Weekly Note 2022.07.11

Cautiously bullish…

On theme with previous weeks of reviewing the outlook for US equities:

Risk is very very oversold where I discussed that any Recession in the US would likely be a quick and shallow one, Bullish sentiment towards EOQ flows and July seasonals which however was mostly wrong that week as the Bullish EOQ flows didn’t materialise, and Recession fears overblown where I looked at some excellent charts from JPM’s End of Q2 guide to markets that puts recession arguments into perspective and that some slowing should be reasonably expected after 2 extraordinary years…

I pay particular attention to downside risks for the S&P500 in the week’s/month’s ahead as US markets have to contend with: i) downside risks to economic data being more likely than upside, ii) US-Dollar risks from Europe and other Emerging markets having a tougher time grappling with stagflation, and iii) inevitable earnings/margin compressions where I see executives using the economic slowdown/recession card this earnings season.

Some highlights from TS Lombard’s excellent chart deck:

MACRO — US activity is slowing but remains far from “actual” (as opposed to technical) recessionary levels. Data so far are compatible with a soft landing, but this is not enough to get the Fed to turn dovish. Leading indicators point to a softening in global labour markets.

FIXED INCOME — Rising real yields (from Fed tightening and perhaps slowing inflation in H2) are a major headwind for equities. The divergence between breakevens and oil signals the market belief that demand will fall enough to bring inflation down. And as recession fears grow, the Fed expected terminal rate has declined to 3.3%; we think the Fed will need to hike above 4%. US IG & HY [spreads] have not widened enough to reflect recession risks.

CURRENCIES — market is not rewarding currencies that hike if it is at the cost of growth, especially if they trade high beta to risk-off. As recession fears grow, we move to the left-hand side of the dollar smile, where USD rises because of its safe-haven status. The Swiss franc is becoming increasingly attractive as the SNB hikes, but the yen will weaken unless the BoJ capitulates.

EQUITIES — past 13 US equity bear markets have been either deeper or longer than the current one — and often both at the same time. High inflation may keep earnings stay afloat somewhat, but downgrades are coming nonetheless. EPS rose in both nominal and real terms in the 1973–74 bear market, but this did not stop such a market from happening.

Referring to the bottom left chart, the last 10 bear markets produced an average P/E de-rating of 7. SPX P/E was at~22x before the bear market and currently at 16x, which puts us 1 short of the average…

Macro-based EPS model based on our GDP, inflation and unemployment forecasts shows EPS growing in the next 24 months. Earnings are nominal and inflation could boost them but our confidence in these results is lower in this cycle: our model was calibrated over periods when inflation was pro-cyclical, hence boosting margins. We believe margins will be under more pressure this time.

Considering Yardeni currently estimates 2023 EPS at 235 and taking a rough average of consensus estimates above: assuming a conservative 225 forward EPS estimate and P/E de-rating to 15x is realized, that would put SPX valuation at approximately 3,375. For now however, I think we are about fair at current levels and will reassess as earnings estimates get updated later this month.

Though I am constructive on risk on the back of a strong US jobs report allaying recession fears and China activity looking to come back in full swing, China is seeing a resurgence of Covid cases and there is a potential threat of Bank runs which could upset sentiment and therefore I maintain a cautiously bullish stance.

I am still targeting at least another 5% of upside in the NDX, but as there are some risks to be cautious of I intend on squaring some positions ahead of CPI and reloading on potential weakness later in the week. I think Fed hikes for the next few meeting is adequately priced barring a massive beat in CPI this Wednesday, and if all goes to plan, I think 12750+ would be a good place to switch short for the earnings season and July Fed meeting EOM.

