Weekly Note 2022.08.01

Taking stock of the Fed and Markets

A slow start catching up with some overdue errands and after one of those “I’m never drinking again” type weekends — words I’m sure many of us have uttered more times than we could count, and yet here we are… More than made up for the previous weekend missed from being sick in bed and just another Monday where I’m glad to be my own boss! Today, I review last week’s action around the Fed meeting and there is no better explainer than the one from Alfonso Peccatiello’s The Crazy Market Rally Explained — The Fed just hiked 75 bps and markets went ballistic: what the heck?!

• Fed observations — Firstly, the Fed remains “highly attentive to inflation risks” and “strongly committed to bringing inflation back down”, and, that they need to see “compelling evidence” that inflation is coming down towards their 2% target — softer prices in Commodities and Input prices as well a slump in Demand via New orders is already pointing towards softer Goods inflation but still no evidence (via CPI or PCE) to suggest a change in policy stance and terminal rate expectations yet. Secondly, they have effectively ditched their forward guidance which, Alf explains has let markets “ freely design their probability distributions across all asset classes without any anchor”, “green light to price a more nuanced tightening cycle and hence still restrictive real yields but less so than before”. There has already been chatter of a Fed pivot since the 100bp Fed insider leak at the June meeting which saw the 2023 Eurodollar curve invert and begin pricing in cuts next year. Real yields also topped out since and SPX bottomed soon after.

• We’ve had some front-running of the ‘fed pivot trade’ which proved right with the Fed going from auto-pilot to data-dependent, which is perhaps a subtle acknowledgement of demand and growth already beginning to slow, and inflation coming down to soon follow.
• Markets may have for now reached the limit of rate cut expectations also with another 100bps of hikes this year to contend and some reasonably resilient signs from the economy — 1) growth and demand may be slowing but we are still far from a cratering economy that is seeing things like ‘jobless claims going through the roof’ and a ‘housing market slump’ that is typically associated with a recession; and 2) earnings have so far faired better than was feared. Whilst these would appear positive, asssuming markets have gone too far with recession fears, it may also be that they have gone too far or reached a limit to further rate cut expectations for the time being.

MAJOR HEADLINES

MARKETS

• The Stock Market Is Rallying. Here’s What Could Make it Tumble Again –While the Fed will likely raise its target for the benchmark lending rate at its next few policy-setting meetings, the probability that it lifts the rate to above 3.5% by February has gone down to 17% from a 44% chance a month ago, according to CME Group data. For stocks to keep rising, the market needs to see that inflation is in fact cooling down. If the result is worse than expected, expectations that the Fed will slow down its rate increases could fade away, sending the stock market tumbling. (Barrons)
• The Power of Positive Thinking Returns to Markets — Powell — finally — stopped offering guidance on what the Fed would do next, gave no reassurance that recession could be avoided and when asked about cuts next year pointed to last month’s forecast that rates would rise further in 2023. Bond yields fell and the Nasdaq Composite soared 4%, its biggest one-day gain since the April 2020 pandemic rebound, as investors bet on even faster rate cuts next year than they already expected. (WSJ)
• Bitcoin Slips After Best Month of 2022 as Traders Weigh Recovery — Bitcoin declines after reaching the highest levels since mid-June on Saturday amid optimism that the market may have recovered from its worst levels. The largest cryptocurrency dropped as much as 2.4% to $23,247 on Monday after hitting $24,658 on Saturday, its highest since June 13. Its 27% gain in July made for the best month since October. Ether slid as well after posting a 70% jump last month, its best since January 2021. (Bloomberg)
• Individual Investors Ramp Up Bets on Tech Stocks — Shares of Amazon, Alphabet, Meta Platforms and others have suffered double-digit declines, but believers say they expect a rebound (WSJ). Giant Pension Bought Apple Stock. It Sold Tesla, Microsoft and AT&T (Barrons).
• More Than 350 Firms Shelve Over $250 Billion in Financing Plans — Americas sees highest number of deals postponed or canceled, Number of bonds held exceeds tally during peak of pandemic (Bloomberg)

