Updated November 15, 2022
Raymond Micaletti, Ph.D.
November 7, 2022 | Allio’s Chief Investment Officer, Raymond Micaletti, discusses how the Fed is moving the market, geopolitical developments, and what could come next for equities.
As we have seen repeatedly since August, the market has rallied into major events only to be beaten down either by ‘bad’ data or by Fed Chair Jerome Powell. Last week was no exception.
While risk assets initially moved higher on the seemingly dovish FOMC statement, Powell came out with guns blazing at his press conference and proceeded to hammer home the point that the Fed has a “long ways to go” before it considers pausing, let alone pivoting.
Near the end of the press conference, a journalist stated, erroneously, that markets were responding positively to the FOMC’s communication and asked Powell how he felt about it. Powell, seemingly triggered, reiterated several bearish talking points that caused risk assets to plunge into the close.
All told, S&P 500 futures fell 3.75% from their post-statement high to their end-of-day low; 2% of that fall came in the last 50 minutes of trading after the press conference had ended.
Ok, Jerome, we get it. You want equities lower. So does Neel Kashkari and perhaps a handful of other FOMC members. Harald Malmgren, a long-time DC insider, has stated that Powell won’t stop until the S&P 500 hits 3200.
We think it’s a solid bet that the S&P 500 will eventually trade below 3200. But in the near term, many signs—technical, sentiment, political, geopolitical, macro, options flows, etc.—are all pointing to a continued rally off the mid-October intraday low (which occurred on the day of the last CPI release).
Of course, this week we will get October's CPI number on Thursday. If it comes in hotter than expected, one would presume risk assets will continue (or resume) their selloff (although a lot will also depend on how markets behave leading up to the number).
But even then, we think there’s a non-trivial probability markets will soon reverse higher.
For starters, the Fed isn’t speaking with a uniform voice. There appears to be a schism within the Fed, where doves such as Daly, Brainard, and Barkin are advocating for a slow-down in rate hikes while they assess the effects of previous hikes—an acknowledgment that hikes act with a lag.
For instance, on Friday Barkin stated that rates might end up higher than previously expected, but it “wasn’t a plan.” (Whereas Powell made it seem like a done deal.)
On top of this pushback inside the Fed, Powell also faces a growing chorus of politicians who seem to be worrying about their future electability. Senators Warren (D-MA), Sanders (D-VT), and Hickenlooper (D-CO) along with Representative Waters (D-CA, Chair of the House Financial Services Committee) have all publicly implored Powell to slow down or outright stop raising interest rates.
Powell might give off a non-political vibe with his hawkish talk, but we would note that Powell was bullied by Trump into pivoting in January 2019. Moreover, Powell did not act against inflation this year until it became a political liability. Right now, the political liability is less inflation and more the destruction Americans are seeing in their 401(k)s, not to mention the added interest expense and bigger deficits that jeopardize U.S. government solvency.
Consequently, we think Powell’s tough talk is more a sign of weakness than strength. In addition, we’re seeing more and more references to well-connected people and institutions (most recently The Economist magazine) saying the Fed will soon be raising its inflation target—under the guise that it can’t do anything about supply.
On the geopolitical front, we have encountered two interesting developments recently. The first is that Brazilian journalist Pepe Escobar, who focuses on the multi-national competition for energy in the Middle East and Eurasia, wrote this weekend that German Chancellor Scholz’s trip to China this week was to lay the groundwork for a peace deal with Russia, using China as the messenger.
Scholz was accompanied by German industrialists who according to Escobar’s sources “actually control Germany and are not going to sit back watching themselves be destroyed.”
This puts the Nordstream explosions in a new light, suggesting the sabotage was aimed at keeping Germany firmly within the Western alliance (i.e., removing a reason for Germany to reconcile with Russia).
The second development is that The Washington Post reports the U.S. government has privately been telling Ukraine to be open to talks with Russia.
This makes eminent sense. To see who’s winning the war, we only need to look at the price of oil versus the price of U.S. Treasuries, which tells us Russia is winning—handily. We have depleted our Strategic Petroleum Reserve and oil prices haven’t budged, meanwhile, U.S. government interest expenses and deficits are in the process of ballooning (e.g., this week the Treasury announced 40% more borrowing than expected for Q4).
Continued conflict in Ukraine will keep inflation elevated, which will threaten U.S. government solvency and force a Fed pivot with still-too-high inflation. If inflation were to take off again as a result, that could lead to severe economic and social consequences.
In contrast, ending the conflict—which it now appears both Germany and the U.S. are looking to do—would likely lead to a selloff in energy prices and a commensurate reduction in inflationary and fiscal pressures. Any easing of inflation would likely be a boon for risk assets.
