So the latest FH Stock Watch went out over the weekend.
You can check out the Stock Watch for the specific stocks / REITs I am monitoring (including rough target prices).
I also included a short update on macro views, but I wanted to use today’s article to flesh it out further.
Now I know that we’ve been doing quite a few macro posts recently, but I just think macro will be the dominant theme for 2022/2023, so it’s worth taking the time out to properly discuss this.
Latest insights from Jerome Powell
So a contact of mine in the US met up with Jerome Powell recently.
He shared with me the notes on a confidential basis, and I have summarized the key takeaways below (emphasis mine):
- Powell’s goal has not changed – dual mandate on fighting inflation while maintaining full employment. Target is to achieve 2% inflation in the medium term
- He cites Volcker positively – on how Volcker took tough action to achieve “price stability”, which allowed the US to achieve long term growth for the next 40 years from 1980 to 2020. He talks about Fed’s credibility in doing “whatever it takes” to achieve the 2% inflation target
- He cites Japan negatively – talks about how Japan is stuck at zero interest rates with no room to lower rates to stimulate growth. Whereas the US is now at 4%+ and can easily cut interest rates to stimulate growth if there is a market crash / recession
- Thinks that US real economy / employment is doing well – While a trade-off between fighting inflation and boosting employment may eventually be required, for now there is no trade-off. US employment market is very tight at 3-4% employment, with 1.9 job openings per job seeker. In fact the tight labour market is driving wage inflation, which contributes to inflation (services inflation).
- Believes US inflation is driven by demand factors (eg. pent up demand from COVID, stimulus check driving demand for manufactured goods from Asia), rather than supply side factors (eg. Europe with Energy). While there are supply side constraints in the US, he believes it is in the process of being resolved.
- Fed staff are not forecasting a deep recession – due to (1) strong job market, and (2) strong corporate and household balance sheets. Believes a soft landing / no recession is possible.
- States that Feds will set monetary policy based purely on domestic objectives, and not international considerations / global markets – Fed’s goal is the dual mandate of 2% inflation with “full employment”. Implications of US monetary policy on international markets is not a concern for the Feds and is not part of the dual mandate. That is a question for the Treasury and not the Central Bank.
Does Powell truly believe this, or does he want the market to think that he believes this?
Now you may argue that Powell has to talk tough of course.
As a central banker, he needs to talk tough on inflation.
Failure to do so would lead to market frontrunning him, and defeat the entire purpose of tighter monetary policy.
You may argue that Powell has to be seen to be saying all this, but when the time comes to fold, he will still fold like a cheap suit.
I don’t dispute all this.
But the point that I wanted to make, is that it really doesn’t matter whether Powell believes he is Volcker 2.0 or not.
Because what matters – is that Powell wants the market to believe that the Feds will do whatever it takes to crush inflation, whatever the costs.
The market for now… is not believing him
And therein lies the problem.
Ever since the recent CPI print, market has started to price in the Fed pivot.
The market sees the recent dovish CPI print, and it does not believe Powell.
What we are seeing across the yield curve (since the CPI print), can be summarized as follows:
- Lower rates across the board (and more inverted curve) – Market is pricing in lower interest rates for the next 12 – 18 months.
At the same time the long end has come down much more than the short end, creating a more deeply inverted yield curve (ie. Market pricing in higher recession risk)
- Lower terminal rate – Market is pricing in a lower terminal interest rate
Now this is contradictory because like Powell pointed out, latest US economic data on employment and consumer spending are still holding up well – showing that talks of a US recession are still too early.
So the market pricing in a lower terminal interest rate, with a higher recession risk, does not make sense.
But I digress.
Short Term (4 – 8 weeks)
The problem with the market pricing in the Fed Pivot, is that the US Dollar has weakened, and equity / bond markets have rallied strongly.
This results in a loosening of financial conditions.
In fact we saw many companies rushing to issue debt once the capital markets opened again.
For the Feds on a mission to stamp out inflation, this is counterproductive.
Remember as a central bank, there are 2 ways to achieve your objectives:
- Actually tighten monetary policy – raising interest rates or quantitive tightening
- “Jawboning” – instead of actually raising interest rates, central banks can also talk about what they are going to do. If the market believes them and prices it in, the very act of talking about doing something can already achieve the goal. Ie. Jawboning.
So with the recent loosening in financial conditions, you see a whole bunch of Fed speakers coming out to talk about how there is no Fed Pivot, and how the Feds are firmly committed to bringing inflation down.
A side note on flows (3 – 4 week timeframe)
A separate sidenote from a flows perspective.
Over the past few weeks we’ve seen massive inflows into equities, with about 120+ billion from CTAs alone.
That’s big buying flows, which takes us to the point where buying and selling flows are much more balanced.
Absent any big fundamental news, you might see the rally stall out from here.
But do note this is just for short term 3 – 4 week positioning, and longer term investors can ignore such short term positioning.
Mid Term (6 – 12 months)
To sum up my latest views, I see cycle peak for interest rates as:
- 0% peak for 2 year US Treasury (current 4.5%)
- 5% peak for 10 year US Treasury (current 3.8%)
As you can see, the short end (2 year) is much closer to the terminal rate than the long end (10 year).
But whatever the case, both probably have a bit more to go before cycle peak.
That being said, I think investors obsessing over whether we get a 50 or 75 bps raise in December are missing the point.
The question now is no longer how high we need to go for interest rates, or how quick we get there.
It is how long we stay there.
