Monday Macro: Is it AI or liquidity pushing the markets forward, critical materials look becalmed, and equity investing in a period of high inflation
A shorter big picture note this week. I’m still bearish overall though getting less so. That said I think its time to tamp down the buying as we head into late spring and summer
Programming note: Next week (w/c 29th May) I’ll be putting out only a short Monday macro, and a Friday links with no investment ideas. Then, the week after (w/c June 5th), there will be no letters as I will be in sunny Croatia, exploring the sights of Split.
I wanted to start with what I think is an astonishing observation, from the quant equities team at SocGen, which comes with the headline “Artificial Intelligence (AI) drove all the US equities gains this year”: The AI boom and hype is strong. So strong that without the AI-popular stocks, S&P 500 would be down 2% this year. Not +8%.
All this is for a sector where none of us truly know what might happen next or who will benefit. But the market has ‘decided’ – the winners will be the existing tech leviathans like Microsoft, Alphabet, and Nvidia. Maybe and I am long all three but I really wouldn’t have any certainty about that AI claim.
So, maybe all the current enthusiasm amongst equity investors, especially in the US, is all about AI?
Maybe but as John Authers at Bloomberg observes, there might be other explanations, not least liquidity i.e there’s a lot of money about, ready to invest. I’ve been making this argument for a while now – the risk is that liquidity tightens considerably as central banks increase rates and shrink their balance sheet. But as the central banks approach peak rates, they’ll start to loosen their balance sheet tightening and pump more liquidity into the market to avoid a hard landing.
According to Wells Fargo & Co. strategists led by Christopher Harvey there might already be evidence of this happening. They point to two sources of increased liquidity:
“1) The Bank Term Funding Program (BTFP), in which the Fed offered to lend to banks on the assumption that the bonds in their portfolio were still worth their face value, combined with the expansion of the Fed’s balance sheet and
“2) the lower cost of capital that came with richer equity multiples and lower bond yields.
“For the first, virtually all of the S&P 500’s gain for the year (barring this week’s surge) can be traced to the 7.5% rally from March 13 to April 13, which took it from 3,856 to 4,146. This coincided with the creation and growth of the BTFP as well as an expansion of the Fed’s balance sheet in response to the collapse of SVB and Signature Bank. Whatever the official interest rates, money was available. As money is also fungible, it had a way of finding where it could make the best return. The Fed’s balance sheet grew roughly $400 billion to $8.73 trillion between March 1 and March 22 as it tried to contain the crisis. It currently stands at around $8.50 trillion.
For the second, there was a slide in the expected federal funds rate on the anticipation that the Fed would pivot (since largely reversed). As the rally started, the projected rate after next month’s Federal Open Market Committee meeting had just dropped from about 5.5% to about 4.7%. Coinciding with this was a “defrosting of credit markets” that saw investment-grade corporate spreads compressing almost 30 basis points from this year’s peak of 163 on March 15 — again a phenomenon that was likely helped by the BTFP and increased liquidity.”
Their bearish conclusion? “The “risk of a market reversal appears elevated on the back of wider credit spreads and/or a shrinking Fed balance sheet.”
Time to take a proper holiday from investing this summer
Global macro strategists at Morgan Stanley have just put out a note today which I think nicely sums up why investors might want to resurrect the old investment strategy of buggering off in May and not returning to investing until later in the year. The MS strategists think that the recent strength in mega large-cap shares is misplaced as investors panic into a bullish stampede.
