He Said He Said

“Has anyone ever told you that you overplay your various roles rather severely, Mr. Kaplan?”???

???????????????????? --Hitchcock’s North by Northwest?

??

When the signal gets noisy, it is best to simplify.??

??

Key takeaways:?

• Fed Chair Jerome Powell may have spoken out of both sides of his mouth during Wednesday's press conference. He said simultaneously there is more work to do fighting inflation and for the first time he sees signs of deflation. Hopefully, clarification comes on Tuesday when Powell addresses Congress.?
• Reserve Balances with Federal Reserve Banks had been positively correlated with the S&P but have since diverged. Reserves have fallen since mid-January as equities?have rallied significantly. This divergence could be explained by record January corporate buyback announcements.?
• The Nonfarm Payrolls report saw huge job gains wildly exceeding expectations coupled with wage growth only matching expectations. That combination is not sustainable. Lower than expected Unit Labor Costs echo the slowing wage momentum from Friday’s report. However, the upcoming data could show renewed wage inflation, as suggested by the improvement in the JOLTs Job Openings/Employment ratio.?

?

Notables:??

• The sharp fall in China’s exports to the US can be dismissed as being caused by sanctions but German trade to the US was also weak, falling an enormous 10% in December. German exports need to be followed since this could become a major red flag.??
• Moody’s forecast that the Speculative Grade default rate will rise to 5.1% from its current 2.8% level. The ratings agency anticipates High Yield spreads to reach 600 bp at the end of Q1, with a worst-case expectation of 1400 bp over Treasuries by the end of Q2.?
• We expect weakness in Commercial Real Estate debt to be more severe than in Mortgages, despite the latter being widely believed to be of great concern. Similarly, High Yield bonds may not see problems, but private Leveraged Loans may spark a systemic risk-off move.??
• HSBC found that the best time to buy bonds is on the second to last rate hike, which would be now for those who think the last hike occurs at the March FOMC meeting. Alternatively, if the last rate hike occurs on the May 2 meeting, buying after the March 21 meeting would be best, according to their rule.?
• Jefferies expects 1% GDP growth and 4% growth in Total Hours for Q1, yielding a 3% drop in Productivity. That would result in a 7% increase in Unit Labor Costs. That data can have a significant impact on the May FOMC meeting.?

A different kind of January Effect Dept: A theme coming out of many tech company’s earnings announcements is to cut staff and announce stock buybacks, the most notable being Meta’s enormous $40 billion program. The chart below compares January announcements back to 2005 and could be titled “a little help from my friends”, since buybacks are contributing to the equity rally and taking financial engineering to a new level for January earnings season.?

My colleague Steve Evans has been pointing out the increasing presence of accounting tricks, with buybacks being among the worst offenders. This can help explain why the broad index Price/Sales ratios are as high as in 2001 while Price/Earnings ratios are much lower.?

The Portuguese have their own saying for “Have your cake and eat it too” and is a better description of last week’s FOMC press conference. It translates to “Wanting sunshine on the floor while it rains in the field”. This phrase perfectly captures the essence of Jerome Powell’s performance who painted a background of more rate hikes despite seeing evidence of deflation. It could be that Powell has rejected his inner Paul Volker, preferring to adopt Ben Bernanke’s “green shoots”. If you may recall, Bernanke was correct back in 2009, speaking about nascent signs of economic growth and lending. However, we are afraid that Powell’s declaration of deflationary green shoots is nothing more than irrational exuberance, if we may borrow another famous phrase from a Fed Chairman.?

Powell’s doublespeak was frustrating because the conflicting arguments of recognizing cooling inflation and maintaining that there are more hikes to come were insufficiently segregated. The idea that the ex-lawyer may now be turning into a true economist (the old joke of on the one hand...) gave a signal that any good stats from payrolls or CPI would lock in the odds of a pause.?

We did not get that go-ahead-and-pause signal from payrolls. Conversely, Friday’s employment report would have made GE’s Jack Welch jealous—it came in around eight standard deviations above expectations, leaving Six Sigma in the dust. We are left with two noisy, and contrary signals—Powell's partial claim of victory over inflation (running against the FOMC mantra of not easing up too early) and a huge gain in payrolls (jolting the market view of an imminent economic slowdown as the reason to pause, and in H2, ease interest rates).??

We believe this conundrum will be resolved soon.?

The conclusion as we see it is not positive under most scenarios unless we quickly shift to a deflationary growth environment. Firms must hope for labor and interest costs to fall AND have business conditions improve. The key is for margins to expand.??

