After a positive trending market in 2021 and a negative trending one in 2022, thus far, 2023 has largely been range bound for most assets, although the correlations within those ranges have started to break down. Thus oil, for example, is now at the bottom of its range, while Gold is at the top (and threatening to break out). The S&P, and especially NASDAQ, are now at the top of their ranges, while the US Long Bond, having been highly correlated with equities (in both directions) in recent years, is now at the bottom of its range. Similarly, ratios such as equal weight to market cap weighted S&P and Large Cap versus Small Cap US Equities are looking very stretched, the latter at its lowest level for 20 years. Meanwhile, the trade weighted $ is at the bottom of its recent range and we would be looking most closely at the JPY pair to drive direction from here. Currently the Yen just failed to break up (weaken), so we suspect that the Yen will attract more attention during the next month as the Yield Curve Control (YCC) issue re-emerges in Japan.
We continue to believe that Equity Markets, having completed the discount-rate driven first leg of a bear market in 2022, remain to be convinced that a second, earnings-downgrade driven leg, will necessarily follow. Not so the macro pundits, who, still flush from their success last year, continue to run large short positions in equities (and consequently keep getting squeezed). Seemingly at the top of a range, momentum players get overly excited about a “Fed Pivot’ and are disappointed, while at the bottom of the range, the bearish pundits find themselves caught in a short squeeze.
Short Term Uncertainties
April demonstrated reasonable seasonal strength and interestingly, despite the well-known phrase of ‘Sell in May and go Away’, May also actually has demonstrable positive seasonality for the last 20 or so years. Nevertheless, May definitely began with a wobble, with a reminder of the SVB debacle as First Republic was ‘rescued’ over the weekend, with echoes of Washington Mutual as equity holders were wiped out and the momentum traders are out in force hammering the ‘regionals’. Between them, Credit Suiise, SVB and First Republic have destroyed over $100bn of equity over the last year, with Silvergate and Signature adding to the total. The ETF for US regional banks (KRE) is back to the 2020 levels as they are, probably correctly, seen as an accident waiting to happen as the interest rate environment shifts to a new paradigm and, in particular, there is great concern over their exposure to US Commercial Real Estate (CRE).
The ‘bad breadth’ in markets, whereby in a small number of NASDAQ related stocks have dominated returns year to date (Meta and Nvidia have doubled year to date against an otherwise flat market for example, with some very painful short squeezes) has attracted almost as many comments as the phrase ‘weak demand’ but not as many as the term ‘AI’, which is now almost ubiquitous. Anecdotally, ‘ladies who lunch’ queuing to get into smart London Brasseries talking about AI is surely the sign of some sort of top? The theme of ‘AI stocks’ reminds us of other, rather nebulous, ones in the past, such as 3D Printing.
The energy sector remains volatile and one interesting suggestion we read about the recent weakness in the Oil markets is that it may actually be connected to higher rates and the resultant higher cost of running inventory at the retail level. A step change from full inventory to perhaps half full may be leading to the appearance of weaker end demand by those looking at inventories as a lead indicator. Also, the ongoing draining of the Strategic Petroleum Reserve (SPR), now at its lowest since 1983(!), at a time when the Biden administration had said they would be filling it has probably caused some CTA traders to adopt a variation of don’t fight the Fed(s); if the authorities are trying to manipulate oil prices down for political reasons, perhaps being ultra long (as they were) might not be the best short term strategy?
Higher cost of funding is changing behaviours and may be confusing some leading indicators
Meanwhile Golden week in Asia means a lot of good news on Chinese consumer spending , but relatively thin trade in financial markets and the ADR tail has been leading the domestic dog in early May, especially as the anti China rhetoric is ratcheted up to another level in the US. This is de-facto sanctions behaviour, rather like ESG, no fiduciary is going to want to get caught the wrong side of a potential ‘rule change’ and as such the risk premium on China has clearly risen.
Medium Term Risks
The perils of the US debt ceiling are starting to come into focus, not just because of the political tensions building over spending, but also because markets recognise that Janet Yelland and the Treasury are holding back on a slew of issuance. This is, almost certainly, a key reason why the US long bond failed to be as excited as NASDAQ was about the ‘bad news is good news’ response to the weak US GDP numbers. Even as the Fed sounds (a little) more dovish, the supply/demand issues for US Treasuries do not look healthy.