US

• Falling Food Prices Ease Upward Pressure on Global Inflation — Agricultural markets remain volatile due to war and hot weather; in U.S., impact on grocery bills might be muted (WSJ). Consumers Have Powered Through the Pandemic and Inflation — Until Now — Families are paring back purchases of items such as electronics and furniture as prices for essentials like food and gasoline have become more expensive. Inflation drove consumer spending in June to a new four-decade high while personal incomes fell when adjusting for inflation and taxes. Changes in spending habits, so far, have been uneven, companies and economists say. Many people are dining out and traveling more after missing chances to do it earlier in the pandemic. Pent-up demand is also fueling sales for automobiles. And some people — especially higher income households — are continuing to shell out for desired items regardless of elevated prices. (WSJ)
• House Approves $52 Billion Bill to Help Chip Manufacturers — Passage follows more than a year of wrangling on tech bill, Supporters say aid will fortify supply chains, US industry (Bloomberg). The U.S. Is Investing Big in Chips. So Is the Rest of the World. The question is whether semiconductor giants choose America over other locations that have offered incentives and lower costs for years (WSJ). US Quietly Tightens Grip on Exports of Chipmaking Gear to China — Lam Research and KLA were notified of new China restrictions, US is trying to contain China’s semiconductor ambitions (Bloomberg).
• Midterm Misery for Biden as Key Economy Gauge Flags 30-Seat Loss — Soaring inflation has pushed the misery index, a measure with a track record of getting elections right, into dangerous territory for Democrats (Bloomberg)
• Pelosi Travels With Delegation to Asia Amid Chinese Warnings Not to Visit Taiwan (WSJ)

EUROPE

• German manufacturing sector contracts as new orders slump — An index of new orders came in at 40.1, dropping further below the 50 mark, which separates growth from contraction, and slumping to its lowest level since May 2020. “The potential for a shortage in gas supplies has German manufacturers seriously worried about the outlook for production in the coming year” (Reuters). Italy manufacturing sector contracts in July — came in at 48.5, down from 50.9 the month before and below the 50 mark that separates growth from contraction for the first time since June 2020. The new orders sub-index dropped to 42.5 from 43.9, well below the key 50 threshold and posting an eighth straight decline (Reuters).
• War With Russia Enters New Phase as Ukraine Readies Southern Counterblow — After months of Russian forces making painfully slow gains in Ukraine’s east, the focus of the war is moving to the south, where a potentially decisive phase of the conflict will play out. Ukraine has used long-range artillery and rocket systems, including the American M142 Himars, to halt Russia’s grinding advances in the east, destroying ammunition dumps, command-and-control centers and air-defense systems that appear to have limited Moscow’s ability to supply its front lines. Now, with the help of these Western weapons, Ukraine says it is mounting a counteroffensive to take back the southern port city of Kherson. (WSJ)
• First Grains Ship Leaves Ukraine for Lebanon in Key Milestone — WFP plans to purchase 30,000 tons of Ukrainian wheat, The Razoni leaves loaded with corn under safe-corridor dea (Bloomberg)
• Sunak Admits to ‘Playing Catch-Up’ to Truss in Apparent Bid for Underdog Status (Bloomberg). British PM candidate Sunak vows 20% income tax cut by 2029 (Reuters)

