2023-09-26 05:03:13 ET
Summary
- The unfolding trend of deglobalization will drive the financial markets, leading to a stagflationary macro environment and more cyclical markets.
- We are currently near the end of the monetary tightening cycle, which will likely end with a recession that is not priced in by the stock market.
- The main tactical opportunities are to sell stocks and buy 2Y Treasury Note to lock in 5%+ yields.
The Investment Framework
The major force driving the financial markets over the foreseeable future will be the unfolding trend of deglobalization. Specifically, we are in a process of the fragmenting the global economy into the two blocks, the first dominated by the US, and the second dominated by China. As a result, the macro environment will likely be stagflationary.
Inflation is likely to be higher. Specifically, 1) there will be more frequent spikes in oil, and other commodities, due to the likely geopolitical events, 2) the cost of goods will likely be higher due to the trade barriers and the higher cost of production due to reshoring and onshoring production from China, and 3) there will likely be a chronic shortage of labor due to onshoring, but also due demographic trends - aging population, which is likely to keep the wage growth elevated, and thus the service inflation sticky.
Growth will likely be slower as the global markets shrink for some goods, resulting in less trade - less exports. Corporate sales are likely to decrease as the global markets become more restrictive for some products.
Thus, the financial markets are likely to be more volatile and more cyclical - with the more frequent recessions. Specifically, the central banks will likely be forced to respond to more frequent inflationary episodes, and given the slow growth expectations, this will likely cause a more frequent recessions - the business cycle will be shorter. This is in contrast with the goldilocks over the last 40 years, where we had low inflation and robust growth, with only 3 recessions, in 1991, 2000, and 2008, excluding the Covid19 related 2020 recession.
Thus, long term buy-and-hold investing is not going to be appropriate in the foreseeable future - investors will have to be more tactical, forced to play the cycle.
The current cycle
Currently we are in a monetary tightening cycle. The Fed has been tightening monetary policy since March 2022 to respond to the post-pandemic inflationary shock by increasing the interest rates and reducing the balance sheet. The inflationary shock has been initially caused by the post-pandemic supply-chain disruptions, and broader supply/demand imbalances. However, the current inflationary forces are more related to the unfolding trend of deglobalization.
For example, 1) the price of oil has been recently rising due to the supply cuts by Russia and Saudi Arabia, both in the China's BRICS+ block, 2) the current labor shortage is partially caused by strong labor demand due to onshoring, and 3) the trade barriers heavily concentrated in the high-tech sectors, like semiconductors, are increasing the costs of some goods, like autos.
So, the key question is where we in the current cycle are. The Fed has indicated that we are near the end of the interest rate hiking cycle, with 1 more possible rate hike in 2023, although the QT is expected to continue. Further, the Fed expects to start modestly cutting interest rates in 2024, by 50bpt, as inflation falls to 2.5%, but keeping the real rates elevated - due to what appears to be expectations of sticky inflation. Specifically, the Fed acknowledges that the labor shortage will persist, by estimating the full employment or a 4.1% unemployment rate, until 2026, which will likely keep the service inflation elevated.
The FOMC SEP
The key macro theme
The Fed does not explicitly expect a recession in the SEP dotplot, but Powell has indicated that soft landing is not the baseline scenario. However, the yield curve has been inverted since October 2022 - and thus, based on the historical evidence, a recession is likely imminent, which in-fact ends the monetary policy tightening cycle.
The yield curve has been deeply inverted for a long time by historical standards, which suggests a very deep recession - a hard landing. However, the recession has been delayed due to 1) strong consumer spending supported with the pandemic-related excess savings, and general post-pandemic pent-up demand for travel and entertainment, and 2) fiscal spending particularly on manufacturing construction. Note, the wealth effect is also still very strong, due to the still inflated housing prices and the overvalued stock market, both initially boosted by the pandemic-related fiscal and monetary policy stimulus - and this has also been supporting consumption.
