Half Baked
”You can’t make a Tomelet without breaking a few Gregs.”
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Happy Thanksgiving. Feeling like channeling my inner Gordon Ramsey, (without the rage) for this commentary.
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Key takeaway: Consensus calls for a soft landing are completely baked into investors’ psyche. The recession scenario is still firmly on the table. Lower inflation is welcome, but the overall level of prices is still high. Market momentum must be respected, but the supporting ground underneath is shrinking.
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Peeling an Onion Dept: Recession forecasts have been abandoned to the spoiled goods bin. The fact is the concept and concern regarding a recession is still with us. Clearly, the Federal Reserve has had to deal with consumers and corporations that have been more resistant to tight policy than had been anticipated. Additionally, revised data has shown a higher level of savings to draw from, but consumer spending is vulnerable to slowing next year. My view is that consumption will drop as layer after layer of demand gets stripped from the labor market. Problems that will start in the small business sector will generate significant drops in real disposable income as persistently high rates create intolerable debt service costs.
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Bitten Off More Than They Can Chew
From consumers’ perspective, they are facing credit card rates of 25%, 14% used car loans rates and new car rates of 10%. Total household debt has risen to a record $17.3 trillion, $1.6 trillion in auto loans, and credit card debt of $1.1 trillion.
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?DQ—Not Dairy Queen
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Delinquencies (DQ) have become a problem with the growth in net charge offs at banks rising 50% in 2023 compared to the prior year. Banks are now reporting net charge offs at a rate 11% above levels existing before the pandemic. This will not help banks lower their lending standards to consumers.
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In a prior note, I highlighted the market relief to the latest Senior Loan Officer Survey that did not show an accelerating deterioration over the prior quarter, but it did contain troubling data.
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Flash Freeze
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Deutsche Bank published the following chart based on the Fed Senior Loan Officer Survey that illustrates 28% of banks have tightened their lending standards for small business commercial and industrial (C&I) loans over the last quarter. This is a major inflection point, suggesting a 90% probability of a recession at any time in the next twelve months. Critically, the chart suggests we have reached the asymptote, meaning that any more tightening beyond 28% will not materially increase the probability of a recession. That is how restrictive banks are right now—lending activity is a block of ice.
The October release of the National Association of Independent Business (NFIB) Economic Trends Survey continues to show small businesses are struggling. Therefore, it appears that banks will not be loosening their standards soon.
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Small Bites
The NFIB Small Business Economic Trends survey for October registered a -32 net percent reading for earnings over the last three months. That means two-thirds of small businesses saw earnings contract in October versus the prior quarter, falling to a 2023 low. As the chart shows, this is one of the lowest readings since the pandemic, where the low reading in 2020 was not much worse, at -35 (see yellow highlights below).
Even more troubling were the two main reasons cited as driving losses:
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Remember, this is the group that drives employment trends, and they are reporting lower unit sales and higher expenses. It is no surprise that over the past year, the NFIB Survey’s Hiring Plans for next quarter have been submerged in a tight range around its last reading of 17, a level so depressed it had not been seen since the pandemic.? ?
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Just One Last Bite on the Banks
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The annual growth rate of C&I loans from small banks stands out in a couple of ways:
Note the arrow above is placed in March 2023, when the Silicon Valley Bank news broke. Loans given out by small banks have never recovered. Secondly, the annual growth rate of C&I loans typically goes negative after a recession, not before (see yellow highlights). This does not bode well for additional liquidity becoming available until after we experience a recession.
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CPI: Pass the Relish
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Markets are relishing the idea that CPI was the nail in coffin for rate hikes, and began pricing in two rate cuts by June 2024, with the first as early as March. The problem is that the Federal Reserve has made it clear they will refrain from cutting their policy rates until it is obvious the economy is on a path to 2% inflation. The following chart shows a convergence to 3% across various inflation measures:
While it is possible over the next four months that these measures can break lower in time for the March 16 Federal Open Market Committee (FOMC) meeting to deliver their first cut, it is not certain, especially when we look at sticky price inflation.
