“All knowledge degenerates into probability.”
-David Hume
At the end of the day, investing is a probability game. On either a stock level or an asset allocation level, investors are (or should be) trying to make the best probability weighted decisions. On the long side, we want positions that have a reasonable probability of a positive outcome and a potential reward that compensates us for taking that risk. The opposite is also true on the short side.
The challenge with making probability based decisions is that they are only as effective as their inputs. Biotech companies with a small amount of drugs in the pipeline are prime examples of this. The payoff of a drug getting improved can lead to an exponential reward, but taking that risk only makes sense if there is a decent likelihood of that approval happening. This investment decision is based on your assessment of the studies, FDA approval process, management’s track record, the potential market size for the drug, and so on. If one of those factors is misanalyzed, then the accuracy of the probabilistic view of the outcome could be way off.
From a top down perspective, the market itself can provide important clues and probabilities as it relates to market moving events. As an example, with measures of volatility at lows, like the VIX is currently at just under 13, the market is, in a sense, telling us that the coast is clear and a negative market catalyst isn’t likely to occur. In reality, though, low volatility environments may also be mispricing future risk. Inherently, if you are looking to buy insurance on a future black swan type event, you want to do it when that insurance is cheaper, which in turn creates a more compelling risk / reward when “betting” on these events.
Currently, the VIX appears to be contemplating smooth sailing ahead. Now perhaps the market knows something we do not about the future. Or alternatively perhaps the market is mispricing the risks that are ahead of us – slowing GDP, tight and tightening monetary policy environment, earnings being worse than expected, contentious elections, foreign policy flare ups . . . the list could go on. Assess the probabilities accordingly.
Back to the Global Macro Grind…
In the last couple of weeks, we’ve had a series of policy announcements from the global central banks. On the positive front for those looking for more dovish monetary policy, China has reduced interest rates marginally. On the neutral front, Brazil, Indonesia, and the Philippines kept rates flat. Then, of course, we have the rest of the world that continued to tighten, which includes the ECB, the Bank of England, Norges Bank, Canada, and Switzerland.
While the Fed took a “pause”, their policy itself was incrementally hawkish with Chair Powell suggesting there will be at least two more hikes this cycle. He doubled down on this earlier this week when he said:
“Inflation pressures continue to run high, and the process of getting inflation back down to 2% has a long way to go.”
While people are free to invent all sorts of narratives and stories, his language has been pretty clear as it relates to monetary policy and it is effectively that rates will be higher for longer. Now we do have the most challenging comp for inflation in June, so on a comparative basis it may look like inflation is under control. But after that comps get much easier and there is a risk, like we are seeing in parts of Europe, that inflation re-accelerates. We saw this in the U.K. earlier this week when CPI came in higher than expected at +8.7% Y/Y . . . in looking at the U.K. it seems monetary truly does work on a lag!
Speaking of Europe, we received a series of June PMIs this morning, which for the pro-growth camp were not great data points:
- France Services PMI 48.0 and Manufacturing PMI 45.5;
- Germany Services PMI 54.1 and Manufacturing PMI 41.0;
- Eurozone Services PMI 52.4 and Manufacturing PMI 43.6; and
- U.K. Services PMI 53.7 and Manufacturing PMI 46.2.
Every single one of these PMIs were lower than expected and decelerations versus the May reports. That, my friends, is slowing growth.
In the last week, the only truly accelerating global macro data point was from U.S. Housing Starts and admittedly it was notable. Specifically, May Housing Starts came in at 1.631MM, which is the highest M/M increase since October 2016 and takes that data series to up +5.7% Y/Y. But we shouldn’t confuse this data point with the U.S. economy all of a sudden re-accelerating. While Housing Starts will have a marginally positive impact on GDP, this positive surprise is more so a function of national housing inventory being abnormally low.
On the demand side of housing, we remain in purgatory. This point is highlighted in the Chart of the Day that highlights MBA Mortgage Purchase Applications going back four years. For the most recent month of June, we are at 160 on the series, which is down more than -50% from the peak of the cycle and well below pre-COVID levels.
Perhaps the Nifty Seven and dreams of AI will continue to buoy the Nasdaq, but below the surface things are changing. We saw that yesterday with SP500 up small and Russell 2000 down -1% on the day, while the Nasdaq put up another +1% performance on the board. This all also came on decelerating volume.
As the great Bob Dylan sang:
“The order is rapidly fadin’
And the first one now will later be last
For the times they are a-changin”
Indeed.
Immediate-term Risk Range™ Signal with @Hedgeye TREND signal in brackets
UST 30yr Yield 3.77-3.94% (bearish)
UST 10yr Yield 3.63-3.84% (neutral)
UST 2yr Yield 4.52-4.82% (bullish)
High Yield (HYG) 74.04-75.10 (bearish)
SPX 4 (bearish)
NASDAQ 13,115-13,876 (bullish)
RUT 1 (bearish)
Tech (XLK) 164-175 (bullish)
Shanghai Comp 3177-3270 (bearish)
Nikkei 32,407-34,122 (bullish)
VIX 12.75-19.57 (neutral)
USD 101.65-104.21 (bullish)
EUR/USD 1.069-1.101 (bearish)
USD/YEN 139.25-143.49 (bullish)
Oil (WTI) 66.64-72.30 (bearish)
Copper 3.65-3.95 (bearish)
Bitcoin 24,518-30,498 (bearish)
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
