Weekly Note 2022.07.18
Recession risks — The June CPI report highlighted inflation pressures with core at +0.7% m/m vs +0.6% in May were extremely broad and likely to trigger a strong response from the FED, or keep them on an aggressive policy path at the least, thus increasing the likelihood of a policy induced recession. 2s10s spread inverted another 15bps to nearly -25bp after the report, which gives me some conviction as to timing the change in my tactical view.
Earnings risks — Factset already observes SPX reporting Yr/Yr earnings growth of 4.2% for Q2 2022, which is the lowest growth since Q4 2020 (4.0%) and where earnings growth is not likely to improve over the next few quarters, risks to earnings are increasingly to the downside.
As I’ve looked at in prior weeks using the chart decks from JPM-AM and TS Lombard, we are staring further at the more negative-case scenarios:
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.
We’ve already seen a huge P/E de-rating so far this year, and putting together the above (rising risks of recession and to earnings), the major risk to SPX now is the decline in forward EPS expectations, BofA for example now sees forward EPS at $218 which would be the put SPX at ~3,270 assuming 15x P/E and above BofA potential floor at 3,000–3,200.
Earnings are cyclically elevated when comparing trailing vs normalized EPS, the spread of which is one of widest spreads in history.
They forecast equity risk premium rising to 575bp and 10bp increase in discount rates which more more likely to increase than decrease from here.
10 year real rates also tends to lead the Growth/Value ratio with a -94% correlation, but the ratio has not followed followed real rates higher in recent months.
I previously had a 12,600 target after the 1st week of July completing a the measured breakout objective, but while volumes have been light, momentum has been evidently lacking above the 12k handle.
Even though I have engaged a fully bearish view into July month-end, that did not stop me trading both ways. I got long NDX on the fake CPI report and took that into the CPI print and took quite the hit.
Waited for the post-CPI retracement and got short; surprised it retraced as much as it but it was a nice trade back to the CPI lows.
I still had a bullish view for OPEX however on the same idea with hedging flows reversing and huge amount of options rolling off and got long…
Missed out on a lot of the Friday move and somewhat frustratingly given my EOW view on options-related flows, but satisfied with the series of NDX trades for the week nonetheless.
Going forward, I retain my bearish scenario through earnings and into FOMC and position trade the short side til the end of the month. A lot of the options related weight has been lifted as a result of OPEX but I think that weight will rebuild with renewed flows on the ongoing market risks. I have tentatively planned to buy into the post FOMC and earnings weakness as I think peak inflation will start to take the edge off markets as they second guess when the Fed pivot will be, but will reassess when we get there.
LAST WEEK’S ACTION
Risk off week (barring the late recovery in US equities).
MSCI World bouncing off the pre-covid highs for the 2nd time, while the ex-US index saw lower lows sitting roughly 12% below pre-covid highs.
More pain felt in Emerging markets (bottom) below the 61.8 fib retracement level while Developed markets (top) is holding above.
China markets are seeing some renewed negativity but given its weak valuations could still continue to find support from longer term investors.
US equities finding support into OPEX and Waller’s comments that market may getting too far ahead of itself expecting a 100bps hike. A strong close to the week but I expect limited recovery and downside pressure to mount into month-end for the aforementioned reasons.
While index charts may itself look a little promising for a relief rally, it is not looking any bit encouraging under the hood:
Poor performance from the mega-gaps last week.
Lows of recent weeks held with a strong late week bounce but new lows were seen in most sectors, particularly in Value stocks, which says a lot about the broader weakness.
Some typical vol-crush into OPEX looks to have provided the fuel for the late week rally, but I think that sets the scene for vol to build again on the shaky macro backdrop like we had back in April.
Wk/wk change in the yield curve show the big inversion move in the belly reinforcing the recessionary outlook induced by fed tightening against the persistently high inflation.
Inflation expectations have risen after selling off last month and the bounce did little to bring down real rates.
BofA also notes a -94% correlation between Growth/Value ratio and 10 year real rates which has tended to lead the G/V ratio, but has not followed followed real rates higher (i.e. G/V ratio lower).
Something that doesn’t quite fit in with my bearish view is Bond market volatility (Move index in Orange) easing off, which usually provides some relief from Dollar strength (DXY in Green) and for Growth stocks (21 day rolling change in the bottom panel).
I do expect real yields to stay high however as we are some ways before a potential fed pivot and cap recoveries in equities.
Commodities are making a small recovery from the sell off last month, driven by Energy. I am currently long WTI and XAU from last week, Oil for structural reasons with demand far outweighing supply even against recession concerns, and Gold for a shorter term trade on the back of real yields easing off some 15bp last weak and scope for a return back to 1730.
I’m mostly focused on EUR shorts and CAD longs:
EUR — In addition to the above points from MUFG, European outlook still looks far from improving and continued risk aversion across global markets should see EURCHF continue its trend lower. I’ve been looking for a meaningful bounce back towards the 1.00 handle but the market has yet to grant me that opportunity with the growing risks around Italy and Russia gas supplies. We do have ECB this week and I will be hoping for a relief rally for an opportunity to reestablish shorts in EUR.
Also worth noting some excellent two way action in the Euro for intra-day trades. There may be no good reason to be long Euro but positioning is so stretched that I think there will be plenty more tactical opportunities with potentially big rewards against tight risk.
Commodity-Dollars — I continue to prefer CAD longs mostly vs AUD and NZD and potentially USD which was one of the better trades for me last week both long and short USDCAD. Oil appears to have put in a solid base to lend support to the CAD, while the BOC’s aggressive stance with their surprise 100bp hike should keep short-term cash rates relatively strong vs peers, while a relatively strong USD also tends to provide CAD support on the crosses.
Wish you good trading.
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