ASIA

• Asia Factory Activity Tumbles on Supply, Weaker Demand — Purchasing managers’ indexes for South Korea and Taiwan took the biggest hit, according to S&P Global. South Korea’s July PMI slumped to 49.8 from 51.3 in June, its lowest reading since September 2020. New orders contracted and weakened the most in nearly two years while output volumes slid at the fastest pace for nine months due to shortages of materials and rising costs. Taiwan’s PMI reading fell to 44.6 from 49.8 while output fell to 40.2 from 45.9 in June. The PMI, output and new orders were at their weakest since May 2020. A reading above 50 indicates expansion from the previous month, while anything below indicates contraction. (Bloomberg)
• S.Korea July exports rise at faster pace, but risks to outlook grow — Outbound shipments rose 9.4% in July from a year earlier to $60.70 billion, matching the forecast in a Reuters poll, trade ministry data showed on Monday, after a 5.2% rise in the previous month (Reuters)
• China’s Stumbling Manufacturing, Property Sectors Show Long Road to Recovery — Pressure isn’t expected to ease as data for two key sectors came in negative for July; Chinese manufacturing activity unexpectedly contracted in July, a nascent two-month recovery in China’s home sales ended in July (WSJ)
• China Banks May Face $350 Billion in Losses [in a worst-case scenario] From Property Crisis — Mortgage boycotts and slowing growth are rattling authorities, Pressure seen growing on China’s $56 trillion banking system (Bloomberg)
• Alibaba shares keep sliding in Hong Kong following delisting threat from SEC — Alibaba’s U.S. shares tumbled more than 11% on Friday, after the U.S. Securities and Exchange Commission added it to a list of more than 250 Chinese companies that could face delisting on Wall Street due to failure to comply with financial-auditing requirements. The Wall Street Journal also reported Friday that Alibaba co-founder Jack Ma is preparing to give up control of Ant Group, the Chinese fintech company that is closely tied to Alibaba (MarketWatch)
• Macau to reopen city as no COVID infections detected for 9 days (Reuters)

EQUITIES

Markets have been very oversold and the last Fed meeting gave markets a reason to find some relief from pre-pandemic pivot levels.

US growth vs value ratio reacted positively to the fed meeting, with July validating the turn signals of prior months.

Rally may have a bit more room to the upside but I expect it be challenged from hereon — reaching the technical objective from the breakout, shorter-term Weekly and Daily indicators reaching overbought territory, and a seasonally challenging August month for risk.

To contrast with the rally seen in most markets, China equities FXI -10.41% has had their worst month since July last year when it had slumped -12.5%. As a longer-term investment, I have bought into China equities via Alibaba (HSI:9988) and monitoring closely. I still think we are around great multi-year value levels and also while economic conditions are extremely bad on the mainland, I do believe things couldn’t get much worse than they are now and expect the China government to do what they need to do to put a recovery back on track.

South Korea and Taiwan are good bellweather markets for global trade and has seen some relief in July from the extreme selling EWY -14.5% (~37% off last year’s high) and EWT -11.64% (off ~25% from January high) the previous month. Still early, but I’m looking for a USD peak to signal a turn of fortunes in these markets, and I don’t think we are too far away.

COMMODITIES

Commodities have broadly recovered in July as a result of US yields plummeting ~50bps last month, resulting in some USD profit-taking and improved sentiment in US equities. Bloomberg commodities index is roughly 10% above July lows and back to the 38.2% retracement of the June sell-off.

Copper finding relief after reaching longer term moving averages and 3sd monthly band, and the softer US crude a positive to US sentiment.

RATES

Above shows the current yield curve (in Orange) and as of July1st (Purple) and June1st (Green) — front-end rates have caught up in recent months and have started to invert against belly of the curve in July.

As seen with the 2023 Eurodollar spread, market pricing in cuts on a slowing growth outlook is starting to dampen longer term interest rates, a welcomed sight for Tech stock investors.

US inflation breakevens also followed the eurodollar curve inversion and risk sentiment higher in July. Recent market developments in higher breakevens and lower real yields wouldn’t surprise me to see fed speakers err on the hawkish side with comments like “market expectations are underestimating” the path of tightening.

Further to the technical observations above (e.g. technical breakout objective and overbought), I have started to layer in some short positions last week.

CURRENCIES

In currencies I am mostly trading around short EURJPY GBPUSD and AUDNZD positions.

• EURJPY should continue its path lower as ECB tightening against extremely weak economic conditions should see a progressively flatter bund yield curve.

• GBPUSD should continue to trade weak given deteriorating UK growth and potentially maxed out BOE pricing. HSBC also likes GBPUSD short with 1.2260 stop and 1.1890 target citing downside risks around this week’s BOE meeting potentially in the form of poorer growth forecasts which would increase market skepticism around scal and persistence of future rate hikes, and that “anything other than a 50bp hike with hawkish forward guidance would be a marginally negative susprise for GBP”.

• AUDNZD could find a turn given China demand for Australian commodities taking a hit as a result of the property and construction slowdown, while NZ data has been improving.

Have a great week trading.