Warren Buffett famously said that when the tide goes out, you find out who has been swimming naked. Now that the Fed is tightening financial conditions and the tide is going out, I undertake an analysis to find out what countries and sectors have been swimming naked, and who has been opportunistically swimming with the tide.
A global perspective
The primary tool for my analysis is the Relative Rotation Graph
, or RRG chart, which is a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotate to lagging groups (bottom left), which change to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.
A few themes emerge from this analysis:
- Laggards: China and most Asian economies, such as Hong Kong, Taiwan, and South Korea. The latter two are seeing the fallouts from the Biden semiconductor export controls.
- Cyclical leaders: Resource extraction economies such as Australia, Canada, and Brazil, which is a heavyweight in Latin America. The Eurozone is also emerging as new leaders.
- New growth leaders: India and Mexico are becoming the new growth leaders within emerging markets. India is benefiting from a rebound in growth after a period of COVID-related stagnation. Mexico is being bought as the winner from the near-shoring boom as manufacturers diversify their operations away from China.
- The S&P 500 has lost its past leadership position as most large-cap growth stocks have reported disappointing earnings. Large-cap growth accounts for about one-third of the S&P 500, which is a disproportionate weight compared to other regional and country indices.
In particular, the market is indicating concerns about China’s growth outlook. The Financial Times
reported that in addition to its struggles with a property bubble implosion and a series of rolling zero-COVID lockdowns, it faces the challenge of slowing consumer demand from the US and Europe. There have been a number of risk-on rallies in China on rumors that Beijing may relax its zero-COVID policies. The market got all excited Friday when China eased quarantine measures for visitors by two days. Bloomberg
reported that Shehzad Qazi of China Beige Book offered the following guide to interpreting stories of a zero-COVID policy pivot: Watch for:
- A real vaccination push, especially among the elderly and potentially involving mandates.
- The concerted introduction of mRNA shots.
- Improved hospital capacity, including downgrading COVID to an illness you don’t necessarily have to be hospitalized for.
- Easing of the border regime.
- Backing away from lockdowns and other Zero-COVID mitigation measures.
- A change in political rhetoric.
None of these steps are evident. Until then, fade any zero COVID relaxation rumors.
I also conducted sector analysis on US and European sectors to find commonalities. Asian markets were excluded from this analysis as the markets are too disparate to conduct sector analysis. Here is the RRG chart for the US using equal-weighted sectors as a way of mitigating the effects of large-cap growth stocks to better capture the sector effects.
Here is the RRG chart for Europe.
Here are the common themes.
- Laggards: Technology is suffering. Interest-sensitive sectors such as real estate and utilities are also lagging.
- Cyclical leaders: Financials, industrials, and energy, though energy looks a little extended and may stall in the short term. Materials are also showing up as emerging leaders.
A cyclical recovery ahead
Here is my interpretation of these results. The equity market is detecting a global cyclical recovery. The rotation begins in Europe, then the US, and finally with China with differing lags. As an example, I have highlighted the BASF/Dow Chemical pair before. Both are large-cap commodity chemical producers. BASF is headquartered in Europe while Dow is in the US. The two stocks tracked each other closely until the onset of the Russo-Ukraine war. BASF tanked because of rising energy input costs but recently staged an upside relative breakout indicating a relative and cyclical recovery (bottom panel).
The bullish outlook in Europe is supported by a more expansive fiscal impulse. The European Commission released a proposed reformed European fiscal framework
which allows for greater flexibility in achieving EU objectives such as green spending, a focus on medium-term debt sustainability, and an end to unrealistic debt brakes. Bloomberg
also reported that Germany plans to more than double 2023 net debt to €45 billion.
In addition, Poland is a sensitive barometer of geopolitical risk as the country borders Ukraine and it is used as a base for aid into Ukraine. MSCI Poland has staged relative breakouts against both the Euro STOXX 50 and MSCI All-Country World Index (bottom two panels).
The tail risk of nuclear war in Europe is also falling. SCMP
reported that Xi Jinping sent a clear message to Russia during German chancellor Olaf Scholz’s visit to China: “Nuclear wars must not be fought, in order to prevent a nuclear crisis in Eurasia”. Indeed, Russia has recently toned down its threat of tactical nuclear weapons. Alexander Shevchenko, a Russian UN delegate, stated, “Russia’s nuclear doctrine is purely defensive and cannot be interpreted in a broad way”.
The key risks to the cyclical leadership scenario is a commitment to cyclical sectors is contrary to the hawkish monetary backdrop of major central banks. Recent risk appetite has been one macro trade. Liquidity is inversely correlated to the USD in 2022.
The USD is inversely correlated to the S&P 500.
While the softer than expected CPI report helped Fed Funds expectations, the market still expects to Fed to hike by 1% or more before it reaches its terminal rate.
The Fed is tightening into a recession, but the earnings recession is only starting and Q4 negative earnings guidance is above average. Such an environment is not usually conducive to overweight in cyclical stocks.
Squaring the circle
I can offer two templates for resolving the conundrum of the technical picture arguing for cyclical exposure while macro analysis calls for caution. The bearish template is the NASDAQ top that began in 2000.
There are a lot of similarities between 2000 and today. While Buffett’s metaphor about finding naked swimmers when the tide goes out is relevant, the degree of nakedness matters to downside risk. Recessions act to correct the excesses of the previous cycle. The NASDAQ Bubble was characterized by overvaluation, but financial leverage was relatively minimal, just like today.
A review of market history from that era shows that the Dow, which was relatively free of technology stocks, traded sideways in 2000 while the NASDAQ 100 tanked. The Dow didn’t really fall until the 9/11 attack in 2001. The Oil Index (XOI), which is a proxy for resource extraction sectors, was flat to up during this period. That said, all indices did make an ultimate low in 2002 and recovered in 2003. History repeats itself but rhymes. The recession of that period was a multi-year downturn, which is unlikely to be repeated today.
The more bullish explanation is market strategist Russell Napier
‘s capex boom scenario. He believes that central banks won’t be able to bring inflation down to 2%, but will settle for a 4-6% range because too much tightening will create financial instability problems. The fiscal authorities will intervene in the banking system by issuing guarantees for selected sectors of the economy, which amounts to a form of financial repression. However, he is not calling for stagflation.
That’s utter nonsense. They see high inflation and a slowing economy and think that’s stagflation. This is wrong. Stagflation is the combination of high inflation and high unemployment. That’s not what we have today, as we have record low unemployment. You get stagflation after years of badly misallocated capital, which tends to happen when the government interferes for too long in the allocation of capital.
While stagflation will eventually be the end game, the initial response will be a capex boom, which would be hugely bullish for cyclical sectors.
First comes the seemingly benign part, which is driven by a boom in capital investment and high growth in nominal GDP. Many people will like that. Only much later, when we get high inflation and high unemployment, when the scale of misallocated capital manifests itself in a high misery index, will people vote to change the system again. In 1979 and 1980 they voted for Thatcher and Reagan, and they accepted the hard monetary policy of Paul Volcker. But there is a journey to be travelled to get to that point.
It’s possible that the old macro relationships are already diverging and breaking up, indicating a regime shift. The USD is no longer inversely correlated to the Fed’s balance sheet, as the USD has broken rising trend line support, which is bullish for risk appetite.