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Inside Markets — Repricing Fed Expectations

Repricing Fed Expectations

April 2, 2024

The recent backup in yields has put renewed upward pressure on bond market volatility (MOVE index).  Increased equity volatility (VIX) often starts in the bond market before spilling into equity markets.  The VIX is higher today to 14.85 with levels north of 20 becoming a major headwind for rally attempts.  Once released, heightened equity market volatility >30 usually takes 3-6 months before returning to neutral levels below 20.  The current ~21x forward multiple on the SPX (high-end of the historical 12-22x range) is only sustainable in a low volatility world and VIX levels north of 20 will result in a lower multiple.

Currently subdued levels of realized equity volatility are the result of the benign macro backdrop that started in late-November when 10-year bond yields broke support near 4.60%.  At the time, the bond market was pricing in lower expected inflation rates.  A subsequent break below 4.35% was pricing in a Fed pivot and the move below 4.02% in December reflected rising expectations for at least four 25bp rate cuts in ’24.  Lower inflation, expected rate cuts and resilient growth are the benign macro conditions that generated low equity volatility/high equity multiples.  Removing one or more of those conditions threatens the outlook and a sustained break in 10-year yields above ~4.40% reduces the likelihood that rate cuts occur in ’24 – at least for the purposes of policy normalization.

The SPX doesn’t require rate cuts to move higher if above trend growth translates into stronger-than-expected earnings. But a lack of rate cuts would result in ongoing yield curve inversion, which makes the case for broader equity participation less compelling.  Ongoing curve inversion pushes investors back into large-cap names and makes a sustained breakout in the Russell 2000 (RTY) far less likely.

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Inside Markets — Rebalancing

Rebalancing

April 1, 2024

Last week, the SPX managed to advance +39bp despite month-end/quarter-end rebalancing pressures during a holiday-shortened week.  The small-cap, cyclically-sensitive Russell (RTY) gained +1.1% last week, while momentum equity baskets – where the rebalancing pressures might be more acute – declined more than -2.1%.  In this way, last week’s performance dispersion could be attributed to rebalancing rather than the start of a more lasting rotation.  The RTY managed to close above range resistance at ~2100 on Thursday and remains just north of that level despite relative underperformance this morning.  Sustaining levels above 2100 would be a bullish development for the index and for the broader market, but we remain skeptical given late-cycle dynamics, highly restrictive real yields, curve inversion and shrinking money supply.  Nonetheless, the potential for a catch-up trade in small cap stocks exists and we’ll follow strength if it develops.

Rising equity volatility is still the bearish trigger for this market.  The CBOE Volatility Index (VIX) is higher this morning but remains subdued at 14.  VIX levels north of 20 usually become a headwind for equity markets.

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Inside Markets — Rotation?

Rotation?

March 28, 2024

This week’s rotation out of momentum stocks could merely be a function of month-end/quarter-end dynamics.  Rotation out of the momentum stocks is the ‘pain trade’ for this market given that positioning in the factor has reached the ~99th percentile. Momentum is a dynamic factor, meaning its composition changes based on the fundamental outlook. At the moment, the momentum factor is primarily composed of mega-cap Tech stocks given their perceived resilience to rising interest rates and slower economic growth. In this way, crowding in mega cap Tech makes sense if you expect high interest rates to create slower economic growth in the future. The current benign macro narrative that includes decelerating inflation, Fed policy normalization and resilient growth should encourage broad sector participation. The benign, soft landing scenario doesn’t end in violent rotation out of mega-cap Tech and into cyclical/value sectors.  In this scenario, cyclical/value sectors get pulled along in a short-lived catch up trade.

Yesterday, the RTY managed to close above range resistance at ~2100. The index now needs to sustain these levels and extend over the next few days to confirm a change in trend. In our opinion, RTY outperformance requires a cyclical recovery of some magnitude and a sustained break above 2100 is the early warning signal.  A cyclical recovery, which is difficult to imagine at this stage, would create a more violent rotation out of mega-cap Tech and into cyclical/value/small cap stocks. The RTY trades at a rare multiple discount to the SPX and has endured the longest/deepest period of relative underperformance in history.  If confirmed, a technical breakout in the RTY could be the start of a significant catch-up trade.

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Inside Markets — Bearish Triggers

Bearish Triggers

March 19, 2024

With an eye out for bearish triggers, the official Fed statement exiting tomorrow’s meeting is expected to be little changed from the January meeting. The ‘risk’ for this meeting likely comes from the Summary of Economic Projections and updated dot plot where we see ~60% probability for the median ’24 dot to reflect a reduction from three cuts to two.  We also see increased likelihood for the long-run median dot to be revised from 2.5% to maybe 2.75%. This outcome would add to dollar strength, generate bearish yield curve steepening and become an incremental headwind for equity markets.

