Preface: Explaining our market timing models
- Ultimate market timing model: Sell equities
- Trend Model signal: Neutral
- Trading model: Neutral
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The Mona Lisa market
The Economist aptly characterized the current circumstances like the Mona Lisa:
What is the Mona Lisa doing? At first glance the subject of the world’s most famous painting seems to be smiling. Look again and her smile fades. When it next reappears, it is a different sort of smile. Leonardo da Vinci achieved this ambiguous effect with the use of sfumato, where he blurred the lines around Mona Lisa’s face. No matter how many times you look, you are unsure quite what is happening.
The post-pandemic economy is like the Mona Lisa. Each time you look, you see something different. After chaos in the banking industry, many analysts are now convinced that the world economy is heading for a “hard-landing” recession. Few seem to expect a “no-landing” scenario, in which the economy remains untroubled by rising interest rates—a fashionable opinion just weeks ago, and one which itself supplanted a common view late last year that a mild recession was certain.
Credit crunch ahead
The banking crisis has sparked concerns about a credit crunch as banks re-calibrate their loan books in light of the heightened stress in the financial system. Reuters reported that New York Fed President John Williams sounded a word of warning about the effects of tightening credit.
“Conditions in the banking sector have stabilized, and the banking system is sound and resilient,” Williams said. But he added the troubles will likely make credit more expensive and harder to get, which will in turn will depress growth.
“It is still too early to gauge the magnitude and duration of these effects, and I will be closely monitoring the evolution of credit conditions and their potential effects on the economy,” Williams said.
Evidence of tightening credit is confirmed by the NFIB small business survey.
The challenges of earning season
FactSet reported that with 16% of the S&P 500 having reported earnings results, 76% of companies have beaten EPS estimates, which is slightly below the 5-year average of 77%, and the sales beat rate is 63%, compared to the 5-year average of 69%. It’s still early in earnings season and challenges are ahead. Historically, the trajectory of ISM Manufacturing PMI has been correlated with the earnings beat rate. ISM has been tanking. Will the beat rate follow?
The debt ceiling and De-Dollarization
In addition, concerns over the resolution of the debt ceiling are rising. The price of credit default swaps has soared to levels last seen in 2011.
The debt ceiling debate has brought the deficit hawks out and raised the fears of de-dollarization, or the loss of the USD as the status of a global reserve currency. We are here to put those fears to rest.
Intertwined with de-dollarization fears are geopolitical concerns and the rise of the Chinese yuan as a reserve currency. But one key characteristic of a reserve currency is that there must be plenty of it sloshing the global financial system. In order for that to happen, the issuing country needs to run a persistent trade deficit like the U.S. Instead, China has been running trade surpluses, which creates headwinds for spreading its currency around the world.
Brad Setser has been a master in tracking balance of payment flows and he finds no evidence of de-dollarization in China’s foreign currency reserves. Remember that when a Chinese exporter sells something to a U.S. customer, it receives USD in return. The Chinese producer then has to decide what to do with those dollars, which shows up in balance of payment flows. In practice, most of it ends up invested us Treasury and Agency paper.
Setser also found that there is no evidence of de-dollarization from non-China sources.
A liquidity retreat
Tactically, the market is likely to seem some headwinds in the week ahead. The stock market has been supported by liquidity injections as a reaction to the banking crisis. Now that the panic is over, the Fed is withdrawing liquidity from the financial system, which is likely to create headwinds for stock prices.
In conclusion, the market is behaving like the enigmatic Mona Lisa as it is beset by a series of cross-currents that investors may not even be aware of:
- The uncertainties stemming from Q1 earnings season.
- The possible effects of a credit crunch on the economy and the Fed’s reaction.
- The concerns over a potential debt ceiling impasse.
- The de-dollarization narrative, and the effects on the USD, which has shown itself to be inversely correlated to the S&P 500.
For now, these cross-currents are serving to create volatility as neither bulls nor bears have been able to gain the upper hand. Expect a range-bound choppy market until a trend emerges.