With respect to inflation, this week we came across several charts that suggest inflation has peaked and will soon be rolling over:
Couple this likely reduction in inflation with the recent spate of announcements on layoffs and hiring freezes by big tech companies and it appears Powell’s work has had its intended effect.
With respect to markets, the dollar sold off vigorously after Friday’s jobs report (which showed an increase in the unemployment rate and a loss of about 300k jobs in the Household Survey).
As we have remarked on in previous commentaries, the dollar appears to be driven by dollar relative sentiment, which peaked in August and has been falling since.
The dollar (as of now) peaked in late September and is below its October 21st level, the day on which dollar relative sentiment turned bearish (after having been bullish from August 2021 onward). Dollar relative sentiment will remain bearish for at least another couple of months. If past trends hold, this suggests the dollar will likely continue to move sideways or down, which in turn should be supportive of risk assets.
Turning to bonds, several indications lead us to believe bonds will be rallying from here. Given the positive correlation during inflationary regimes between equities and bonds, this too should be beneficial for equities.
What makes us think bonds will rally? Four things:
Bonds tend to do better historically when dollar relative sentiment is bearish, which it currently is.
Institutions have been buying long-duration bonds (retail has been selling).
The MOVE Index (essentially the VIX for bonds) has come down dramatically in recent weeks.
Bloomberg reported on a large options trade for November 18th expiry that would pay off if the 10-year yield hits 3.75%—a whopping 41 bps below current levels. Such (10-day) moves happen only 0.75% of the time. This smells like a trade with inside information.
Turning to gold, on Friday the precious metals complex, which almost always sells off intraday (after typically being up overnight), rose 2%-3% intraday. That type of intraday strength suggests future (near-term) strength. It also suggests that gold may be anticipating a fall in real yields. Gold hates rising real yields. Thus, it’s unlikely we would have seen that type of intraday move on Friday unless the market was sniffing out a near-term fall in real yields.
At the moment, real yields look like they might have plateaued, but have not given any real indication they are about to roll over. So…let’s see if gold is right about real yields.
Finally, with respect to equities, there are several points of interest. The first thing to note is that both the S&P 500 and Nasdaq 100 are above their mid-October intraday lows DESPITE several mega-cap tech stocks (e.g., AMZN, GOOGL, META) being much lower than their mid-October lows (anywhere from 10% – 25% lower).
The S&P 500 is 8% above its mid-October low as of Friday’s close. The Russell 2000 is 10% off its October low (and never violated its June low). The Nasdaq is 4% above its October low.
The fact the Nasdaq 100 is above its October low when so many of its major constituents are well below their respective October lows is remarkable. It reinforces the notion that most stocks bottomed in June (after having peaked in February 2021).
Now the “generals” are being shot. AAPL has lost 15% in 5 trading days. TSLA fell 9% intraday high-to-low on Friday (in the span of only about 2 hours). META is down 80% from its 2021 high. AMZN is down 50% from its 2021 high. The list goes on.
While we have little doubt that mega-cap tech has further to fall eventually, in the near term we think it could bounce, which would help propel equities higher.
While institutions sold equities in the aggregate last week, they actually bought the Nasdaq (they sold the S&P and Russell). Further, as mega-cap tech is sensitive to interest rates, if interest rates fall (and we previously listed several reasons we think they will) that too should be supportive of tech and thus the market as a whole.
On the options front, several “whales” purchased large December 2022 at-the-money call option positions in AMZN this week. AAPL also received some large bullish option flows.
Lastly, we have seen several references recently to a rotation by investors out of tech and into energy. That makes sense and will likely be a winning trade over the coming decade. But in the short term, the effect of that rotation has led to strongly overbought conditions for energy and strongly oversold conditions for tech.
If this stretched rubber band snaps back, we would expect energy to consolidate and for tech and the broader market rally.
Thus, we think a potential scenario is that while the Fed maintains its hawkish stance, we could see equities rallying in anticipation of a pivot—on the back of easing geopolitical tensions, falling inflation, rising unemployment, falling nominal and real yields, and a relief bounce in mega-cap tech.
When it becomes obvious that a pivot is in the works (or when the pivot actually happens), equities might then begin another leg down (as retail investors rush back in).
Where this analysis might be wrong is that we’re assuming equities and bonds will maintain their positive correlation. If inflation is falling and unemployment is rising, however, we may see bonds rise and equities fall (if there are concerns about earnings, consumer demand, etc.).
But given a falling dollar and falling yields (both real and nominal), we would expect equities to benefit.
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