Stark change in geopolitics with the development of a war between Israel and Hamas, negative for all risk-on assets (including equities, bonds, and rates). Cash, USD, and commodities are the only asset classes in which it makes sense to invest now. Reassessing the economic/rates scenario; the disinflation expected in 2H23 might not materialise. Watch out for the US PPI on Wednesday and the US CPI on Thursday, but any economic news will be trumped in the short term by the evolution of the conflict in the Middle East.
Major market events 9th – 13th October 2023
Highlights for the week
Mon: DE Industrial Production
Tue: EU ECB President Lagarde speaks
Wed: DE CPI, CN New Loans, US PPI, US FOMC Meeting Minutes
Thu: JP PPI, UK Trade Balance, UK manufacturing Production, UK GDP, US CPI, US Initial Jobless Claims
Fri: CN PPI, CN Trade Balance, CH PPI, FR CPI, EU Industrial Production, US Michigan Inflation Expectations, US Michigan Consumer Sentiment
|Euro Stoxx 50||4,174.66||4,144.43||-0.72%||7.48%|
* A short and much-needed respite from Equities on Friday, in the midst of an otherwise bleak week. The pain in rates and fixed income endures, and market pundits are speculating that soon something will break (as mentioned in a past weekly with the chart ‘When the Fed rises, usually something breaks’). If there was to be some healing from the data, that was nowhere to be found, unfortunately. There continue to be plenty of job openings in the US, and the Non-Farm Payrolls were double the estimates, although coupled with non-inflationary average hourly earnings. continues yet for another week, with an ongoing rally in yields keeping all risk assets in check. What the world didn’t need at this point was another war; the conflict between Israel and Hamas risks upsetting geopolitics in the Middle East, complicating a scenario that has already seen Saudi Arabia align with Russia in driving the global price of oil up. It is very likely that this additional escalation will be negative for all risk on assets, with the only possible refuges of the USD and commodities, as highlighted by Tom in his most recent post. This will also likely mean that all bets on the Fed making just one more increase are off, as the US Central Bank will continue on its mission to stave off inflation. Last week I stated that a potential capitulation would mean 10-year treasuries achieving a yield of 5% – they have already increased from 4.69% to 4.80% in just one week. I hope I am wrong, but I fear that we will reach that level (and beyond) tomorrow, and if not surely next week; hence the capitulation level has to be increased higher, starting from a minimum of 5.5% to possibly 6% and beyond (in March 2000 the yield on 10-year treasuries was 6.98%). I would like to state, however, that what is different this time is that inflation is not driven by consumer or corporate spending alone, but there are other factors at play, including the rising cost of energy, politics, and the progressive de-globalisation taking place pretty much across the world. If a full-scale war does develop we really should brace for (much) higher rates. There’s no question in my mind about the Fed’s hawkishness – they are clearly looking at inflation and if in order to win the game they will send the economy into a recession, so be it. We have a couple more weeks to go before we can look at earnings, and in the meantime, it’s probably better to hedge your bets. Data will be key in driving the Federal Reserve going forward, but under the current environment talking about 6% (or more!) is no longer taboo. The market is definitely not sold on Fed cuts and fears we have yet to touch the summit in rates.
* In this immense confusion, growth managed to have a decent week, trumping value. Technology continues to do well and shone particularly in Friday’s rebound, but is very sensitive to any further rise in yields. While the recent employment report got me to be more upbeat about the upcoming earnings report, there is no question that interest rates will be in the driving seat for at least the possible 6 months, and everything else will be a reflection of that. Therefore the current recommendation is to be very prudent on both equities and bonds and prefer cash, the USD, and commodities. Don’t put all eggs in one basket, but reinvest periodically at what are likely to be higher rates available in the near to mid-term future.
* Once again markets are licking their wounds, and while valuations are cheaper now, there needs to be a catalyst to trigger a recovery. This can be one of the following: i) lower rates, or ii) earnings growth. The first seems to be nowhere to be found and we need a couple more weeks for the second, but as just stated, they cannot counter the powerful effect of the first. The CME FedWatch tool left the door open for a potential hike in December with a 43% chance (please note that these data relate to pricing as of last week), including a small possibility that the hike might lead us to 5.75% – 6.00%, and an interval of 4.50%-5.00% by the end of 2024, with 4.75% as the mid-point, envisaging a cut of 75-100 bps depending whether the Fed hikes again or not (but remember Powell said no cuts for the time being). The release of the employment reports was once again a testament to the strength of the economy, but with unemployment at 3.8%, the Fed will continue to increase rates. As a rule of thumb, the unemployment needs to be at 4% and above for the Central Bankers to relent their hawkish cycle, even though that is only one of the many data they will look at. Meanwhile, the CME FedWatch tool has updated the first cut to June/July 2024 – I just wonder if will it be possible? I fear this latest development in geopolitics means that rates will have to go up before they come down. Wars can last for years, as we have seen with Russia/Ukraine, unfortunately.
