A fire and ice challenge to risk assets

 In case you missed it, the 10-year Treasury yield fell and broke a technical support level even as the 3-month T-Bill yield rose. This left the 10-year to 3-month yield spread inverted further, which has historically been a strong recession signal.



The 10-year and 3-month Treasury yield spread has inverted before every recession. If history is any guide, a slowdown is just around the corner.




The stock market and other risk assets are facing a fire and ice challenge. Fire in the form of still overly hot inflation readings and ice in the form of a deteriorating economy.



The Fire Threat

The fire threat of too-hot inflation was outlined by Cleveland Fed President Loretta Mester, who explained in greater detail of why the Fed has much more work to do to tame inflation. She said that the Fed should raise the Fed Funds rate above 5% this year and hold it at restrictive levels, which she defined as the inflation rate, for some time to quell inflation. The Fed remains data-dependent and the path of monetary policy depends on how quickly price pressures ease.




The seriousness of the global inflation fight was reinforced when the Reserve Bank of New Zealand (RBNZ) unexpectedly raised rates by 50 basis points. Despite New Zealand’s small size, the RBNZ was a leader in the latest tightening cycle and the recent aggressive move could be interpreted as a signal that a pivot to an easier monetary policy may not be as close as the market thinks.

Mester’s remarks stand in stark contrast to the Fed Funds market expectations of a near-term plateau that peaks just below 5%, followed by a series of rate cuts that begin in mid-2023.



Former Fed economist Claudia Sahm explained the difference in the Fed’s and the market’s thinking this way. The Fed expects inflation to be sticky.

The Fed thinks that inflation, especially ‘super core,’ will be very persistent, and bringing it down will require high rates for some time. It also does not expect a recession.

On the other hand, the market expects a recession:

Markets also expect a recession, possibly a severe one. The thinking is that the Fed will not stand by and do nothing as the economy tanks. Inflation should soften in a recession, giving the Fed cover to cut some.

Sahm thinks that we will see a recession.

The Fed will not cut. And there will be a recession starting in the second half.



The Ice Threat

The ice threat can be neatly summarized by the U.S. Economic Surprise Index (ESI), which measures whether economic releases are beating or missing expectations. ESI recently peaked at a high level and began to roll over, indicating a loss of economic momentum. 



Looking ahead to Q1 earnings season, forward 12-month sales estimates have been flat to up while forward EPS has been falling in an uneven manner, indicating margin compression. This is not an environment that’s conducive to strong equity returns.



Q1 earnings season will kick off with reports from large banks. Even though financial stocks have stabilized after the banking crisis, their relative performance continues to struggle, and so has their relative breadth conditions (bottom two panels). How will the market react to the reports from the banks?



As well, market internals of the relative performance of cyclical industries are weakening. Even the semiconductors, which had been the last holdout among the leaders, recently violated a rising relative trend line, indicating a loss of cyclical momentum.


By contrast, defensive sectors are either staging relative breakouts or on the verge of relative breakouts, indicating that the bears are trying to seize control of the tape.



In the current environment, investors have been piling into large-cap quality as a refuge. We measure the quality factor in several ways. One way is profitability. Standard & Poors has a higher profitability inclusion criterion for its indices than the FTSE/Russell indices. Therefore, the return spread between similar S&P and Russell indices could be a measure of profitability quality. In addition, the dotted line (middle panel) shows the relative performance of a quality ETF against the S&P 500. As the accompanying chart shows, investors panicked into large-cap quality in March, but the return to small-cap quality was flat during the same period.




Remember China Re-opening?

One of the last hopes for the cyclical bull case was the China re-opening narrative. The market greeted the prospect of China re-opening its economy after abandoning its zero-COVID policy with great fanfare in January. Since then, the China re-opening trade has gone nowhere. The relative performance of China and the stock markets of its major Asian trading partners have either gone sideways or down.



What about China’s domestic economy? The accompanying chart shows the relative performance of selected cyclical sectors compared to MSCI China. Here are my main takeaways:

  • Material stocks, which are sensitive to commodity demand, mainly from infrastructure spending, are lagging after showing a brief burst of strength.
  • Consumer sensitive sectors such as consumer discretionary and internet stocks, which contain heavyweight consumer spending sensitive Alibaba and Tencent, have gone nowhere on a relative basis since the re-opening announcement.
  • The real estate sector, which is the most vulnerable part of the Chinese economy because of the collapse in prices and major developers like China Evergrande, along with the financial sector, have been steady against MSCI China. This is an indication that the authorities have stabilized the property market and the tail-risk of a disorderly breakdown has been diminished.




