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.
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.
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.
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.
- 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.