2023-03-21 15:58:49 ET
Summary
- During 2022, the market perceived good news about the economy as bad news for the stock market because of the Federal Reserve tightening cycle.
- The peak of this narrative was likely reached in January 2023, as disinflation changed the expected monetary policy stance of the Federal Reserve.
- The positive price trend of risk assets in January caused investors to overlook the chances of a recession in 2023.
- I believe bad news will be bad news again, as the market will likely refocus on the economy, rather than the Fed.
The regime of 2022
During 2022, the market perceived good news about the economy as bad news for the stock market due to the Federal Reserve's focus on fighting inflation. In continued attempts to front-run the central banks, market participants piled in after the release of bad economic data as it increased the likelihood of a Federal Reserve pivot. However, it takes time for higher interest rates to impact the economy, and during the past year, there were almost no shocks to companies' earnings. The downward trend in 2022 resulted from higher risk-free rates, which compressed earnings multiples - the 'P' in 'P/E' went down. Therefore, high inflation prints were particularly bad for the stock market, signaling a 'still-too-hot' economy, more monetary tightening, and higher rates across the board.
No wonder the market temporarily bottomed out in October 2022, when panic about inflation peaked after a horrendous > 8% YoY CPI report. Since then, inflation has been coming down, and we have likely seen the peak of the first inflation wave for now.
Corresponding with the peak of inflation in October 2022, yields at the far end of the curve significantly decreased. The 30-Year US government bonds rallied from 4.4% to 3.5%, providing a massive tailwind for the stock market that coincided with very bearish positioning on average. This resulted in a massive interest-rate-driven bear market rally.
What happened in January?
Narratives always follow price action. With the S&P 500 ( SP500 ) up from its October 2022 lows and the peak of inflation clearly in the rearview - and therefore also the peak of monetary tightening - investors piled in again. Retail inflows into the stock market reached a historic $1.5 billion per day in January. Tesla ( TSLA ) doubled in price, while Bitcoin ( BTC-USD ) and Ethereum ( ETH-USD ) had a 40% rally.
All of a sudden, the talk of a recession was dismissed as FUD (fear, uncertainty, doubt) because assets were pumping again. But with the housing market becoming illiquid due to surging mortgage rates, the yield curve historically inverted, and the biggest global corporations signaling profit warnings for the next year, was it really time to look at the historically lagging labor market data or earnings from Q4/22 to gain perspective on the market cycle? Or was it really cherry-picking of positively fitting data to support the bear market rally?
Don't focus on the Fed for now - Even after the recent easing
The Federal Reserve's monetary policy is starting to become less relevant for the market as the Fed Funds rate nears its peak at around 5%, and inflation is clearly trending lower due to the slowing economy. The Federal Reserve will keep its policy tight until something breaks, and monetary stimulation becomes necessary. The process of breaking has to be systemically relevant, and historically, it has never been bullish for the stock market. The market has only bottomed out after the Fed Funds rate has been substantially lowered in response to bad economic data, primarily consisting of the unemployment rate, because of the central bank's dual mandate.
Talking about a true pivot may seem premature at the moment, but I believe we are reaching the peak of the tightening cycle. It remains to be seen if the recent bank failures of Silicon Valley Bank ( SIVB ), Silvergate ( SI ), and Credit Suisse ( CS ) turn out to be systemic. But even if these events represent the 'breaking' that everybody has been waiting for, front-running it probably won't work this time either.
If the Federal Reserve changes its monetary policy stance to ease financial conditions, it will take some time for the easing to work its way into the financial system. The damage to the value of collateral has already been done in 2022, and in 2023, we will start to see the consequences.
All of the above-mentioned failures were because the underlying collateral of these banks has been severely impaired by higher rates. The most vulnerable and risk-exposed banks got caught first. The new Bank Term Funding Program (BTFP) aims to compensate for the collateral damage that higher long-term rates have done to the long end of the yield curve. Excluding the technicalities, it's basically quantitative easing for banks that need additional loans, but their collateral has substantially devalued. In my opinion, the Fed is starting to turn around, but if history is any indication, this will not be the next bull market, since economic data (unemployment and corporate earnings) will likely come in way below expectations.
The knee-jerk reaction of the market after the revelation of the BTFP was quite satisfying, though. Due to the new buying pressure for government bonds, 1-2 Year Yields sold off massively, and the most interest rate- and liquidity-sensitive assets (such as Bitcoin and Gold) started a major rally. Meanwhile, the Federal Reserve Balance Sheet increased by $297 Billion within one week.
A pivoting Central Bank doesn't mean that a storm is coming. It means that a hurricane is already ripping houses apart. I believe, we are still a tad away from this point - but the odds are increasing that we will go there:
E of P/E
As the volatility of Fed Funds lessens, and rates stay elevated, the market will likely focus on the 'E' of 'P/E'. Let's have a look at the 'E' side of things:
1. Housing
The housing market is very sensitive to changes in interest rates because, like banks, the value of the collateral is immediately at risk. However, banks usually hedge their interest rate risk due to regulatory reasons. The housing market can't collectively do that and is much more prone to speculation manias. However, most mortgage rates, especially in the US, are fixed for several years, so the rapid rise in interest rates doesn't affect owners with a multi-year fixed mortgage rate. Mortgage debt service payments as a percentage of disposable income in the US are rising at a non-comparable pace to 30-year fixed mortgage rates. Only if houses change hands, the service payments increase materially.