* I also believe that this increases the risk of a hard landing for the US economy, choked by the powerful double whammy of higher rates, and higher crude prices. The US is close to energy self-sufficiency; that is not true for Europe, whose lower rates might do little to absorb the shock of higher energy prices and higher inflation. We’ve heard for some time about a hard (more likely) or soft landing for the economy, with a recession that was supposed to begin as early as in 2Q23, and the US economy seems to have performed better than anyone expected. Indeed, the Atlanta Fed’s GDPNow model is forecasting 3Q23 growth of 4.9%, stable from last week. One notable aspect is that – from the same survey – the current forecast derived from the Blue Chip consensus is now nearing 3%. The New York Fed Nowcast, which produces an annual forecast, sees annual growth at 2.5%, up from 2% in May. Even more interestingly, there is no recession forecast in their model, up to one sigma. Watch out for earnings, with a -0.3% growth now expected in 3Q23, matching an estimate of -0.3% as of Sep 30th. Revenue growth is faring a little better, at +1.7% in 3Q23, vs 1.6% as of Sep 30th.
Source: Federal Reserve Bank of New York, New York Fed Staff Nowcast
* Earnings are finally here, with the big banks starting on Friday. If the current estimate of -0.3% is confirmed, it will be the fourth straight quarter of negative year-on-year growth. And geopolitics is likely to obscure everything for a while
Earnings, What’s Next?
3Q23 reporting will start this week, with many more crucial reports following in the next two weeks. Here’s a list of companies reporting this week. Highlights include JP Morgan Chase, UnitedHealth, Citigroup, Blackrock, and Wells Fargo (Friday, Before Open).
Source: Earnings Whispers
Revenue growth estimates for 2024 are forecasted to grow by 5.5% (5.6% on Sep 30th) and earnings growth estimates for 2024 are predicted to grow by 12.2% (12.2% on Sep 30th), so the future looks to be bright. We continue to debate whether the US economy will fall into a recession or not and what will be the peak rates for Fed Funds. October is traditionally a difficult month, often characterised by extreme volatility, so my optimism is somehow tempered here, even though the strong performance so far should prevent a catastrophe. However, I wish we didn’t have to deal with another war. We need to see whether this will be left to Israel and the Palestinians or whether it will include anyone else. The news, as I write, that the US is moving an aircraft carrier close to the affected region, highlights the danger of a potential escalation.
We are probably shifting from a monetary risk to a macro risk, where the economy’s performance is more important than what the Fed does. We should be mindful that the economy is probably just doing okay, even though passing the peak in rates will remove the overhang present on the market. If and when rates diminish in importance, earnings (and top-line growth) will hopefully pick up their pace.
I fear it is inevitable that, for the S&P 500 at least, the Feb 2 peak (4179.76) will be violated, possibly as soon as this week. The Nasdaq 100’s Feb 2 peak is a bit further down (12,803.14) and, barring a major escalation in conflict, or lousy earnings, should hold. Next week will be lower once again, and my advice is to stay out of the equities market until we have greater clarity on where the rates are headed.
Regarding bonds, the expected disinflation in 2H23 might well not materialise, given an expected spike in the price of crude. The Brent may well go to $100 per barrel soon – it all depends on how the geopolitics scenario will unfold. Once again, until we have more clarity on any peaceful resolution of the conflict between Israel and Hamas, I advise staying on the sidelines and investing any liquidity in the money market (up to 1 year).
Cash (money market funds), USD, and commodities are a few of the asset classes that make sense now. Japanese equities might well be more defensively positioned, but they are facing an increase in rates as 10-year JGBs at 0.80% are currently on their way to the upper band set by the BOJ (1%). Before the great fall to negative rates, 10-year JGBs were yielding 2%, and it might well be that it is there that they are heading. Watch out for the JPY as it may slide further as the world becomes once again centered on the USD.
Happy trading and see you next week!
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