Never a Dull Week at the Fed’s Circus
Despite being another objectively wild week in global markets, this week felt calm compared to events of the recent past—like the calm in the eye of a hurricane. The prime contributor to the relative calm was the ongoing rally in stocks. The Nasdaq led indexes higher, followed by gains in the S&P 500, then, to a lesser extent, the Dow Jones. The small cap Russell 200 Index, however, couldn’t keep up and closed lower on the week. Gold and gold mining stocks fared well. Energy surged, while most commodities were higher. Along with the continued rally in stocks, plunging bond prices and soaring yields were the story of the week.
The message from the bond market is unequivocally of trouble, while the sharp rally in equities argues that the skies are clear. To locate the truth from these conflicting signals, let’s examine the rally in stocks. Investor sentiment is a contrary indicator. When excesses form, be they bearish or bullish, the extremes suggest too many market participants are leaning in the same direction. When a trade is “crowded,” the stage becomes set for a countertrend reversal to take shape. When sentiment extremes occur in conjunction with extremely overbought or oversold technical conditions, countertrend reversals are increasingly likely and to be expected. Sentiment and technical factors are powerful market forces, and are always interacting with fundamental price drivers in a complex dance.
In late February, as markets sold-off aggressively, investor sentiment on equities turned extremely bearish. According to the American Association of Individual Investors (AAII), bearish sentiment reached highs not seen since the early stages of the Covid pandemic panic. At the same time, market technicals were pegged at extreme oversold levels. The stage was set for the selling pressure to ease and a counter-trend rally to ignite.
Such a rally has since begun, and the S&P 500 has added over 425 points on a 10.5% rally off of lows. At this point, technical indicators are no longer oversold, but have fully reset to the hot side of neutral. At the same time, investor sentiment has similarly been reset. In fact, the number of market bears—a majority of market participants at the start of the rally—has fallen precipitously back down to a 35% minority. That’s a level nearly back to the long-term historical average for bearish market sentiment. Despite a return to near average levels of complacency, however, make no mistake, there is absolutely nothing average about the bearish price potential fully loaded into this market. On the other hand, amazingly, bullish sentiment levels have reflated all the way back to the levels in place when the Dow Jones and the S&P 500 hit all-time-high prices during the first week of the new year.
For students of the market, we’re watching a rare real-time clinic on the psychological makeup of investors and the importance of market psychology as a whole. The rapid culling of the bears at this juncture underscores the manic nature of this market. It’s still grappling with a fundamental narrative phase change and the wild swings of emotions caused by rapid price moves. After experiencing a bull market for the history books for over a decade, investors’ buy-the-dip muscle memory and fear-of-missing-out emotional vulnerabilities are still very much in play and on obvious display.
Below the surface, however, market internals signal caution. Technical momentum indicators portend lower market prices, and breadth measures tell of continued internal market weakness. The advance/decline breadth numbers are significantly underperforming the index level rally in prices. Far from the powerful thrust higher in the advance/decline breadth ratio that would be expected if the market rally were part of a reinvigorated bull market move, a sluggish A/D ratio indicates selling on strength. In fact, there were more stocks making new 52-week lows than new 52-week highs on the New York Stock Exchange this week. In addition, the percentage of up volume relative to total volume continues to be lackluster. The muted up-volume signature is hardly offering any display of the strong buying intensity typical of a rally off a significant bottom.
There is a methodical rhyme and reason to the often-chaotic appearance of complex market madness. So, while sentiment, technicals, and market prices have all recovered and moved in a bullish direction, downright scary underlying fundamentals remain unchanged. Big market moves are a process, and sometimes, after a market has discharged a first shot of intense selling pressure, all that’s really changed after a convincing bear-market rally is that the pistol has been reloaded and the hammer re-cocked.
At this point, having worked off sell-side excesses, the ongoing rally in equities is rapidly approaching stiff technical resistance levels and a moment of truth. The market is now set up for and vulnerable to the next leg lower, courtesy of the bearish fundamental gravitational pull from below. Short of an end to the war in Ukraine; an abrupt kiss-and-make-up from parties on all sides agreeing to immediately resume global economic cooperation; a miraculous disinflation to cut the Gordian knot of a multi-factored, high-powered, escalating price spiral; and an April Fool’s “just kidding” from the Federal Reserve; this market remains in grave peril.
If the weakness observed in market internals suggests that skeptical institutional investors are recognizing a bear-market rally and using the strength to unwind long positions, Michael Wilson, chief strategist at Morgan Stanley, wholeheartedly agrees with the take and strategy. In a note out this week, Wilson, who was early but ultimately dead on in isolating key market-moving factors and their bearish unfolding interplay, offered his perspective on the rally. Wilson matter-of-factly stated that this is “nothing more than a vicious bear market rally…and while it may not be completely finished, it is a rally to sell.”
Since the early stages of the post-Covid market cycle, Wilson’s view has been that this economic recovery will run hotter but far shorter than any comparable recent precedent. Wilson’s view is consistent with the opinion that we’ve had “an extremely hot—not healthy—economy,” expressed in last week’s HAI. Courtesy of near-zero interest rates, trillions in fiscal and monetary stimulus, and record loose global financial conditions, this recovery raced out of the gates at a turbo-boosted rate not seen in recent market history.
