Updated February 7, 2023
Raymond Micaletti, Ph.D.
The broad U.S. equity market gained 1.9% last week on the heels of underwhelming mega-cap tech earnings, a dovish Jerome Powell press conference, and a (seemingly) blowout jobs report (“seemingly,” because with all the seasonal adjustments it’s hard to tell what the true state of the jobs market is—other jobs data was less exuberant).
The broad U.S. equity market is now up 8.7% on the year and 16.4% from the October low, while the Nasdaq 100 is up 15% on the year and 18% from its November low.
Clearly, those rates of increase are unsustainable. Were the broad market to continue at that pace, it would finish the year up 127% (the Nasdaq would finish the year up 262%). Neither is remotely plausible.
Thus, we should expect the market’s rate of increase to slow, either by the market moving sideways or by giving back some of its recent gains.
The recent rally in equities started in October when the dollar topped and proceeded to fall more than 10%. Thus, we should pay attention to what the dollar is doing now.
Last week, the dollar rose 1%, its biggest weekly gain since late September. It was overdue for such a bounce and that bounce may continue in the near term.
But should the dollar bounce continue, we would expect it to eventually fizzle and for the dollar to eventually resume its decline.
We think this scenario is likely for three reasons:
The smart money is still deeply positioned for a dollar decline and has shown no inclination to change that positioning, even as the dollar has tumbled significantly. If the dollar were about to embark on a sustained rise, one would have expected the smart money to have bought the recent dip, but they haven’t.
The loss of jobs indicated by the Challenger job cuts report is at levels seen only in 2001, 2008, and 2020. Each instance proceeded further declines in the dollar, some lasting more than a year (we are only four months into the current dollar decline).
The U.S. government’s fiscal situation requires looser financial conditions lest the U.S. government default on its debt or the U.S. treasury market cease to function.
On the latter point, we mentioned in last week’s commentary how the U.S. Treasury Department started running down its General Account from mid-October onward—thereby increasing market liquidity. This easing of financial conditions coincided with Treasury Secretary, Janet Yellen, voicing concern over bond market dysfunction and global officials complaining to Washington about dollar strength causing economic devastation worldwide.
Further, this week we learned that the Treasury will issue $353 billion more bonds in the first quarter than previously estimated. That is, our deficit keeps growing and is compounding at higher rates of interest when debt-to-GDP is already 125%.
The likely reason for the increased issuance is because of decreased tax receipts due to falling asset prices (e.g., stock, bonds).
The only way the U.S. government can keep from defaulting on its debt is to have negative real interest rates. Currently, the 10-year real interest rate is at 1.3%.
The driver of real interest rates is the dollar. If the dollar rises, real rates tend to rise. If the dollar falls, real rates tend to fall.
Thus, we would expect this dollar bounce to fizzle eventually simply because the U.S. government needs a weaker dollar.
A falling dollar would lead to lower real rates, which in turn would justify higher equity (and gold) prices.
As a result, we don’t think the recent equity (or gold) rally is over—despite the likelihood the market will slow its rate of increase.
Indeed, judging from the vibe on Finance Twitter, many market participants still think this is a bear market rally. The big sell-side banks are almost uniformly bearish (and the one that has been bullish is saying to sell the S&P 500 over 4200).
In short, most macro strategists can’t wrap their heads around the idea that the economy (and equity markets) could have a soft landing.
The big debate now appears to be whether we are witnessing a “transitory” soft landing that turns into a hard landing later in the year or whether we are headed for a re-ignition of inflation that will force the Fed to keep interest rates “higher for longer” than the market is currently anticipating.
A third option might be that we see a reacceleration of inflation but that the Fed won’t be able to keep rates high without blowing up the bond market—something the Fed and Treasury won’t let happen (especially if it’s later in the year when the 2024 presidential election season begins to heat up).
If the latter option materializes, and we think it will, equities and gold would be the likely beneficiaries.
Thus, we think this equity rally will last longer than most market participants currently expect. Such duration would jibe with institutional and retail positioning in the derivatives market (i.e., relative sentiment)—institutions are overwhelmingly bullish, while retail is overwhelmingly bearish.
Indeed, one startling occurrence is that as the Nasdaq 100 rose 10% in January, institutions continued to add to their substantive long positions while speculators and retail investors continued to sell. That’s not the behavior we would expect from institutions if the market were about to roll over.
Further, an extended equity rally would fit with the recent breadth thrusts we witnessed in mid-January, which tend to foreshadow higher equity prices up to 12 months later.
Such a rally would also allow the U.S. government to stabilize its fiscal position (higher asset prices would lead to more tax receipts, while lower real rates would decrease its marginal interest expense).
Consequently, unless and until the smart money changes its positioning, we believe any dips in equities or gold represent opportunities to buy—just don’t expect the market to keep rising at the blistering pace it has the past month.
At Allio, we've updated our forecasts for equities accordingly. Should the market dip without a material change in the tactical landscape, we would likely add to our existing equity positions.
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