“One thing the American defense establishment has traditionally understood very well is that countries don’t win wars just by being braver than the other side, or freer, or slightly preferred by God. The winners are usually the guys who get 5% fewer of their planes shot down, or use 5% less fuel, or get 5% more nutrition to their infantry at 95% of the cost.”
What a novel concept. War stories are usually adorned with lovable heroes and detestable villains – both of whom are typically larger than life – as well as tall tales of clear technological, personnel and/or geographic advantages shared by the victorious side. Rarely mentioned are “relatively insignificant” details such as luck or operational efficiency.
That’s not unlike our industry. Stories about great trades and investors alike are usually teeming with and often commenced by tall tales of how “smart” a particularly investor is or how much money they have. Rarely mentioned and seldom highlighted are “relatively insignificant” details such luck, process or simply being alive and having access to capital at the onset of major bull markets.
The quote highlighted above comes from a book I just picked up titled, “How Not To Be Wrong: The Power of Mathematical Thinking” by the aforementioned Jordan Ellenberg, the Vilas Distinguished Achievement Professor of Mathematics at the University of Wisconsin-Madison. Despite the fact that the author attended Harvard (pardon the petty rivalry), I am looking forward to the read because the book’s sole mission is to simplify complex mathematic concepts in ways that even former football and hockey players like ourselves can internalize and apply the knowledge to one’s craft.
Back to the Global Macro Grind…
As macro research analysts, simplifying the complex is something we are tasked with daily. The economy – fully loaded with the public and private actors therein and the financial markets that underpin it – is a large, unruly beast that operates in a chaotic, nonlinear fashion.
Accurately forecasting inputs as basic and widely understood as GDP or CPI requires at least some understanding of advanced stochastic approximation methods. Moreover, the dependency of financial market returns at any given interval to growth and inflation is a dynamic function in and of itself that anchors on the slope of the policy vector = P. Advanced statistical analysis reveals that [GDP] growth, [consumer price] inflation and [monetary] policy are principal components of asset class returns, which is why accurately forecasting deviations in these variables is such an important task for investors.
That’s a particularly non-simplified way of saying investors would do well to understand pending material changes in growth, inflation and policy. I like simplicity. It makes my head hurt less.
5 bullets on GROWTH:
- Amid a sea of ongoing deterioration in domestic economic data, there have been a few noteworthy sequential upticks that have given both equity bulls and the Atlanta Fed’s overhyped forecasting team hope. The January Retail Sales, Industrial Production and Chicago Fed National Activity Index reports are among the most notable.
- As we detailed in our 2/17 note titled, “What’s More Important: the Short Squeeze in the Market or the Data?” neither the market, GDP base effects nor trends across a preponderance of high-frequency data agree with the increasingly consensus assessment that U.S. growth has bottomed.
- In fact, yesterday we received incremental confirmation of our U.S. #Recession theme in the form of a sharp downtick in Consumer Confidence during the month of FEB. This series is now slowing on a sequential, trending and quarterly average basis.
- Recall that a breakdown in Consumer Confidence is among the top three (of several) proprietary indicators we use to forecast an economic downturn, with the other two being a breakdown in Corporate Profits and a breakout in Initial Jobless Claims. The confluence of these indicators is currently suggesting a recession is likely to commence within 1-3 quarters.
- Do we need the NBER to timestamp a technical recession to be right on our call for stocks and credit to keep going down and for Treasury bonds to keep going up? Absolutely not; the domestic credit and corporate profit cycles are far more material risks to asset markets than what is likely to be a shallow – if any – recession. For more details on why that is the case, we encourage you to review the second half of our 2/3 note titled, “Ex-Energy?”. I can assure you that most investors have yet to arrive at this very basic conclusion, let alone understand where we are within the context of those respective cycles.
5 bullets on INFLATION:
- The inflation picture remains fairly simple to contextualize as a cyclical recovery within a secular downtrend. We discussed this dynamic in great detail within our 12/15 note titled, “Quantifying Why the Fed Is Wrong On Its Outlook For Inflation”.
- Much like the preponderance of high-frequency growth data, reported inflation data throughout the YTD has been in line with our expectations of ongoing sequential and trending acceleration through Q1.
- Specifically, the rates of change in Headline CPI, Core CPI, Core Services CPI and our proprietary basket of Consumer Essentials, suggest the U.S. consumer’s wallet was squeezed, on the margin, at the fastest rate in ~12-18 months in JAN.
- Even PPI showed sequential and trending strength during the month of JAN. On the margin, this eases the deflationary headwind to corporate sales and earnings growth, but a headwind it remains at -0.2% YoY.
- Inflation expectations – be they market based or survey based – continue to substantiate our lower-for-longer view of structural inflation trends in the U.S., which is also augmented by our proprietary analysis of the U.S.’s short-run demographic outlook.
5 bullets on POLICY:
- The intersection of the aforementioned vectors (i.e. Growth and Inflation) should lead one to anticipate marginally dovish policy out of the Federal Reserve and, absent a gangbusters FEB Jobs Report at the end of next week, most market participants expect them to revise down the fairly steep slope of their infamous “Dot Plot” when the FOMC releases its revised Summary of Economic Projections on the 16th of next month.
- The problem with revising down the Dot Plot is just that – it’s not QE. The road from communicating “3-4 hikes in 2016” to implementing “QE4” is rocky at best. The FOMC risks losing a substantial amount of credibility by communicating that transition in a hasty (i.e. stock market dependent) manner.
- The presidential election cycle may be a complicating factor for any such transition as well. A lot of investors thought Jeb might keep Janet in check, but with his decision to [appropriately] bow out of the race, the focus shifts to Bernie’s anti-Wall Street rhetoric. Trump and Rubio have been openly critical of the Fed at various intervals as well.
- Ignoring those factors for argument’s sake, it remains to be seen how impactful incremental QE will be in asset price appreciation terms. To butcher an old saying, every time the corporate profit and credit cycles met Fed easing, only the cycles left with their reputations intact.
- Specially, the most important takeaway from studying the 1990-91 downturn, the 2000-02 downturn and the 2007-09 downturn in unison is that the stock market will appropriately price in obviously-bearish fundamentals no matter how much the Fed eases.
All told, the confluence of the aforementioned factors continues to underpin our bearish outlook for domestic equities and credit. Accordingly, we anticipate that the performance divergence between investors who are selling rallies because of deteriorating fundamentals and those who are buying dips because “everyone is bearish” will widen from here.
And even if we’re dead wrong on all the fundamental factors detailed above, there’s always the Chart of the Day for bears to hang their hats on…
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.61-1.83% (bearish)
SPX 1 (bearish)
VIX 19.64-28.96 (bullish)
EUR/USD 1.09-1.13 (neutral)
YEN 111.20-114.80 (bullish)
Gold 1176-1258 (bullish)
Crude Oil (WTI) 25.97-33.69 (bearish)
Keep your head on a swivel,