Privatus CIO Flash - So Where To From Here? (Tuesday, June 14th, 2022)

Good day all,

This was meant to be released yesterday but with the current volatility, one decided to wait and incorporate events of the US session. And what a session it turned out to be.

Those readers who?recall my similarly titled note of April 4th?will remember our call for a recession in Q1 2023, but not in 2022. While the recession call is now mainstream (Deutsche Bank alone among Tier 1 research desks published a similar call later in April), I still stand by the call that the timing is still likely to be in 2023 rather than some of the doomsday scenarios that some market watchers have swung towards at the moment.

The Key Talking Points?

? Inflation, Inflation, Inflation

• ?The FOMC is set to meet Wednesday, with the?fresh 40-year high in the CPI?adding to the motivation for Chair Jerome Powell & Co. to deliver a widely-expected 50-basis-point hike. Indeed, 75 bps is now very much on the table. Rising inventories are cooling goods prices, but not enough to offset the impact of supply shortages in energy, food, and services, which are driving the index higher.?
• Federal Reserve Chair Jerome?Powell is facing an increasingly grim calculus.?He?probably has to push the economy into recession in order to regain control of prices.?An increasing number of economists say it may take an economic contraction and higher unemployment to bring inflation down to more tolerable levels, much less back to the Fed’s 2% price target.
• However, it is?worth noting that the Fed cast the 2% inflation target in terms of the Personal Consumption Expenditures Price Index, a measure that has much better grounding in economic theory, rather than CPI which garners most of the headlines. The monthly PCE reading will only be released in the last week of June. The?PCE end-April reading was at 6.3%,?or more than 3 times the Fed’s target level.?Core PCE was 4.9%,?still almost 2.5 times the target. Having said that, it?fell for the 3rd?month in a row to the lowest level of the year.?
• The question of?whether the Fed can achieve a soft landing?is as much about the nature of today’s inflation as it is about the scale. If there’s still something to the “transitory” hypothesis, a softish landing is plausible. If inflation is as deeply rooted in the public’s psychology today as it was in the 1970s, bringing it down to 2% will be painful.?Inflation expectations are currently showing a worrying blip.

The?Bear Case

• With stocks, bonds and crypto plummeting, inflation out of control and months of Federal Reserve tightening to come, it’s starting to feel like everything that can go wrong in financial markets is. Panic is in the air. The?S&P 500 has fallen nearly 9% in three days, a bruising stretch that has left virtually nothing unscathed, including energy shares, the year’s best-performing group.?Selling in bonds has accelerated. Yields on 10-year US Treasuries touched 3.28% Monday, surpassing a peak in 2018 to trade at the highest since 2011.?Two-year rates are at the highest since the financial crisis. The cost to protect investment-grade debt from default soared and an ETF tracking that sector plunged to the lowest since March 2020.
• Can it get worse? Yes.?History is replete with examples of premature bullishness. Bottoms prove false, data get uglier, and things that seemed cheap turn out to be expensive a day later. How long it still has to go is unknowable - though there are indicators that have helped in the past.?
• For more food for thought, see below:???US Consumer Confidence?is?at all-time low?-?signalling a?hit to expenditures?down the line??

• What’s more,?Mortgage rates rose to the highest level in more than a decade, reversing the previous week’s reprieve. The 30-year fixed mortgage rate reached 5.6%, up 2.3 percentage points since the start of the year. Mortgage applications fell sharply in the last week of May. Higher mortgage rates hitting demand for homes is one of the main channels for Fed tightening to slow the economy.

The?Bull Case

• Nevertheless, there are “green shoots” of hope to be discerned among the wreckage. See below.
• ?Supply and demand for most goods is now more in balance?than at any time since the pandemic began

• The U.S. economy never enters a recession at a time when?Capacity?Utilization at factories is on a roll.?Currently it remains close to 80%, rather than the 60% area of past recessions:

• U.S.?Consumption,?the pillar of American growth,?is holding up

• Finally -?what?signal?is?the bond market sending? See below - the white line tracks the spread between 10-year and 3-month Treasury yields. The curve has largely steepened since 2020 in line with the economy’s recovery from 2020’s pandemic slump with the long end yield rising faster than the short-end rate. The?blue line shows New York Fed probability of recession?in US 12 months ahead, which stands at 3.7.?Past recessions occurred only when the recession probability index rose above at least 10

• For more encouraging indicators,
• A?bellwether semiconductor price?index- a barometer of costs of finished electronics products as diverse as laptops, dishwashers, LED bulbs, and medical devices delivered worldwide - is now half its July 2018 peak and down 14% from the middle of last year
• The?spot rate for shipping containers?has declined 26% since its September 2021 all-time high. An?indicator of easing supply chains?
• North America’s fertiliser prices?- an early?indicator of where global food inflation is going,?is 24% below its record high in March

• ?For the first time in two months, the Port of Los Angeles expects inbound container volumes will exceed year-earlier levels. It’s too soon to say whether this is a blip or the start of a bigger wave of goods from Asia, but these numbers will be closely watched as the busiest US turnstile for trade edges closer to crunch time.

So What?Are?You Finally?Saying, Vinod?

• ?I do believe on balance, that?things will get better in the second half of this year, the current doom and gloom notwithstanding. In fact, it now appears that?US recession is at least 12 months away, and unlikely to be either this year or even the 1st?quarter of 2023 as per my previous call. A recession is almost certain, but probably only in the middle of 2023. As mentioned in my April note, 11 out of 12 Fed hiking cycles have been followed by recession – the timing is the question.
• ?Having said that,?the next few weeks are likely to continue to be difficult, unless Jerome Powell succeeds in calming fears in his post-FOMC press conference. The?July earnings season may provide important clues?to the viability of a recovery in risk assets. If corporate earnings hold up (last quarter saw ~80% of companies beat expectations), then the summer may turn out to be a bit brighter than seems likely at present. The Fed response and messaging this week will be crucial (again). Also,?remember that much of the “Bull case” data is fast-moving and volatile, particularly with respect to Consumer Sentiment and Inflation Expectations
• What do we need to see for a market bottom? Market veterans indicate the following -?heavy volume, a?spike in the CBOE’s volatility gauge, gappy moves in equities and?surrender on behalf of the retail-investing cohort. Based on these, current indications are?we are approaching a bottom but we are not there yet.
• Trading?volumes on US exchanges topped 15 billion shares?Monday,?3 billion more than the average?so far this year
• But the?VIX?is?not yet quite at extreme levels. The CBOE volatility gauge rose above 34 Monday, versus a "thumb rule" level of 38-40
• Retail Surrender?&?Breadth of Selling:??The?ratio of puts to calls on the S&P 500 has approached its highs?for the year, another sign that a potential wash out of bearishness is near. On the other hand, the technical Relative Strength Index for the S&P 500 sits at 32, above the level that would indicate an oversold condition.?Monday’s session also marked?a “big drawdown” day with extreme breadth.?All but five stocks in the benchmark index fell.

So all in all, we are almost there! Stay strapped in, and all the best.