However, it appears that the consumer excess savings have been nearly exhausted. Further, given the restart of student loan payments, the consumption is likely to decelerate over the near term - supporting the imminent recession thesis. Further, the excess fiscal spending is flagging the unsustainable deficit, which is starting to get reflected in higher long-term interest rates, also contributing to the expectations of slower consumption and investment.
Thus, the current tactical positioning opportunities are based on the expectations of an imminent recession - which is the key macro theme, within the longer-term investment framework.
What are the financial currently markets pricing - the tactical positioning opportunities?
2-Year Treasury Note
The 2-Year Treasury Note ( SHY ) is the proxy for the expected Fed's interest rate policy over the next 24 months. Currently, the 2-Year Note, with the yield at 5.12% is predicting:
- About 40% chance of another hike in December 2023 or January 2024, which ends the current hiking cycle. The assumption is that the policy is sufficiently restrictive at 5.25-5.75% range to tame inflation.
- The opportunity here is to bet on 2 more hikes, by shorting Dec and February FF futures (or sell calls), especially if oil keeps rising, and the labor market remains tight into the end of 2023.
- The first interest cut in July 2024 - the beginning of normalization - new cycle. The assumption is that either a) inflation moderates, while growth remains resilient or b) inflation remains elevated despite a recession, preventing the Fed from cutting more aggressively.
- The terminal rate of 4.25% by July 2025 - end of the normalization cycle, with about 1.25% in total cuts. The assumption here is no recession.
- The opportunity here is to buy 2Y Note and lock in the yields above 5%, or to buy July 2025 FF futures.
10-year Treasury Note
The 10-year Treasury Note nominal yield is reflecting the real interest rate and the inflation expectations. The 10Y yield has been rising, and currently the 10Y yield of 4.51% reflects:
- The real yield of 2.13% which has been recently rising from 1% in April, mainly due to the supply/demand dynamics:
- The Bank of Japan monetary policy tweak in July to allow 10-Year JGB yield to reach the 1% level is increasing the fears that Japanese investors would start selling US Treasury Bonds.
- There is also a fear that China stops buying US Treasuries as the trade surplus with the US narrows due to deglobalization, and China possibly sells US Treasuries. Japan and China are biggest holders of US Treasuries.
- There is also a fear that the Saudi Arabia and other OPEC members reduce their buying of US Treasuries as less petro-dollars are recycled into the US Treasuries due to the use of other BRIC+ currencies in the global oil trade, again due to deglobalization.
- The US fiscal spending and the resulting budget deficit is increasing the supply of US Treasuries, at the time when the demand is decreasing, which was evident in the weak US debt auctions in July.
- The US political divide is increasing the probability of default, which already caused the US debt downgrade in July.
- The Fed is still implementing the QT, which reduces the demand.
- The inflation expectations have been anchored recently in a 2.2-2.4% range, which reflects the Fed's commitment to the 2% inflation target.
Tactical opportunities:
- The real rates are likely to continue rising towards the 2.5% level over the near term. The supply-demand imbalances are likely to continue until the Fed's restarts the QE program, which is likely to start only in a deep recession with the credit crunch. The QE program has to be massive enough to replace the waning foreign demand for the US Treasuries due to deglobalization. Global disinflation/deflation due to a deep recession is also likely to bring back the Japanese investors into the US Treasuries.
- Over the near term, there is more upside risk to the inflation expectations due to 1) the potential of a premature Fed pause, and 2) rising oil prices. Over the longer term, due to deglobalization, inflation expectations are unlikely to fall below 2%, so the downside risk to inflation expectations is small.
- Overall, the nominal yield is still expected to rise due to rising real yields, and potently rising inflation expectations - thus the tactical position is to short 10Y Treasuries ( TLT ).
- The opportunity to lock-in the long-term rates, or to short futures, will arise with the signs of a deep recession, when the Fed stops the QT program, with the expectations of a new QE program.