Meanwhile, the shadow from Ukraine remains/grows darker and hopes for an early settlement are fading. We note a clear shift in the narrative tone in ‘the west’ away from ‘inevitable Ukrainian victory’ towards something more fatalistic, ironically confirming much of the more nuanced observations from ‘the rest’ that have been so readily dismissed until now. The likelihood/success of any spring (now summer?) Ukraine offensive offers enhanced uncertainty over the next few months and with the option of a high return on 3 month money, it’s not surprising that many are sitting on the side-lines. Incidentally, the fact that Libor ends in June, to be replaced by the other reference rates, but principally the Secured Overnight Funding Rate - SOFR - will likely have some disruptive effects. Given over $600trn of notional lending is fixed to Libor and that SOFR has traded at a 10-40bp discount to Libor, this theoretically means that a lot of loans, such as those held in CLOs, may be worth ‘less’ to investors. Perhaps that will have no impact on valuations, but the recent experience with LDI and pension funds should at least put us on watch.
Shifting $600trn notional based on Libor to SOFR by June 30th implies some potential disruption
Inflation remains stubbornly high, even as the Fed keeps choking demand, leading to periodic concerns that the Fed (and by extension all other western central banks, who appear to simply follow) will ‘over-tighten. We certainly see this as a risk, low interest rates never caused inflation and high interest rates won’t ‘cure’ it, rather they will just compound the pain for those ‘needing’ a low cost of capital. However, we see the inflation issue more as a, likely short-term, attempt to boost profit margins. Using the excuse of an exogenous ‘shock’, corporates often collude without actually colluding to raise prices in an oligopolistic fashion, but also to drive down input prices in a monopsonist fashion. This is straight out of business school texts on Porter's Five forces of competitive advantage. Supermarkets are the obvious example, where wholesale price cuts, reflecting monopsony power of a few buyers, are currently not being passed on to consumers, reflecting oligopolistic power of a few sellers. This is good for margins, but at the expense of volumes. Sooner or later, the old model of competition will emerge and this will ‘cure’ the inflation. Central Bank modellers know things move with a lag, but sadly rarely appear to have the patience to wait.
Central Bankers constantly focus on trying to control demand, rather than looking at supply
In the meantime, the risk is that the economic models at the central banks, now switched to the ‘higher interest rates are now the only answer’, mode, will see the continued need to crush demand rather than let supply respond. This is certainly one of the key aspects of ‘the wall of worry’ for equities to climb this summer, although on balance, we think a pause is coming soon, albeit not the pivot that many traders are hoping for.
Long Term Trends
Interest rates are now ‘normalised’ and we suspect will remain higher for longer, note that is not high, just higher than the previous regime, where ultra low rates mis-priced capital. The failings in the Regional Banks and the likely follow through in CRE are just part of this process. Bear in mind that the US has literally thousands of Banks, so the news flow on failure/consolidation can continue for some time yet. In this new paradigm, normal companies can make normal profits and good companies can make good profits, but bad companies won’t be propped up with ‘free money’, so supply/demand balances will shift and so will pricing power. These fundamentals will re-assert at the stock and company level once the discount rate shifts settle down.
We have written quite a lot about de-Dollarisation recently, most particularly that de-Dollarisation is also a process not an event and one that it began in earnest in the wake of the ‘freezing’ of Russian assets following the start of hostilities in Ukraine. Unfortunately, discussions about what looks now to be an unstoppable process affecting financial markets have become caught up in morality judgments about Ukraine and/or are being seen as somehow an ‘attack’ on the US. This has led to a large number of ‘defensive’ articles such as this latest Lex column which conflate the process with the Rmb somehow replacing the dollar as a reserve currency, or even the major trading currency. This is both a straw man and to miss the point; currently almost 90% of global trade goes via the $, de-Dollarisation means that much of this trade will be bi-partisan instead, albeit with the Rmb playing a larger role for no other reason than the fact that China is the biggest trading partner for more than twice as many countries as the US is.
As we noted in an article about the Bancor last year, the ‘alternative’ to the dollar for most countries is only likely to be needed for the net balance of trade, without having to always go via $s, the volume of dollar trade will shrink dramatically, even if the balance is still settled in $. And remember, the Chinese have around $1.4trn of gold, as well as around $3.2trn of foreign reserves, such that the Rmb does not have to be fully convertible, an offshore Rmb can be backed by Gold and $s, just as the offshore $ was backed by Gold in the 1950s and 1960s.
Finally we would note that 2024 is going to be a big year for Elections, obviously the US, but of increasing importance will be Taiwan in January. Four years ago, the pro US DDT party secured a dramatic turnaround in the polls thanks to the anti China sentiment generated out of the Hong Kong protests. This time, for a similar turn around to happen, the anti China rhetoric around a Taiwan invasion needs to be kept ‘front of mind’ as they say.