“First, valuations are not attractive, and it’s not just the top 10-20 stocks that are expensive. The S&P 500 median stock forward P/E is 18.3x (in the top 15% of historical levels back to the mid-1990s), the S&P 500 ex-tech median P/E is 18.0x (also within the top 15% of historical levels) and the equity risk premium is only 200bp. Second, a very healthy re-acceleration is baked into 2H consensus earnings estimates (mid-to-high single-digit growth for both the overall index and the index ex-tech). This flies directly in the face of our forecasts, which continue to point materially lower. We remain highly confident in our model given how accurate it has been over time and recently. We first started talking about the coming earnings recession a year ago and received very strong pushback, just like today. However, our model proved quite prescient based on the results and is now projecting a much more dire outcome than consensus. Given its historical and more recent track record, we think consensus estimates are off by as much as 20% for this year. Other reasons we are wary of the current rally:
· The equity market is now pricing in Fed cuts before year-end without any material implications for growth. Yet, Morgan Stanley economists believe the Fed will only cut rates if we definitively enter a recession, or if stresses in the banking system increase and/or credit markets deteriorate significantly. What’s more, the Fed cuts currently in the price implicitly assume that inflation will fall to at least 3%. That is possible, but not without significant growth implications.
· There’s also a presumption that the banking situation will not worsen and become systemic. While we don’t think this is 2008-09, we do think it will accelerate the credit crunch that was already likely to begin by year-end, based on loan officer surveys from January.
· The war in Ukraine and the situation in Taiwan are not expected to escalate.
· While the consumer has been quite resilient in the face of a number of headwinds, some signs are emerging that this strength may finally be fading. Discretionary spending intentions have slowed according to our recent surveys, even for high-end consumers.
· Finally, while a debt ceiling resolution removes a near-term market risk, a material dislocation was never priced in and the bigger risk for markets now is that raising the debt ceiling could decrease market liquidity based on the sizeable Treasury issuance we expect over the six months after it passes.
Bottom line, while many individual stocks and sectors have traded poorly this year, the major indices are priced for simultaneous good outcomes on multiple fronts where we think risks are elevated and even increasing in several instances. “
HSBC analysts at their global markets unit have a rather more optimistic take on what might happen next. They’ve developed a new model (it’s called a logistic regression model) which looks at equity markets and then assigns a different macro-outcome using probabilities. Obviously, this is then coupled to the bank’s own big picture narrative: that “the Fed is close to the end of its hiking cycle and the US will avoid a recession this year”.
So, what does the model say about the various scenarios? In essence markets are too worried about stagflation.
· “Goldilocks/soft landing (35% implied probability): Our model shows considerable upside for equities if the Fed can engineer a soft landing: the S&P 500 has rallied 22% on average between when the Fed first paused hikes and 6m after the Fed started cutting when a recession did not imminently materialize. A lot is priced into certain areas of cyclicals. Globally, we prefer Banks and Construction & Building Materials.
· “Recession (20% implied probability): Market expectations of a recession have fallen from 90% in August 2022 to 20% today but are at odds with what's implied by the yield curve (70%). The S&P 500 has on average declined 16% during recessions. The risk today is around earnings: S&P 500 EPS is 19% above its long-term trend but during prior recessions has fallen 23% below trend. Looser monetary policy, however, should provide a counterbalance. We estimate each 25bp decrease in the US10y is a 2-3% boost to valuations.
· “Stagflation (45% implied probability): We believe the stagflation trade is stretched. Our screen of global stagflation winners vs losers implies a 5y breakeven close to 3.5% vs 2.1% currently. The inflation outlook is key: The S&P 500 has rallied 18% in the 1 year after peak inflation when CPI eased quickly afterwards. The bear case scenario is elevated inflation (>4%) and tepid growth (ISM <50) which has historically seen the S&P 500 PE multiple range between 8-15x.
Their bottom line?
“We believe a higher probability assigned to a soft landing scenario will support equities (every 10ppt increase in our implied probability is a 2% tailwind). We favour the growthiest (US and Asia) and most cyclical/high beta (LatAm and EMEA) areas of the market.”
Personally, I think the odds of a stagflation scenario emerging are real but not the most likely scenario – for me the most likely scenario remains something none of us could have predicted !! I also have some comfort that central bankers, for all their faults, have learned one lesson from the 1970s – that stagflation cannot be allowed to take root and that every policy lever will be yanked to avoid this scenario. The challenge, of course, is that controlling inflation may well be beyond their control.
