightening.
That doesn’t mean the Fed’s focused on their dual mandate right now; employment is still inconsistent with a Fed-friendly level of inflation. Weakness in the last employment report was not a scene changer. Tail risk is lower, but people seem to have ignored Brainard’s insistence that the FOMC’s job is not done, and equities continued to rally while yields fell.
Brainard also noted USD strength could help cool inflation. That’s helpful while USD strength lasts, which we don’t have conviction on. We can help with positioning for either side of the Dollar and financial conditions trade though. John Roque expects an even stronger Dollar, and positioning for that involves being long Low Vol with no/low foreign sales.
There is also a possibility that European growth improves. Commodity prices have been falling, the Central Bank rate differential may shrink, and Europe is making progress on its energy dilemma. To play a short-term reversal of Dollar gains and tighter financial conditions, go long high Liquidity stocks with high foreign sales exposure.
Both stock baskets mentioned above are in the full report. We’re also happy to run exposures for any stocks or portfolios – just ask us.
MARKET VIEWS: Eyes are on central bankers again today; the ECB announces its policy this morning, and Powell speaks ~9 AM ET today. Market-based expectations for 75bp hikes are ~70% for the ECB and ~80% for the Fed. Sell-side shops are shifting to 75bps too; Goldman changed to 75bps in September and 50bps in December, up from 50bps and 25bps, respectively. Narrative shifts (PEs) are once again dominating market returns. Market correlation is exceptionally high (93rd %tile for the overall S&P), which is leading to interesting internals. Cyclicals were flat relative to Defensives yesterday despite the market gaining 1.8%. Utilities and Discretionary, two sectors that are consistently negatively correlated, were the two best performing sectors yesterday.
Brainard, who is worth paying attention to, said yesterday, “at some point in the tightening cycle, the risks will become more two-sided.” That’s conveniently consistent with what we wrote a week ago – the Fed’s tone will change once the urate starts to rise, limiting downside (HERE). Tail risk IS lower; the Fed wants to slow growth, not crush it. The nuance is important; we don’t see a reason to call for 3200. This is consistent with downside being more limited by already higher vol, lower multiples, and tighter conditions than earlier episodes of tightening.
But that also doesn’t mean the Fed’s focused on their dual mandate right now; employment is still inconsistent with a level of inflation the Fed will accept. Weakness in the last employment report was not a scene changer. Tail risk is lower, but people seem to have ignored her insistence that the job is not done, and equities continue to rally while yields continue to fall.
Goldman’s FCI is back to its July peak. No one knows if financial conditions are tight enough on level terms, but if market conditions improve too much, then they weren’t tight enough. That is the problem with using financial conditions as a timing tool in either direction. The chart below illustrates there is no level of financial conditions that indicates a recession. There may be another bout of risk-on outperformance, as has happened earlier this year, but it’s tough to get excited about a sustained rally until the inflation outlook improves. Goldman’s economist noted the drag from tight financial conditions will endure.
Brainard also noted USD strength could help cool inflation. That’s helpful while USD strength lasts, which we don’t have conviction on. The ECB may go 75bps and Europe is working at solving its energy crisis (like the UK allowing fracking) but the USD is a safety trade and the economic outlooks in Europe and China are bleak, and financial conditions are tightening in the US. John Roque does have more conviction on the Dollar – he expects additional Dollar strength.
A strong Dollar is a tailwind to low foreign sales stocks. Tech and Healthcare have the highest exposure to foreign sales, Utilities, and Financials the least.
Layering in factor exposure to financial conditions has been an alpha-generator this year. Low Vol outperforms and Liquidity underperforms as financial conditions tighten. Low Vol names with no foreign sales have outperformed high Liquidity names with high foreign sales as the Dollar strengthened, more than just low foreign sales have outperformed high foreign sales.
Go long Low Vol with no/low foreign sales if you expect additional Dollar strength and tighter financial conditions. Stock basket below. We’re also happy to run exposures for any stocks or portfolios – just ask us.
There is a possibility Europe improves. Commodity prices have been dropping, the CB rate differential may shrink, and Europe is making progress towards its energy dilemma. To play a short-term reversal in trends (financial conditions stop tightening and the Euro works higher), go long high Liquidity with high foreign sales.