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This Syrup Is Sticky
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While many were puzzled by the size of the market’s reaction to CPI, which beat headline and core by a mere .1%, the fall in core services CPI ex-housing was what excited investors the most.?
There was undeniable improvement in that series, which is important because services inflation has been resilient of late. However, the Atlanta Fed sticky price CPI for October was released last Tuesday with CPI. It registered 4.9%, which is reason to celebrate in the short-term because it is lower than September’s 5.1% reading and has been on a steady decline all year from January’s level of 6.7%. However, before inflation started to rise in 2022, you must go back three decades before we see a similar sticky CPI inflation rate of 4.9%.
Note that sticky CPI had been falling at the last two major stock market peaks in 2000 and 2007 (see highlights). Furthermore, with sticky CPI being above 4% for all of 2022 and 2023, is it surprising that long term inflation expectations are hitting 12-year highs, and 1-year expectations are at a new high of 4.4%? We have warned that persistently high inflation will cause a ratchet higher in inflationary expectations. The Fed cannot advertise that expectations are higher, because it will become self-reinforcing, but they must be concerned about the data. Unless inflation expectations fall by March, there will be no FOMC rate cut.
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Cross Asset Cornucopia
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Crude at its lows, and a flattening yield curve are signs of an economic slowdown, incongruent with stocks at recent highs. It should be noted that as rate hike expectations fall for 2024, it is normally the case that you see a curve steepening.
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We take a closer look at the markets below
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领英推荐
Markets
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Fast Food
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When equities move this sharply, it is a sign the market is going to be somewhere vastly different in a few months. As I have said before, the nature of the next pullback will speak volumes about whether that is vastly higher, or vastly lower.
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Rapid rallies can be short covering or a regime shift that brings in longer term players. The S&P 500 index closed Monday near our key 4415 level, then gapped up to open at 4458 after the CPI number. If this is truly a regime shift, increasing capital flows into equities will keep bids above 4458, and certainly prevent a close below 4415. We will continue to track those two levels, as will all market participants.
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The semiconductor ETF SMH is a poster child for AI, led by NVDA, whose earnings are due Tuesday. The 157.6 to 159.5 gap that occurred after Tuesday’s pre-market release of CPI is a critical launching pad/support region. My technical target for SMH sits a mere three points higher than Friday’s 162.5 close and stretches all the way to 170. Anything above 170 constitutes a blowoff. I would only advocate getting negative on the industry on a close below 157.6 from a trading perspective. The trend in the bigger picture remains bullish all the way down to 135.
Early Signs of the Soufflé Collapsing
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The drama over the sudden departure of Top Chef Sam Altman from OpenAI is ongoing. We will get a glimpse of whether the stuffing comes out of the AI-fueled rally on Tuesday when NVDA reports earnings; softness on a beat would be a negative tell. A blowout NVDA earnings release that fails to push SMH above 170 would be significant and bearish. Conversely, a subdued drop on a miss will carry a lot of bullish information.
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Bubbles always rise to their illogical conclusion. One can never point directly to a particular reason why bubbles turn down, but there are signals of problems around the edges that do creep up.
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What…You Want Thirds?
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Hedge Funds are registering their highest exposure to mega-cap tech in the last seven years.
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In January 2022, hedge funds showed an above average exposure to mega-cap tech shares as shown by the chart below. As growth stocks hit their lows in January 2023, hedge funds positioning almost fell to the bottom decile.
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Now?
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In the ensuing 11 months, hedge fund exposure in mega-cap technology shares has reached a true FOMO fear of missing out level of 99%. This can work for a while, but we all have seen this picture before, and it does not end well.
The S&P still had three months of rally left in it in 2007 when Citibank CEO Chuck Prince said the party would end at some point. There was so much liquidity, the problems would be pushed into the future. He famously said “…as long as the music is playing, you’ve got to get up and dance.” Today, the music could be getting close to stopping.