MAJOR HEADLINES

US

• Nasdaq rises for fifth-straight day after strong jobs report as Wall Street notches winning week (CNBC)
• Is a Recession Coming? Investors Turn to Earnings for Clues — Energy crisis, inflation, weaker euro are all in focus. Lockdowns in China have also cast a shadow on profit (Bloomberg). The Stock Market Faces Next Test as Inflation Looms Over Earnings Season — Quarterly reports begin this week with financial companies; some investors see corporate-profit forecasts as too optimistic (WSJ). ‘If it’s a recession… buy!’ This little-known market indicator is telling you to scoop up stocks on the cheap — The ‘Recession Buy Indicator’ is a contrarian measure that’s been right more often than not (MarketWatch).
• Biden Says Action on China Import Tariffs Still Being Discussed (Bloomberg) Commerce secretary says she expects decision ‘shortly’. Administration divided over impact, scope of tariff easing. Biden’s move to lift some China tariffs will likely be ‘modest’ in short term, former trade negotiator says (CNBC).
• Large Retailers Are Getting Hit Hardest by Overstocking — Supply-chain experts say overall inventory levels remain thin while general merchandise stores cope with a supply-demand mismatch (WSJ). Tech’s Red-Hot Hiring Spree Shows Signs of Cooling (WSJ) Twitter, Netflix, Amazon and others are slowing hiring or cutting jobs; economists point to mixed picture with data. Twitter Assembles Legal Team to Sue Musk Over Dropped Takeover (Bloomberg)

EUROPE

• Putin warns of ‘catastrophic’ energy crisis if west boosts sanctions — Russian president says western countries risk inflicting more harm on themselves (FT)
• Manufacturers Brace for Nord Stream Repairs, Fearing Pipeline Won’t Reopen — Russia is closing the natural-gas link this week for maintenance, and European governments worry the shutdown will be permanent (WSJ). French Minister Says Russian Gas Cutoff Most Likely Scenario — Nation trying its best to avoid power shortages (Bloomberg).
• German utility Uniper requests government rescue after Russian gas squeeze — State expected to take a substantial stake in company as a result of potential bailout (FT). Canada Will Return Sanctioned Nord Stream Turbine to Germany — Decision pitted Europe’s energy needs against Russia penalties. Equipment built by Siemens unit got stranded over Ukraine war (Bloomberg).
• Omicron sub-variants push up Covid hospitalisations in Europe and US — Infections less likely to cause severe illness or death than past waves, FT analysis suggests (FT).

ASIA

• China’s Bumper Data Week Will Set Tone for Economic Stimulus — China will unveil a bumper set of economic indicators this week that will likely set the pace for monetary and fiscal stimulus for the rest of the year as Beijing chases down its ambitious growth target (Bloomberg).
• Shanghai Covid Outbreak Grows as First Sub-Variant Case Detected — The city recorded 69 new infections for Sunday, the most since late May and up from 57 the day before. Shanghai found its first case of the more contagious BA.5 sub-strain of the omicron variant Friday, triggering two rounds of mass testing (Bloomberg). Macau Shuts Casinos as City Enters Weeklong Lockdown — Decision comes as authorities struggle to contain a Covid-19 outbreak in the Chinese gambling hub (WSJ).
• China factories are feeling some heat as U.S., Europe demand slows (CNBC). Freight Rates Are Starting to Fall as Shipping Demand Wavers — Shippers are trying to reset contract agreements to cut expenses, but costs remain several times higher than before the Covid-19 pandemic (WSJ).
• Chinese Bank Depositors Face Police in Angry Protest — What had been a local scandal became a national incident last month because of the misuse of the COVID-19 tracking app (Bloomberg).
• China Watchdog Fined Alibaba, Tencent Over Reporting Past Deals — The regulator said it was accelerating the disposal of existing anti-monopoly cases and will fully support the involved companies’ development (Bloomberg).
• Japan Ruling Bloc Wins Big in Vote Held Days After Abe’s Murder — Nikkei starts the week strong as investors welcome the news (Bloomberg).
• Sri Lanka Crisis Flashes Warning for Other Indebted Economies — Protests forced out president and prime minister and signal tough choices ahead for other countries with high debt and shortages of food and energy (WSJ). Investors pull $50bn from emerging market bond funds in 2022 — ‘Perfect storm’ for developing economies triggers most severe net outflows for 17 years (FT). ‘This is all because of the politicians’: rising prices anger Indians — Narendra Modi’s government opens fiscal taps to tackle inflation as costs of staple foods soar (FT)

LAST WEEK’S ACTION

US equities made a full recovery back to highs of recent weeks despite higher yields and UST futures finishing lower. European equities almost flat with Dax lingering at the lows. Crude was ~10% lower but made a strong late week bounce, Precious metals continue to stay under pressure on stronger real yields and Food commodities extended lows but finished the week higher.