The Bearish Tripwire

So far, these signals are only bearish warnings and not outright bearish signals. We would watch for a technical break in NASDAQ 100 leadership as a sign that the bulls have lost control of the tape to the bears. As well, keep an eye on the relative performance of European equities, which are still in a relative trading range. An upside relative breakout or downside breakdown out of the range could be a useful signal of how leadership could develop in the next market cycle.



5 thoughts on “A fire and ice challenge to risk assets

  1. Perhaps we need a new saying, “It’s the printing press stupid!”
    This time is not different, just really rare.
    We are in a sovereign debt crisis, and not just one country, and also the great economies, and of course fiat currencies.
    But look at what has happened since the GFC. They guaranteed the MBS for Fannie and Freddy, we had zero to negative interest rates for years, then they blew away the FDIC caps. These should all be shocking us, but we have become desensitized. There is no limit to the printing press. In Hungary they had 100 quintillion pengo notes, that a 1 with 17 zeroes. I’m not saying that popsicles will be one billion dollars any time soon, just that there is no limit.
    One can ask oneself why countries like Weimar Germany, Zimbabwe, and Hungary printed like that. Personally I think it is because the elites wish to stay in power, they don’t want havoc and mayhem to take their place, even though they are part of the reason for the mess. So what are our leaders thinking? If they want inflation to come down, and they create a recession, what is not negotiable for them other than losing power? Zombie companies can refi if their loans get government guarantees. Will the populace riot from loss of jobs if there is a recession? Not if they get stimulus checks to keep them happy. Remember that it’s not what bad things happen, it’s just so long as it doesn’t happen on their watch.
    Fiat currencies always die, always, because of the human nature of the leaders, this time is not different. Some places have endured rates of 100% inflation and kept plodding along, just look at South America. But first we must make it look like we can beat inflation, so we might be in the stern of the Titanic, it’s not sinking….yet.
    I think they will paper over everything, guarantee everything except maybe what you and I are owed to save face and keep the appearance that all is under control. Most people don’t have savings, the market does not matter much to them, they live paycheck to paycheck or support check to support check.
    So when will this nasty inflation show it’s face? No idea.
    Will they get inflation numbers down (with hedonics as a tailwind) maybe, but to sum it up, just because something is unthinkable or has never happened in this regime does not mean it won’t happen.
    The market may go down a lot in real money, but less so nominally.

    1. So let’s have a little fun with simple math. 50 years ago around this time, Spring 1973, gold is about usd$79.3 per ounce. Last Fri it was usd$2026.4. So the ratio is 0.03913. 1973 makes sense because it is soon after Nixon set this country on a path of no return. Now you get a 96% reduction of purchasing power of every dollar you own. That said, the show must go on and everyone has a role to play. I have been preparing for a disaster to happen but it did not come. I have a farmland in Norcal above Sacramento on a hill not far from I-80. It has a camouflaged dwelling and a well and a large basement with everything required for lasting 6 months. I also have seeds and fertilizer and can sustain even longer. And yes a decent amount of fire power and equipment that can produce biofuels (EV is useless in time of distress) for generating power and running ICE cars. Pray to god that I never have to move there by necessity.

      1. Good for you! Solar panels and a wall battery?
        Been thinking of a place where there are less people. It’s people I fear the most.
        As far as the math goes, back in 72/73 a friend bought a Toyota Celica for 2200 CDN so about 1800 and now they must be around 25 times that. But collectable assets esp the ones for the elites! My most extreme example is buying Romanee Conti 69 (a rare burgundy of extremely small production, a few 1000 bottles a year) in 1973 at Fortnum and Mason for 19.95 ponds a bottle. The La Tache was 14.95 pounds a bottle, Ch Haut Brion was 6 bucks a bottle in NYC. The Roman Conti is close to 20,000 bucks. Insane. I sold mine at auction in 2002 for around 1500. It’s only wine. Farmland was dirt cheap then. The $ has gone down. can they debase it for another 40 years until all the boomers are gone and social security rights itself? Dunno, but this could drag on much longer than we think.

    2. The total debt in the world economy has grown exponentially. Do the borrowers collectively have the means to repay it? I doubt it. This does not even include private debt. So, in a global financial disaster, who would keep their head above the water? People who are debt free and own assets like gold. Over the period 1980-2022 (when we started buying), gold has roughly kept pace with inflation. At least get us through a year or two of turmoil.
      I think the global financial conditions will stay volatile for much longer than people expect.

  2. What is the rationale for Nasdaq 100 to ACWI acting as a tripwire? Wouldn’t credit spreads widening further be a good indicator?

Comments are closed.