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Seasonal Menu
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Lower rates should be a boost for the Russell 2000 small cap index relative to the other larger cap indices (the S&P 500 and especially the Nasdaq 100). The Daily Shot provided this chart on the explosion in call option volume in the IWM, which is often a sign of a buying climax. The excitement is for the Russell to do better thanks to a favorable rate environment, and from the fact that all equities generally perform well in the last two months of the year. The seasonal recipe is for the Russell to outperform larger cap stocks into the first quarter of 2024. However, sentiment may be getting a bit too spicy here:
Call positions were being built beginning around the time we started discussing how depressed small caps were in October, and how the seasonal tendency for outperformance was to start at the end of that month. There was more small cap enthusiasm from macro players once the Quarterly Refunding Announcement lit a fuse under bonds and the entire yield curve enjoyed a rally. Higher rates have had a dampening impact on the Russell. Notice that there were spikes in options activity at year-end 2019, 2020, and 2021. However, small caps only outperformed in Q4 2020, and going back to 2017, 2020 is the only positive final quarter in this chart of IWM/SPY:
This would not be the first time that a tidal wave of option buyers end up with indigestion. We are still open to the idea of small cap outperformance, but we want to wait for a break of the recent high on October 30 for initial confirmation (see red arrow above).
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Chinese or Indian?
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There is continual hope for an economic turnaround in China. There are hopeful signs, such as crude shipping rates doubled in the last month from the middle east to China, and crude cargo shipping prices from the U.S. to China are up 40%. However, the property crisis overhang continues to be felt, as China new home prices across 70 cities fell .4% in October, the largest drop since the 2015 crisis. There are some signs from weekly floor space data across the top 30 cities that property may be basing; if the worst has been priced in, coupled with the dollar’s recent drop, we are eying China versus India.
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India has strongly outperformed this year. As an aside, the country just reported record silver imports, just exceeding their prior record in 2011, which was a major peak in silver. There have been major capital flows all year out of China into India. The following daily chart spanning from 2021 is the India equity ETF INDA divided by the China A-Shares ETF ASHR.
There is no sign of a reversal in our models, but positioning for a reversal in this pair could become appetizing. The stronger dollar had made the Chinese hesitant to lower rates to stimulate the economy for fear a lower Yuan could accelerate foreign selling of stocks and bonds. Now that the dollar has eased recently, the PBoC created their largest cash injection in seven years through their one-year Medium-term Lending Facility. We will see if this latest bout of easing turns out to support the Chinese economy as it was intended, or is merely pushing on a string, with no effect.
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Fixed Income Sugar High
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The 10-year yield closed at 4.44%, below the important 4.50% support level and an intermediate sell signal (buy signal for fixed income). Our long-term model will confirm a bond buy as signified by a flip in our trend model (signified by a red bar) and a weekly close below 4.375%.
This Needs More Oil
Futures data reveals that money managers have quadrupled bearish bets on oil shorts over the past month. The concentration of oil shorts is the highest since July, when crude was last in the low $70’s. Back then, WTI futures contracts rose to $90 within two months as those shorts were squeezed. Crude markets became too stretched last week and culminated in a selling climax with a 5% drop on Thursday.
One year crude spreads also fell to an extreme last week. In the following chart, December 2023 / December 2024 crude spreads slid to extreme lows, as shown in blue
:Low spread pricing means that current demand is seen as quite weak relative to longer term demand. When the spreads get so weak it is a sign of extreme pessimism. WTI crude futures prices are shown in red, and when spreads show their first sign of a rebound, as they did on Friday, it can mean an important low has been reached. If crude rallies, it should lend support to further equity gains, so we are watching the energy sector closely over the coming weeks. Any resumption of its downtrend would be a signal of global weakness.
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?Peter Corey
PavePro Team
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