USD was higher against most currencies. On index view, AUD finished the strongest while EUR and EMFX were the weakest for the weak.

EQUITIES

Global equities are still showing significant weakness and would have probably finished deeply negative if not for a strong week in US large-caps.

US rebound was led by mega tech stocks pushing NDX +4.66% for the week, while DJI and SPX finished +0.77% and +1.94% respectively.

If US equities is to build on last week’s strength, it will most likely be led by NDX stocks again which is on a breakout.

Commodity and manufacturing related sectors were the weakest sectors, while defensive sectors apart from Healthcare fell out of favour.

Bond (Orange) and Equity (NDX Blue, SPX Purple) volatilities have sold off slightly last week reflecting lessened recession fears.

3month implied correlation (Orange) has also been gradually falling since the June peak indicating improved dispersion, though slight is usually a healthy sign for Equities (NDX 3month rolling returns, Green).

Negative gamma unwound slightly leading to an uptick in the neutral level ahead of OEPX this week. Last week’s high was in SPX was also capped by a huge wall of gamma at 3900 where the picture would look much more constructive if it trades above that level.

As noted in prior weeks, market is still very short and @MacroCharts shows record level CFTC short interest by Asset Managers and Hedge Funds.

Looking at Developed and Emerging equity indices, technical continue to remain weak but there has been some consolidation over the past month with slightly bullish divergence on the lows and a potential break of short-term trend.

COMMODITIES

Commodities saw some relief after the broad sell off last month, and we are seeing a potential break of trend.

Last week I looked at the long side of Gold following some strong technical signals for the bounce, but the trade failed almost immediately as real yields continued higher. Long PM ideas will probably stay wrong as this trend will most likely continue with Fed tightening likely continuing to exert upward pressure on higher terminal rates and downward pressure on inflation expectations going forward, i.e. higher real yields.

With global manufacturing slowdown playing through along with FED tightening effect on real yields, the only long trade that gets my interest is Oil longs (above ~102bbl) and Precious Metals shorts on rallies to take out the 61.8 retracement level.

RATES

US yields higher across the board last week.

Comparing it with the move in real yields:

• 5yr nominals +23.6bp vs reals +23.8bp
• 10yr nominals +18.6bp vs reals +17.6bp
• 30yr nominals +12.5bp vs reals +13.0bp

indicating last week’s moves was driven entirely by real rates, which given the strong jobs report last week, seems to indicate the market has put off recession fears for the time being and is more comfortable with a hawkish for longer fed, or higher terminal rates while inflation expectations moderates.

In addition to higher real rates, IG and HY credit spreads soaring is likely to continue casting a shadow on US equities for the big picture macro view.

CURRENCIES & TRADE IDEAS

Short risk from Asia into the European session, and long risk into the US session has generally been a good bias for intra-day trading and I expect this pattern to continue working well.

• AUDJPY short — due to some negative China news and a soft open in Asian equities, I start week with an AUDJPY short until there is more positive news and sentiment neutralises again.

• USDSEK short — is my trade of choice this week due to a very strong technical signal in both USDSEK and DXY and my constructive risk view. Good risk/reward offered if it works out, but there is an early sense the trade may fail (stop at last week’s high) on the negative turn in sentiment over the weekend.
• AUD longs — for the medium term trade favouring the currency on dips betting on China’s commitment to gradual recovery and the necessary fiscal and monetary stimulus to achieve their economic targets.
• AUDCAD and NZDCAD longs — I’m keen on building a longer term position on these pairs to express a bullish China/APAC region view vs the weak turn in Canadian data as well as some temporary relief in USD strength. Looking for improved broader sentiment and slowing USD upside to engage in this idea.
• NDX long — I continue to remain tactically bullish for reasons noted at the top of this note. The more SPX or NDX continue to rally above current levels, the more I expect the short squeeze to gain traction, targeting the 12.5k+ with potential for a retest of 13k.

— — — — — — — — — — — — — — — — — — — — — — — — — — — — — —