We’ve been getting a lot of the same questions from a number of clients spanning the gamut in terms of investment strategy and AUM, so we figured we might as well address them in a public forum given the broadly applicable nature of our responses.
Q: “What gets the SPX to go down from here?”
A: The data.
Since the late-September lows, the S&P 500 has held a reasonably tight positive 0.75 correlation with the Citi U.S. Economic Surprise Index, which itself has rallied hard off its early-February lows as U.S. economic data stabilized in rate-of-change terms and perpetuated a waning of recession fears.
Source: Bloomberg L.P.
Now, a topping process in the latter index appears to have gotten underway over the past two weeks, as most recently highlighted by big misses in this morning's Philly Fed and Chicago NAI surveys. While our process generally underweights survey data – particularly one-off regional surveys – in lieu of doing the actual rate-of-change calculus on relevant “C” + “I” + “G” + “NX” metrics, we reiterate our view that economic deterioration from here is itself the catalyst for the stock market to reverse course a meaningful manner.
Simply put, because macro consensus doesn’t have our economic outlook, we believe domestic economic data will start to miss by wide margin again as it did in the early part of this year. It’s also worth noting that economist consensus always has a natural upward-sloping bias to their growth estimates, which creates additional downside surprise risk to the extent we're right on where the data is headed over the next couple of quarters.
Q: “The market is clearly pricing in a high likelihood of monetary accommodation out of the Federal Reserve. Doesn’t the imminent threat of a rate cut and/or QE4 prevent a market sell-off in almost circular reference fashion?”
A: Not at all.
For starters, it’s important that market participants do not disrespect just how bullish the confluence of economic stabilization in the U.S. and China + a remarkably dovish pivot by the Federal Reserve has been for reflation assets.
As the following table highlights, a healthy amount of key domestic high-frequency growth indicators stabilized on a sequential basis in the FEB/MAR time frame. While the trend of broad-based deceleration remains firmly intact per the “Trending Data” column, there is plenty enough green in the “Sequential Data” column for market participants to have broadly perpetuated a general reduction in near-term recession fears.
And while we disagree with the conclusion (i.e. the risk of a 2016 recession has subsided), we acknowledge that delaying the commencement of said downturn is decidedly bullish for risk assets in the context of the early-February highs in pervasively bearish sentiment.
Secondly, the aforementioned stabilization in the face of Janet Yellen going full-frontal dovish proved to be a powerful elixir for risk appetite – particularly among reflation assets. Specifically, factor exposure leadership across every major asset class is pricing in some version of QE4 per our Tactical Asset Class Rotation Model:
***CLICK HERE to learn more about TACRM and its proprietary methodology for quantifying VWAP price momentum across multiple durations and amalgamating those signals into a composite Adjusted VAMDMI score.***
But as we penned in yesterday’s Early Look titled, “Back To Basics”, the Fed has little scope left to manipulate asset markets absent an explicit commitment to monetary easing – which we don’t think will occur in proactive fashion. Specifically, spreads across Fed Funds futures contracts have compressed dramatically in the YTD; the next rate hike is not fully priced into the market until Q3/Q4 of 2017, as opposed to October of 2016 when we started the year.
That’s an important distinction to make given the fear among bulls and bears alike about this squeeze being perpetuated higher by increasing talk of QE4.
In summary, the dovish shift by the Fed has largely run its course and that they can’t do much in rhetorical terms to convince market participants of their dovishness even more so than they already have. They need to bring out the bazooka and we don’t think they can or will absent material degradation in the economic data (which we are forecasting) and a commensurate decline in risk asset prices as implied by the first chart in this note.
Q: “What do you make of the recent selloff in Treasury bonds and Utilities?”
A: It’s one of two things and neither is good for the forward outlook for risk assets.
Specifically, we think the back up in Treasury bond yields and commensurate sell-off in Treasury bonds and Utilities is a function of investors broadly capitulating on the bear case and that capitulation is obviously in the process of reaching its inevitable crescendo today. In positioning terms, investors broadly giving up on playing defense implies they are either tacitly or explicitly increasing their exposure to risk. We are taking the other side of that decision at the current juncture and keen to do quite the opposite by adding to defensive factor exposure longs today.
Another reason for the aforementioned selloff could be a marginally hawkish shift by the Federal Reserve in next Wednesday’s FOMC statement. If, like us, you believe the FOMC is a collection of bureaucrats that stress the crossing of T’s and dotting of I’s, then there’s nothing like a couple of months of backward-looking stabilization of economic data and 2100 on the SPX to resuscitate the “policy normalization” debate.
Specifically, there is risk that Janet Yellen pivots fairly hawkishly and sets the stage for another rate hike in mid-June. If that’s the case, the next six weeks could resemble the first six weeks of the year – which, coincidentally, was the worst start to the year ever in equity market performance terms.
Remember, this is the same policymaking entity that opted for “liftoff” amid the worst swoon for stocks since 2011 and into peak U.S recession fears. Don’t disrespect their willingness to take another ill-timed “victory lap”.
We hope you find these discussions helpful. Feel free to email us with any follow up questions and we’ll be happy to assist further.