1. If the economy is recovering, margins are not guaranteed to expand, potentially being hampered by rapidly rising interest rates and higher wage demands. That would set the stage for a wage-cost spiral and a much higher terminal fed funds rate.?
2. If the economy experiences extremely low growth due to consumer demand sputtering under negative real income and businesses trying to grow with an overhang of 450 bp in Fed hikes, it is hard to make a case for higher multiples or expanding earnings.?
3. Even if Average Hourly Earnings (AHE) growth has peaked, then we are faced with the historical evidence that recessions tend to occur not with low, but high wage growth. The chart of AHE annual growth shows that tendency and is a reminder that strong employment is a coincident indicator.?

Therefore, appropriating a phrase from Powell when he was determined about fighting inflation last year, the ground is shrinking for a soft landing.?

__________________?

Regarding the markets, 4030-4080 was identified as the S&P 500 resistance range and during Powell’s speech, 4080 was the breakout point, pushing the market up another 3 percent toward 4200. There has been a lot of media discussion about breaking above a long-standing downtrend line and moving 3% above the 200-day moving average, which has signified the end of bear markets in the past.?

It has been useful to use our version of a trading envelope that capped the January all-time high and the three subsequent bear market rallies. It is overlaid on the S&P 500 daily chart below:?

It is no coincidence to us that the price action has hesitated at the upper envelope once again. This week it is critical to watch price action around this resistance. Key support is 4080, the point from which the market launched its fast rally upward.??

A breakdown below this key support level puts the 4030 level in play, and any future break pushes the market down to the next support zone at 3900-3925.?

I had mentioned last week that any move above 4080 would mean there are better levels to sell against. While 4200 in the S&P 500 is a major resistance level using the bands pictured above, if we can trade toward 4250 selling should intensify. Looking back on 2023, it may turn out that the 4250-4350 region was the best level to become defensive.??

One quick note about this weekend’s helium hysteria. It appears China has little reason, or room to retaliate, so risk assets should not see a major repricing over the next 24 hours. If there is a large selloff on Monday, it would be symptomatic of other factors. However, the violation of our airspace now becoming part of the public conversation could have unforeseen consequences in terms of deepened de-globalization down the road.?

?

Peter Corey?

PavePro Team?

??

??

? Copyright 2023 Pave Finance, Inc. All Rights Reserved Pave is an SEC registered investment adviser. Such registration does not imply any level of expertise by the registrant. Pave provides services on a non-discretionary basis. Clients are responsible for opening a brokerage account and placing any trades in their own account. Clients will also need to input their investments positions and trading activity in our application. The enclosed material is for educational purposes only, any client subscribing to Pave’s advisory services will need to accept the Term of Service and execute, by accepting, the Investment Advisory Agreement in the Pave application. Investing is speculative and involves risk, including the possible loss of principal. The information contained herein is provided for discussion purposes only, is only a summary of key information, is not complete, and does not contain certain material information about Pave or any of Pave’s affiliates and is subject to change without notice. The distribution of the information contained herein in certain jurisdictions may be restricted, and Pave may not be available in all jurisdictions.?

??

Unless otherwise indicated, the information contained herein is believed to be accurate as of the date it was produced. No representation or warranty is made as to its continued accuracy after such date. This material is not intended to be, nor should it be construed or used as an offer to sell, or a solicitation of any offer to buy, any securities or investment advice. No offer or solicitation may be made prior to the delivery of an Investment Management Agreement, which will contain additional information about Pave, including disclosures relating to risk factors and conflicts of interest. Clients will also receive ADV Part 2A, 2B and Part III (Form CRS). You should review all the material provided about the advisor. In the event of any discrepancies between the information contained herein and the Investment Management Agreement, the Investment Management Agreement will control. You should make an independent investigation of the investment described herein, including consulting your tax, legal, accounting or other advisors about the matters discussed herein. Pave’s non-discretionary investment methodology may not be suitable for all investors. There can be no assurance that any investment objectives will be achieved. Investment losses may occur, and investors could lose some or all of their investment. No guarantee or representation is made that Pave’s investment methodology will be successful. Nothing herein is intended to imply that Pave’s investment methodology may be considered "conservative", "safe", "risk free" or "risk averse”. Economic, market and other conditions could also cause Pave to alter the investment methodology. Certain information contained in this material may constitute "forward-looking statements," which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "target", "project", "estimate", "intend", "continue" or "believe" or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance of Pave’s methodology may differ materially from those reflected or contemplated in such forward-looking statements. Pave believes that the information contained in this material to be reliable but does not warrant its accuracy or completeness.?