A Matter of Deflation

“Now, there are all kinds of ideas that would be fun to believe in: mental telepathy, time travel, immortality, even Santa Claus.”

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There is a big difference between discounting future events and the market getting ahead of itself.

Key takeaways:

o??December subprime auto loans 60 days overdue hit 5.7%, exceeding the 2009 crisis high level of 5.1%.

o??Semiconductor inventory days exceeded the highs reached in 2000 and 2008. Inventories are not falling despite firms operating at historically low utilization rates.

o??After the Bank of Canada announced a pause in rate hikes, annual wage growth rose strongly to 4.2%, matching the March 2022 high. In the US, Walmart, the nation’s largest private employer, just raised its minimum starting wage by 16%.

o??The US Treasury added $200 billion in liquidity over the last two weeks to counteract the debt ceiling being hit.

o??Margin debt continues to fall after equities bottomed this October. The same dynamic preceded the 2001, 2008 and 2020 recessions/stock selloffs.

Tastes Great / Less Filling Dept: This Wednesday’s FOMC meeting could go a long way toward inflating or deflating bulls betting the Fed will not reach its 5-5?% final funds target before pausing. December’s latest FOMC Summary of Economic Projections lists that target rate as their forecast for 2023 year-end funds. The target funds rate as of Wednesday should be 4? -4?%, 50 basis points shy of their terminal rate. Continued hopes for an early pause will rest with Chairman Powell’s tone during the press conference; If his emphasis is on recent moderating inflation and margin compression, then the rally will continue. However, if Powell’s focus is on a resilient economy, a 6% reading for the Atlanta Fed Wage Tracker, a falling but stubbornly high JOLTS Job Openings/Unemployment ratio, etc., then there will be deflated bulls (not to mention stock prices).

On which side of the divide he sits could be determined by Tuesday’s Employment Cost Index (ECI). Released on the first day of the FOMC meeting, it is of particular importance to influential hawks such as Governor Waller. The ECI quarterly chart is shown below. If the recent blip down in Q3 does not drop significantly, it will mean that wages remain elevated and would not result in a softer tone from the FOMC.?

What to look for on Wednesday:

Statement—Base case is no language change and a 25bp hike. Any changes would be dovish. One sentence in the third paragraph could be altered: “The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.” To suggest there may not be 25 basis point hikes at either the March or May meetings could be communicated by tweaking the “ongoing increases” phrase. Changing the language from “a stance of monetary policy that is sufficiently restrictive” to “has been sufficiently restrictive” would signal an immediate pause, which seems highly unlikely, unless they raise by 50bp (not the base case). No language change increases the chances of Powell sounding more hawkish than the soft-landing crowd would prefer. ?

Press Conference--In addition to whether Powell is favorable toward the recent easing in inflation data versus stubborn wage, food, and energy trends, we anticipate a question about where the million+ jobs went. For background, the jobs report is an estimate—there are seasonal adjustments and birth/death overlays to model the number of new corporations coming into the economy or closing down, just to name two. Obtaining the actual number of jobs created takes months. The Bureau of Labor and Statistics (BLS) confirmed a recent Philadelphia Fed report that a proper estimate of Q2 2022 payrolls was a loss of 300,000 jobs, not a gain of 1.1 million as the BLS originally reported based on the monthly jobs reports last year. This downward revision represents one-third of last year's strong employment gains. The originally reported BLS employment reports were the primary reason behind the Fed hiking so aggressively. Powell may be asked: “Given the strong downward employment revision from the BLS, will the FOMC be forced to scale back their concern about the upward wage price spiral?”. If that is one of the first questions, then how he responds will set the mood for the remainder of the conference.

Corporate Defined Benefit Plan dynamics

?As the risk-free rate has skyrocketed, future pension liabilities have decreased because they are discounted by this higher number, resulting in improved funding ratios. Corporate pension liabilities are calculated off a corporate bond yield curve: hence, they are not affected by equity or bond performance in the same way as public pension funding ratios, which have deteriorated. As corporate pension deficits turn into surpluses, these pensions are beginning to buy bonds to better match their assets to their liabilities. This phenomenon has been one of the reasons why Wall Street strategists have called for bonds to rise and stocks to fall, as corporate pensions sell equities to buy fixed income. While stocks have not been underperforming bonds, the fact remains that corporate pension funds will be a source of equity selling pressure.

More important from our perspective is to look at previous periods when pensions have been fully funded. The last two periods a funding surplus occurred was during excessive peaks in equity valuation, as seen in the chart below. As demand for stocks from corporate pension funds is withdrawn, it can act as a negative catalyst if other problems exist.

Other negatives that would contribute to a further selloff? See the chart below when 2000-01 and 2007-08 displayed negative divergences as margin debt fell. Waning margin debt was also a warning into 2019-2020.

Another reduction in equity demand comes from shorts that have capitulated recently. As short positions are covered, there is reduced future demand from the shorts who are left, and new long positions were established at high prices. While there still may be shorts that are still holding, if earnings, inflation, or both disappoint in an environment where major equity cash inflows are absent, then it sets the stage for another volatile period for stocks.

Therefore, we stand at a crossroad. Bullish sentiment has improved, expecting lower inflation. That expectation spawned the hope for a Fed pause that generated dollar depreciation, helping Emerging Markets flows. Already, EM equity positions are nearing extreme overweights relative to the last 15 years. These shifts occurred as investors expect improved economic prospects in the US, but more so in Europe and China. However, the dollar may be hitting a low if the FOMC is perceived as steadfast in their fight against inflation and China’s recovery is not linear on the upside.

Our conclusion: It may be more profitable to expect future deflation in bullish expectations than in consumer goods and services prices.

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Regarding the markets, last week we thought demand could diminish if the S&P 500 rallied into the 4030-4080 range. We were strongly bid into the end of the week on uninspired volume as demand did fall off as prices reached the high end of the range, closing Friday at 4070. The key levels to watch for a reversal would be after Wednesday’s FOMC meeting--the first sign of a major reversal is a move below 3950, confirmed by a close below 3900 in the S&P 500. 4000 is critical support on Monday and especially Tuesday, the release date of ECI. Any close above 4080 SPX means there will be better levels to sell from, eventually.

Parallels to the bear market rally of January 2001

Morgan Stanley found that the current yield on a 60-40 Stock Bond portfolio yields below cash interest rates, a very unappealing proposition. This is the least attractive yield since January 2001, which would be a dangerous analogy to draw because the Nasdaq 100 fell almost 50% into early April 2001 after the head fake rally that January.

Some could dismiss the analogy simply based off the far higher P/E ratios back then, but if one uses Price to Sales as a valuation metric, the link between the two periods is more valid (the Nasdaq P/S ratio is currently 4.8x).

Technically, the January 2001 rally ended when it reached the standard Fibonacci retracement of .236 from the March 2000 highs. The recent rally only slightly exceeded the .236 retracement from the November 2021 highs as of Friday. Furthermore, the Leading Economic Indicators’ one month diffusion index sits at a similar recession level near 20% as it did in January 2001.

Analogies were made to be broken, so it is not prudent to position today for similar 2001 price action into the end of the first quarter, but we will revisit the analog, along with some interesting price parallels between the darling of 2000, CSCO, and TSLA in 2021.

As we have written in the past few weeks, “For now, momentum is higher in both asset classes. Nonetheless, we are watching for tremors” should be upgraded to “we are anticipating tremors”. Do not anticipate downside action in positioning yet, but do not hesitate to act if it begins to unfold.

Peter Corey

PavePro Team

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