If you buy the stagflation scenario it is also worth noting some Deutsche Bank research picked up by John Stepek at Bloomberg which looks at data on real returns from the US stock market going back to 1957. This makes the very salient point that inflationary scenarios are constantly changing, mutating and evolving and that there is rarely one ‘typical’ regime. But the exact shape of the inflationary surge really does make a difference to returns from equities. Here’s John’s summary:
· “ In the period between 1992 and 2021 [low inflation], investors enjoyed “a stunning 30-year period of +12.9% annualised real returns for the S&P 500.” What was special about that period? A key factor was “low, stable and predictable inflation.” The similar period, between 1957 and 1966, saw annual returns of 8.6% on average.
· “ The period between 1966 and 1992 was a more inflationary period – over that period, real returns averaged 4.3% a year.
· “For the [stagflation] period between 1966 and 1980 real returns were negative, with an investment in the S&P 500 losing value at a rate of about 0.7% a year.” [my emphasis added]
As John Stepek observes in his article, that last scenario is the scary one for investors.
That 1966 to 1980 period “is a whopping 14 years of your retirement pot losing value if it was all sitting in the US equity market. The good news for most people that age is that many of them had defined benefit pension schemes and a lot of them probably bought houses in that period too, and benefited from the debt collapsing relative to their incomes. But the point stands — what most of us probably regard as the premier long-term investment asset really didn’t do very well over a period that might generously be described as medium-term. What’s the lesson? You really do need to think differently about asset allocation during persistently inflationary periods. And we have probably entered one of those now. “
I’ll finish with a short aside on thematics and big trends. Much as I love waxing lyrically about the big themes of our age, markets have a nasty habit of making these niches and spaces hugely volatile and unpredictable. Take the critical materials and metals space which I think will be of huge importance over the next few decades. I can quite easily mount an argument that this resource-focused space should be the focus of a speculative investment strategy for the next 10 to 20 years, predicated on the thesis that insatiable demand will run into supply constraints.
Unfortunately, that doesn’t mean that in the short term, key niches within this theme won’t run into stiff headwinds. As they are doing, as we speak, according to the latest monthly report on Battery Metals and EVs from the S&P Global Commodity Insights team.
Electric car sales may be picking up again but the critical metals market still looks very anemic:
1. Passenger PEV sales : “Passenger PEV sales rose 32.7% month over month in March across the top markets of China, Europe top four, and the US. China's sales rose 21.9%, but they are still 15.2% lower than the peak in December 2022. Pent-up demand on big-ticket items is still relatively muted, lagging recovery in retail sales and services since COVID-19 restrictions eased in December 2022. China also ended the central government subsidy on PEV sales after 13 years, which caused sales to be pulled forward into the last months of 2022, resulting in a sharper-than-usual sales drop at the start of this year.
2. Lithium : “China's spot lithium carbonate battery-grade price began to increase about April 20th for the first time in over five months, following a slump in China's passenger PEV sales, especially after central government subsidies were discontinued at the end of December. Seaborne (CIF North Asia) lithium chemical prices continue to fall, bringing DDP China and CIF North Asia very close to parity for lithium carbonate on a Yuan/mt basis when accounting for port costs, logistics and 13% VAT
3. Nickel — “CIF Asia Nickel Sulfate prices continued to fall as demand from nickel-manganese-cobalt (NMC) battery sector remained tepid. S&P Global Commodity Insights expects the primary nickel market to remain in surplus through to 2026, on expansions in Indonesia
4. Cobalt — “While the LME cobalt price downtrend tapered in April, support from the two major end-use sectors, consumer electronics and passenger electric vehicles (PEV), is lacking. Discretionary spending remains constrained by the inflationary environment while battery-makers are favoring cheaper, cobalt-free lithium-iron-phosphate batteries amid a slump in passenger PEV sales in China and Europe.