Base case I think we will be close to 5% on the Fed Funds rate by Q1 or Q2 2023.
I don’t think there is much point in concerning yourself on whether it will be 5% or 5.25%, or on whether we get there by May or June 2023.
5% is already a ridiculous level of interest rates, that will slow the economy.
So the better question is – How long will we stay at 5% interest rates.
My personal views on how long we will stay there?
If the Feds are serious about bringing inflation down to 2%, it might take a while.
US unemployment is sitting at 3.7%.
To seriously bring inflation down to 2%, you might need to bring it up to 5%+.
In a very strong labour market, that will take some time.
Which is why I still think talk of rate cuts are premature.
Before all this is over, Jerome Powell will need to choose between fighting inflation and preventing a deep recession.
For now, the market is expecting him to prioritize the latter, even without clear signs of a recession or unemployment going up.
Which comes back to the point that Powell raised – without a recession or financial contagion, the Feds can simply keep interest rates at 5%, until inflation comes down to 2%.
If there are no painful costs of keeping interest rates up, why would the Feds be forced to cut?
Higher interest rates take some time to work their way into the real economy
At 5% interest rates, any company that is refinancing debt will face a huge shock in higher interest rates.
The longer we stay at 5%, the tighter liquidity will get – making it harder for companies to raise new debt, forcing them to borrow at higher rates.
Interest rate hedges will fall away, and companies / funds will be forced to confront much tighter funding markets – or sell assets into a weakening market, exacerbating liquidity issues.
Private funds are still paying out capital for now. As liquidity tightens, and asset prices start to drop, you’ll start to see these funds shift from capital distribution into capital calls, to plug financing gaps.
Long story short – liquidity is like the tide.
And the tide is going out.
For now you see the damage primarily limited to fringe areas like Crypto and the more speculative areas of financial markets.
But the longer we stay at 5%, the more the liquidity shortage will spread.
Peak of USD is very unclear
Quite a few have asked me where the dollar is headed from here, and where is the USD peak.
Really, that’s the million dollar question.
The timing for the USD peak this cycle is still very unclear for now.
And that’s the big wildcard here.
I know many “Experts” on Bloomberg are saying the peak for the Dollar is behind us.
But don’t be fooled.
Where the dollar peaks this cycle is an incredibly tough call, and anyone saying USD has peaked for certain is just understating the complexity of this call.
The truth is no one knows, not even Powell himself.
My personal view – 2023 is going to be wild
So… 2023 is shaping up to be an absolutely wild year for financial markets.
Long only Investors
If you’re a long only investor, I would be holding elevated cash positions.
I myself am holding about 60% cash right now (as a proportion of liquid, investible assets – excluding real estate etc). But exactly how much cash to hold – only you can figure out for yourself.
I don’t deny that for long term investors, some parts of the market are trading at interesting valuations.
Energy, commodities, energy services, some names in tech / REITs, China stocks etc are interesting.
But the fact remains that macro risk and uncertainty remains high.
If you’re long term patient capital, and you don’t mind holding long term or being underwater in the short term, sure you can start deploying some of it as valuations are getting attractive.
You see value investors like Warren Buffet starting to deploy his capital, something he hasn’t done in size for a while.
But even the guys like Warren Buffet are still holding significant cash, to capitalize on any further market downturn if it comes.
Don’t forget that as a retail investor, you always have the option of putting cash into risk-free T-Bills at 4%+.
In a climate like that, the hurdle rate for any new investment becomes very high, and the urgency to deploy capital much lower.
Don’t buy a dull market
There’s a good saying that in a bull market, don’t sell a dull market.
And in a bear market, don’t buy a dull market.
Because In a bull market when the broader trend is up, you want to buy dullness, because the market is simply preparing for a move higher.
In a bear market when the broader trend is down, you don’t want to buy dullness, because the market is simply preparing for a move lower.
For traders who are short, I don’t need to remind you that the biggest rallies come in a bear market.
Protect capital, don’t get greedy, and have good risk management in place.
You can get the call right, but still lose money due to poor risk management.
What about interest rate sensitive sectors?
Been getting some questions on my view on interest rate sensitive sectors like real estate and technology.
Simple view is that these sectors thrive in a low inflation, low economic growth, low interest rate climate.
So the past 10 years was an absolute godsend for these 2 sectors.
Moving forward, if I am right, many of the structural tailwinds will reverse.
We may see higher inflation, higher growth (although much may be due to inflation), higher interest rates.
Just to be clear I’m not saying inflation will stay at 8%, I’m just saying that it may never return to the pre-COVID days of sub 2% inflation.
Can real estate / technology do well in a climate like that?
Yes of course, you can still outperform by:
- Picking names that perform well from an earnings perspective
- Buying when valuations are cheap
But this becomes a very different game from the past 10 years where you just buy the sector, and let the tailwind of low interest rates power the growth for you.
You need to be much more selective about what / when you buy, when buying into an industry without the tailwinds on your side.
Which sector has the tailwinds?
In a higher inflation, higher rates world, I suppose the sectors that benefit will be those that have strong real world cash flows.
Think financials (banks), commodities, industrials etc.
The boring, real economy value stocks.
Investors don’t differentiate from where growth is coming from.
A consumer goods company like Unilever that can raise revenues 10% a year simply by raising prices – that looks the same as a tech company growing revenue 10% a year through market share growth.
In a higher inflation world, growth becomes much more abundant.
And the limiting factor becomes one of liquidity / capital, not growth.