The US Dollar
The US Dollar ( UUP ) is pricing the relative economic strength, and the relative monetary policy.
- The expectations are that the ECB has paused the interest rate hiking cycle, with an expected first cut in Sep 2024. The Fed appears to be more hawkish with another possible hike. This is expected to cause the EUR ( FXE ) weakness.
- The Chinese economy is slowing significantly, partly due to the initial shock of deglobalization, partly due to the property bubble, which is negative for the EU economy and the Australian economy, both reliant on exports to China. This is also negative for commodity-oriented emerging markets.
- Thus, over the near term, the USD is expected to strengthen.
- Further, the initial response to the expected recession should be positive for the US Dollar, assuming a possible flight to safety, and the liquidity shock due to the possible credit crunch.
- The USD should start to weaken as the Fed starts aggressively easing monetary policy, including the resumption of the QE.
- The USD is also facing the risk of de-dollarization and the loss of the global reserve currency status, given the threat of a new BRICS+ currency. However, currently this is not affecting the value of USD, despite the fact that oil is being sold in different currencies in global markets - not exclusively in USD.
Gold
Gold ( GLD ) price remains elevated near the 2000 level, despite the increase in real yields - historically, higher real yields resulted in a lower gold price. Given that real yields are expected to increase, gold is unlikely to sustainably break above the 2000 level. However, gold is likely to remain near the 2000 level in anticipation these events, which could push gold much higher:
- The resumption of the QE as the recession with credit crunch forces the Fed to ease monetary policy.
- The threat of de-dollarization and the loss of USD status as a global reserve currency.
- The unsustainable fiscal deficit and the potential for a default.
- The US internal political divide and the risk of US domestic instability.
Oil and cyclical commodities
The current cycle is likely to end in a recession, which will curb the demand for oil and other cyclical commodities. Thus, the oil price ( USO ) is likely to fall, despite the supply curbs. Any short-term gains are likely to be limited, depending on further geopolitical escalations, which are possible, but unpredictable.
Stock market
The stock market is currently pricing these 3 assumptions:
- The PE ratio for S&P 500 ( SPY ) ( SP500 ) is near 20, which is overvalued, and suggests that the market assumes an above average growth over the near term.
- Given the projection of low longer-term growth, and a near-term recession, the PE ratio should be below 15, which suggests at least a 25% correction in price.
- The analysts project 11% earnings growth for 2024 for S&P 500, which assumes no recession.
- Given the anticipated recession, earnings growth should actually decrease in 2024, thus earnings will have to be significantly downgraded, which suggests a further correction in price.
- The credit spreads are tight, which assumes no credit crunch, despite the rising real rates, and the expected wave of refinancing in 2024 particularly in the vulnerable CRE sector, and the effect this could have on the exposed regional banks.
- Credit spreads are likely to spike, causing liquidity shock and causing a deeper selloff in stocks.
- Thus, the tactical positioning in stocks is to sell, in anticipation of the cycle-ending recession with the credit event.
Summary
Within the longer-term investment framework shaped by deglobalization, we are currently near the end of the current monetary policy tightening cycle. Given the depth and the time length of inverted yield curve, this cycle is likely to end with a recession, which is currently not priced by the markets.
There are two major cross-asset tactical positioning opportunities at this stage. First, there are an opportunity to buy 2Y Treasury Note and lock in the yields above 5% for the next 2 years, or bet on the deeper Fed cuts in 2024 by buying FF futures with expiration in mid-late 2024. Second, there is an opportunity to sell stocks in anticipation of a major drawdown due to the PE multiple contraction, earnings downgrade, and the spike in credit risk.
Looking at the step forward, the new cycle will likely start with a weakening USD, as the Fed starts the new policy easing cycle, with interest rate cuts and balance sheet expansion. But for now, the strategy is to play the expiration of the current cycle.
For further details see:
Cross-Asset Tactical Opportunities In A Cycle-Ending Recession