For the moment, two and 10-year Treasury yields remain anchored just below key inflection points of 4.80% and 4.35% respectively. An upside break in either benchmark will likely remind investors of the narrow path to a soft landing and reinstate the negative stock/bond correlation. The impact would be far more acute if an upside break in yields was accompanied by disappointing growth data. Note that February ISM manufacturing and February retail sales were fairly significant recent disappointments. The recent lift in nominal yields followed hotter-than-expected Jan/Feb inflation data. The only way to stay on the path toward a soft landing is to see near-term inflation data cool. February PCE is due next Friday 3/29 but is unlikely to change the narrative around sticky core inflation. Any change in the inflation outlook will likely have to wait for March CPI due on April 10.

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Inside Markets — Central Banks and Treasury Yields

Central Banks and Treasury Yields

March 18, 2024

Markets are being driven by company-specific developments ahead of a busy week of macro catalysts including five central bank meetings. The BOJ is widely expected to increase rates for the first time in 17 years when it meets  tomorrow (or later this evening depending on your time zone). Other central bank decisions include the RBA after the US close, FOMC on Wednesday, SNB on Thursday and BOE also on Thursday. This week also includes housing starts/building permits tomorrow and the Philadelphia Fed manufacturing index/weekly jobless claims/existing home sales and March flash PMIs on Thursday. NVDA’s ability to maintain the AI theme will be tested this afternoon and tomorrow at the company’s GTC conference and AVGO’s ‘Enabling AI in Infrastructure’ event that starts on Wednesday.

Treasury yields are higher with the 10-year testing key levels near 4.33%. Both two and ten-year Treasury yields approaching key inflection points into this catalyst-heavy week. Equity markets have ignored the recent repricing of rate cut expectations up to now as the assumed cause was better-than-expected growth.  However, a sustained break in 2-year yields above ~4.80% and 10-year yields above ~4.35% would refocus investor attention on the equity/bond correlation.

The current benign macro environment includes falling inflation, resilient growth and a near-term Fed pivot (or insurance cuts). This environment is responsible for the current 21x forward multiple on the SPX. Benign macro conditions often result in subdued bond and equity market volatility. Higher bond yields from here, combined with disappointing near-term growth data could threaten the benign macro environment, increase volatility and pressure the forward multiple on the SPX. Higher bond yields and still resilient near-term growth data could also generate SPX downside as investors rotate away from mega-cap Tech into more cyclically-exposed names.

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Inside Markets — Momentum Factor

Momentum Factor

March 12, 2024

Position squaring and hedging coming into today’s data are being unwound this morning as the CPI print came in ‘no worse than feared.’  Make no mistake, a hotter-than-expected CPI report in the current environment is not a bullish development, but market participants also understand there will be four more CPI prints before the Fed is expected to issue its first rate cut at the June meeting.  Today’s rally may also reflect some discounting of the shelter/gasoline components and acknowledgement of the MoM pullback in ‘super core’ CPI.  While the passing of a feared catalyst often generates equity upside, the magnitude of today’s rally is likely influenced by ORCL’s bullish AI commentary.

AI is the dominant theme at the moment and the following catalysts will be important drivers for markets: 1) ADBE earnings (Thursday pm); 2) NVDA CEO keynote at the GTC conference (Monday 3/18); 3) AVGO AI analyst meeting and MU earnings (Wednesday 3/20); 4) MSFT ‘new era of work’ event focused on scaling AI with Copilot, Windows and Surface: (Thursday 3/21); 5) ADBE analyst meeting (Tuesday 3/26); 6) GOOGL Cloud Next conference (4/9-4/11) and; 7) MRVL AI analyst meeting (Thursday 4/11).

ORCL’s positive AI commentary is helping the momentum factor outperform this morning after two days of underperformance. The four main equity factors are momentum, value, low volatility and quality. Momentum is the most dynamic factor with underperformance often preceding a macro-induced change in its composition. The momentum factor is currently led by mega-cap Tech, where indicators suggest crowded positioning in the ninety-ninth percentile. This makes an eventual shift in the composition of the momentum factor the most likely pain trade on the horizon.

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Inside Markets — Russell 2000

Russell 2000

March 1, 2024

US equities are mostly higher with the small cap Russell 2000 (RTY) outperforming large cap indices for a second day.

Yesterday’s inline core PCE print drove a modest rally in equities given the upside surprise in January CPI. January inflation data has skewed higher for the last few years, which suggests trend continuation until investors get a look at February inflation reports. The February Jobs Report next Friday 3/8 is the most important near-term catalyst followed by February CPI on Tuesday 3/12. We continue to expect the broader underlying trend for inflation will be moderating over time, but markets tend to be impatient and near-term data could lead to increased equity volatility.

The RTY is trading above technical resistance near 2070. In our view, the index needs to sustain closing levels above the range before a breakout is triggered. The RTY is a cyclically-sensitive index and we’d like to see any breakout in the RTY confirmed by strength in cyclical cross markets. The EuroStoxx 50 (SX5E) is a cyclical cross market that’s making new highs, but cyclical recoveries are usually led by strength in industrial metals, especially copper. Unfortunately, the price of copper remains ~20% below the recent peak in late-’21 and has been trading sideways for the better part of a year. The relative underperformance of the RTY over the last 6 months has reached record levels and a break above range resistance without confirmation from cyclical cross markets would still trigger a period of mean reversion. The duration would be extended and the magnitude of the move would be greater if it included strength in cyclical cross markets.