While house prices have come down from their peak, they remain elevated, especially in comparison to the extreme increase in debt service costs that new owners face. The result is an illiquid market, where owners are incentivized to keep their mortgage, and buyers are reluctant to purchase at current prices. Since interest rates started rising, the number of homes for sale in the US has kept trending upwards while fewer houses are getting sold. This divergence was last seen in 2006, right before the Great Financial Crisis, which in essence, was a collateral crisis too.
Home builders are also beginning to suffer for the same reason, with new housing permits authorized already showing a mean reversion.
The illiquid housing market has two potential solutions: lower prices or lower mortgage rates. Although home prices have started to trend lower, they are still not attractive at current mortgage rates. Thus, I believe that house prices need to fall further, even if mortgage rates start to decrease. Lower house prices should lead to lower rents with a lag, contributing to the disinflationary trend.
Furthermore, since approximately 15% of jobs in the US are connected to the housing market, a decline in home prices could put some of these jobs at risk and potentially lead to rising unemployment in the future.
2. Credit Creation
The effects of higher interest rates are starting to hit the economy in 2023. The Net Percentage of domestic Banks reporting stronger demand for commercial and industrial loans from large and middle-market firms ('US loan demand trend') only started to reverse in late 2022. Real Commercial & Industrial Loans follow this demand trend with a lag.
Additionally, the percentage of Banks tightening standards for loans recently increased similarly to 2019-2020, 2006-2008 and 1998-2000. These last three times the unemployment rate was quick to follow.
The TED-Spread remains close to zero, showing that the trust for interbank-lending remains strong for now.
3. Corporate Earnings
The Personal Savings Rate currently stands below 5%, one year into the monetary tightening, and the consumer is starting to feel the pressure.
Even though inflation is now declining, the average consumer lost purchasing power throughout 2021 and 2022.
It is no surprise that major US corporations are now cautiously guiding for lower profitability in 2023. I believe that Apple ( AAPL ) appears vulnerable in this kind of environment as the company sells luxury products with little innovation to middle-class retail consumers who may have less disposable income.
Moreover, during the supply shock, many corporations overordered and stocked up as demand outpaced supply. Now, as demand wanes and storage facilities remain loaded, corporations may come under pressure to sell the over-ordered goods, leading to margin compression.
The regime change of 2023
All of the above mentioned financial and economic trends, and especially the market reactions of the last week confirm my view of a regime change in 2023, which I already described in my previous article .
If the market shifts from primarily focusing on the monetary policy stance of the Federal Reserve to focusing on data from the real economy, correlations of assets change: If the markets price in a significantly weakening economy, yields fall. In that case, the 'E' in 'P/E' gets hit simultaneously. This results in a steepening of the yield curve.
The underperforming assets in this environment are likely to be those receiving a majority of their valuation from near-term earnings, such as industrials or energy companies. Last week's price action of oil ( CL1:COM ), which tumbled below $70, fits well with this framework. Meanwhile, assets that are more sensitive to interest rate changes and less sensitive to earnings changes, such as gold and Bitcoin, should outperform, although that does not necessarily mean they will trend higher nominally. It's important to note that as the economy enters a recession, selling pressure from missing liquidity will likely affect all assets at once.
The dominant correlation in 2022 was:
1. Yields up (Flattening Yield Curve)
2. Assets down
= Even though the economy is doing well in terms of earnings, the rising interest rates and the Federal Reserve's hawkish stance are negatively affecting the valuation of assets.
The proposed Regime change during 2023 should have the following correlations:
1. Yields down (Steepening Yield Curve)
2. Assets down
= The economy is weakening due to tight financial conditions (collateral crisis), and the Federal Reserve is likely to ease again.
During the last week, we saw exactly these correlations flip:
Implications for my portfolio:
Due to my aforementioned expectations, I am currently very cautious. For the most part, I am staying out of the market because the risk-free rates are very attractive, given the recessionary circumstances. However, I am more bullish on long-duration assets than short-duration assets.
Personally, I started Dollar-Cost-Averaging into Bitcoin in January and continue to do so. I also have exposure to the long end of the yield curve through the iShares 20+ Year Treasury Bond ETF ( TLT ). To complement this heavy focus on long duration, I have a position in Uranium, which admittedly trades heavily with liquidity conditions.
My simplified model portfolio is now up 2.6% in 2023. No changes have been made from the start in 2023. At the start of the year, 69% of the portfolio was in cash. Since the risk-free interest rate has increased, this would add another ~0.8% to the performance, resulting in a total performance of 3.4% YTD.
Nothing spectacular but: There's a time to buy, there's a time to sell and currently I believe it's a time to go fishing.
Just make sure you don't fall asleep and miss the fish on the hook.
For further details see:
Are You Prepared For A Regime Change?