The speed of the economic and corporate earnings rebound has been intense. Corporate sales, margins, and earnings have already reached prior cycle peak levels. Corporate earnings accomplished that feat in just 16 months, marking the fastest earnings recovery in 40 years. Even more intense has been the escalating ferocity of severe inflation. The ballooning money supply and flood of new money directly entering the economy got this inflation storm brewing. Subsequently, the Fed has negligently left a heavy foot on the stimulative policy pedal for far too long. The result is that, after a decades-long absence, inflation has returned, matured into a monster, and is hitting with breathtaking force—accelerating in short order from non-existent to 40-year highs. Again, that describes an economy that is white hot, unsustainable, and, as such, toxic and unhealthy.
An initial casualty is the increasingly squeezed consumer. Unsustainable consumer pain is growing as a direct consequence of this inflation. The pain is well exemplified by the University of Michigan’s Surveys of Consumers finding that, “Personal finances were expected to worsen in the year ahead by the largest proportion since the surveys started in the mid-1940s.” In the most recent survey out this week, survey chief economist Richard Curtin points out that when asked to explain personal changes in finances in their own words, respondents mentioned “reduced living standards” more than at any time outside of two of the worst recessions of the last 50 years.
For months the surveys have been increasingly clear that the primary cause for the dramatic escalation of consumer pessimism to over decade-high levels has been inflation. The impact of inflation-induced pessimism is now also manifesting across an increasingly broad spectrum. Pessimism due to inflation “was mentioned throughout the survey, whether the questions referred to personal finances, prospects for the economy, or assessments of buying conditions.”
In addition, the story of consumer pain is likely only just getting started. Inflation is still increasing, and consumers are drawing down savings. With ongoing negative real (inflation adjusted) incomes in place, savings will continue to draw down, and the smaller the savings pool from which to draw, the greater the pain for consumers. As long as negative real wages persist, there is likely no getting around a sharply slowing consumer economy eventually headed toward recession. The question is only one of timing. According to Bank of America chief strategist Michael Hartnett’s view on timing, a US recession is likely incoming “if real wage growth remains negative by summer.”
The 800-pound inflation gorilla is a severe problem. Whatever negatively impacts the consumer soon hits the economy and then spreads to the corporate sphere. Back to Michael Wilson’s point on the violent and greatly accelerated nature of this economic cycle: His Morgan Stanley team sees its economic cycle model peaking in as soon as two months and rolling into a cyclical downturn in as soon as five months. Wilson sees corporations already facing decelerating sales growth coupled with higher costs moving into a steep deceleration in earnings per share growth over the coming months. All of this, according to Wilson, sets the stage for negative earnings revision breadth and argues for further stock price declines.
Meanwhile, the rate of continued decline in consumer welfare will speed the unfolding economic transition into a downturn and likely recessionary decline. Consequently, any signs of a faster deterioration on the part of the consumer will be an important factor to watch. The accentuated nature, in terms of both speed and degree, of this hot and unhealthy cycle is also likely to have another unwanted consequence. Rather than the soft landing hoped for by many, including the Fed, the accentuated boom signals a high risk of accentuated bust.
All the while, in full-on policy error reaction mode, the Federal Reserve is now aiming its policy sights squarely at ending inflation. Given the starring role surging inflation is playing in this unfolding economic drama, it’s easy to understand the Fed’s newfound concern over its negative impact. This week, the Fed’s hawkish rhetoric continued to escalate. Citigroup picked up the hawkish thread and is now expecting four straight 50-basis-point rate hikes this year, with the fed funds rate reaching 3.5%–3.75% in 2023. Market expectations are now for nine additional rate hikes by the end of December.
Bank of America captured the rate hike fever well, saying that when it comes to Fed rate hike increments, “50 is the new 25.” It’s all an admirable intention, but likely more than just a little late to successfully engineer a soft landing. This is the “nightmare scenario” Mohammed El-Erian, Larry Summers, and many others have warned about: a Fed miles behind the curb, trying to make up for lost time with increasingly dramatic action and the sharpest Fed policy pivot ever witnessed.
As Victoria Green, CIO at G Squared Private Wealth told Bloomberg, “Bull markets die on policy errors, and this is setting up to be a big one.” Unfortunately, the economic recovery cycle has already burned too hot, too fast, and is already peaking. Inflation has likewise burned too hot, too fast, and is pushing the consumer toward stress levels that will soon trigger demand destruction. A Fed aggressively raising interest rates will not, at this point, unwind the mess, but further complicate it by accelerating and accentuating the down cycle. The Federal Reserve’s dreams of a featherbed landing seem increasingly farfetched by the day.
The bond market reacted all week long to escalating hawkishness by screaming of incoming trouble. The global bond rout now amounts to the worst drawdown for global bonds on record. Yield curves are in a flattening nose-dive, and the number of newly inverted curves signaling a likely upcoming recession continues to grow. All the while, as near-term rate hike expectations continued to rise, so too did longer-dated expectation for the subsequent Fed rate cuts that the market anticipates will be needed after a hard landing. Despite the fact that, compared to the recent past, this week was “relatively” calm, there’s never a truly dull week at the Fed’s three-ring circus.
Weekly performance: The S&P 500 rose by 1.79%. Gold was higher by 1.29%, silver was up 2.07%, platinum lost 2.65%, and palladium was hard hit, dropping 3.96% on the week. The HUI gold miners index was up 3.48%. The IFRA iShares US Infrastructure ETF gained 0.98% on the week. Energy commodities were volatile to the upside. WTI crude oil had a big week, up 10.49%, while natural gas surged 15.36%. The CRB Commodity Index was up 4.31%, while copper lost 0.83%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 0.73% on the week, while the Vanguard Utilities ETF (VPU) was up 2.65%. The dollar was up 0.62% to close the week at 98.84. The yield on the 10-year Treasury surged by 34 bps to end the week at 2.48%.
Have a wonderful weekend!
Chief Executive Officer