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Inside Markets — Holding Pattern

Holding Pattern

February 28, 2024

Markets remain in a holding pattern ahead of tomorrow’s January core PCE print and Friday’s ISM report. Risk/reward into tomorrow’s PCE print may be skewed to the upside given the reflation reset following hotter-than-expected January CPI and PPI reports.

In our opinion, the backup in bond yields that followed a hot January Jobs Report is nothing more than mean reversion in a developing long-term bull market for bond prices.  The backup lost momentum late last week as 10-year yields approached technical resistance near 4.35% and we expect that level to cap the move for the cycle.

The cyclically-sensitive RTY should continue to face selling pressure on the approach to range resistance near 2070.  A break above ~2070 would be a very bullish signal for the broader market and a rare opportunity to generate relative outperformance vs. the SPX.  Unfortunately, a break above ~2100 doesn’t seem likely given negative earnings growth for the RTY, highly restrictive real yields and patient Fed policy.  Relative outperformance in the RTY usually begins just prior to a policy-induced cyclical recovery that often follows a painful recession.  Nonetheless, we respect the collective intelligence of markets with a sustained break above ~2070 and corresponding strength in cyclical cross markets (SX5E and copper/gold ratio) as our signal to add small-cap exposure.

Tomorrow’s core PCE print and Friday’s ISM are important inputs, but next Friday’s Jobs Report is a more significant market catalyst.  The SPX will only keep its 20.5x forward multiple as long as the macro environment remains benign.  Any developments that threaten the benign outlook will result in higher realized volatility (VIX) and a lower forward multiple.

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Inside Markets — Mild Flight to Safety

Mild Flight to Safety

February 20, 2024

US equities are mostly lower as we start the holiday-shortened week with a mild flight to safety.  Tech underperforms as the momentum factor unwinds into NVDA earnings tomorrow afternoon.

Market-based Fed rate cut expectations for FY’24 have declined to ~85bp from ~130bp in early January. This is now pretty close to the Fed’s dot plot, which suggests 75bp of cuts in ’24.  Market-based probability for the first March cut has declined to ~11% from a peak of ~70% in early January. We maintain our expectation for the first rate cut to occur in June based on April core PCE falling back to ~2.2% YoY.

The repricing of rate expectations has yet to be reflected in US equity markets, but that can quickly change. The current 20.5x forward multiple on the SPX is justified as long as the macro environment remains benign and equity volatility remains subdued. Equity volatility as measured by the VIX Index has lifted off cycle lows near 12 (late December) but remains relatively harmless near ~15.7 today. The reacceleration in January CPI and PPI has largely been attributed to seasonal factors as labor-heavy businesses often reset prices at the start of the year. Next week’s core PCE report is expected to show a similar reacceleration. US growth data has remained resilient over the last three months but any near-term disappointments (before February CPI due 3/12) would result in an emerging stagflation narrative and increased equity volatility.  An increase in the VIX above 22 would become a headwind for rally attempts, while a spike above 30 would pressure the SPX below support at ~4800.

The cyclically-sensitive Russell 2000 (RTY) remains below key resistance in the 2000-2100 range after the latest rejection (fourth in >2 years) in late-December. We expect the index will continue to find selling pressure in that range as long as Fed policy remains restrictive late in the cycle. Sustained levels north of ~2070 would be a major surprise with bullish implications for the broad market.

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Inside Markets — Dow Theory

Dow Theory

February 15, 2024

Charles Dow developed ‘Dow Theory’ back in the late 1800s and it still works today – in one form or another.  The central message is that new highs in the Dow Jones Industrial Average (INDU) must be confirmed or led by new highs in the Dow Jones Transportation Average (TRAN) to be considered a healthy, sustainable bull market.  In the late 19th century, the most cyclical stocks were all transportation companies – basically railroads.  That’s still the case today, but we can also use the Philadelphia Semiconductor Index (SOX) as a modern cyclical benchmark.  The SOX is basically leading this rally and is just below last week’s all-time high.  Transports have been strong, but the index remains ~4% below its November ’21 peak. In our opinion, a confirmed breakout in either the TRAN or the small-cap RTY would validate the recent rally and suggest further upside.

A more stable bond yield environment helps equities lift, but we don’t see a material advance until a peak in yields becomes more evident.  Ten-year yields breaking below 4.19% would confirm a near-term peak and should provide support for equity markets.

Market-based rate cut expectations for ‘24 have declined from ~135bp in late January to ~80bp today (Fed dot plot shows ~75bp of cuts).  The rerating started after the January Fed meeting and accelerated after Tuesday’s hot CPI print.  After going through the details, market participants seem less concerned about a second inflation peak, but rate expectations remain anchored by resilient growth data.  The above trend GDP growth seen in H2’23 (~4% real GDP) has mostly continued, which allows the Fed some flexibility on when to cut vs. an environment where real GDP is growing by only ~1%.

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