We entered the year with an outlook for the Fed to become “inflation fighters” for the first time in a long time. It didn’t take long, with the turn of the calendar for the regime shift (from easy money to tighter money) to become evident in markets.
This has translated into a deflation of the “companies of the future” bubble.
And for those spots, particularly the no earnings companies, the air continues to come out. The portfolio managers with long-term 30-year visions for these companies, are finding out that the term of their vision doesn’t match the term of the capital they are managing (i.e. redemptions).
With that, we see constant selling pressure in the small cap indices, since the start of the year, that looks consistent with forced liquidations. In these cases of forced liquidation, investors tend to sell what they can, not what they want to. And that can carry over to other segments and asset classes in markets.
In these environments, there will be the “baby thrown out with the bath water” situations. It presents an opportunity to buy quality, cash flowing companies at a discount.
They had already guided to an end of QE by March. And given that Jay Powell told us back in December that they wouldn’t start the liftoff on rates until they concluded their bond buying program, we could deduce that March could be the earliest they would move on rates.
On that note, the markets in the past month have priced in that scenario (a March hike). Powell confirmed that today. The other piece of the “tightening” plan, shrinking the balance sheet, has been telegraphed to come in the summer. Nothing was said today to change that course (probably June).
So, if no surprises, why the violent reaction in markets?
The Fed has a good record of managing stability through manipulating expectations on the policy path. On the latter, Powell was sloppy in his press conference (maybe on purpose). He created a gap between what the Fed has been guiding and what he expressed (in words) as a reality.
Keep in mind, the Fed continues to fuel the inflation pain through QE and zero rates, until March. Yet, Powell expressed how inflation was hurting people’s ability to afford basic needs. And he said it has gotten “slightly worse.” Add to that, he said that affordability will become more painful, as fiscal is no longer stimulative and price pressures from supply chain constraints will persist — into next year (according to Powell).
Is he setting us up for a more aggressive path? He should be. Remember, unlike the “taper tantrum” of 2013, the policy error this time isn’t removing emergency policies prematurely. It’s a Fed that has been/is too late.
Last week, we talked about the unwinding of some bubbly assets.
It got uglier today. And then it got better.
Let’s talk about what’s going on …
Remember, we have over 40% growth in money supply in less than two years. That’s a lot of excess money in an economy, chasing a relatively stable quantity of assets. When this happens, you get inflation, and you get irrationally allocated money. This can tend to result in money over flowing good assets, and being pushed to lower quality assets.
Much like the dotcom bubble, and the housing bubble, we again have seen this dynamic of irrational investment. The time of reckoning is here. In this case, it was the overly aggressive Fed and Government response to the pandemic that created the liquidity deluge, and the resulting excessive investment. And now it’s the ‘change in direction’ of those policies that is ending it.
The prospective path of rising interest rates, is already putting downward pressure on valuations. With that, some selling can quickly turn into more selling, which can turn into forced selling.
We’ve talked over the past two weeks about forced selling of overvalued, under-earning tech companies in the famed ARKK Funds. That was the “canary in the coal mine.”
Here’s the good news: After the selling today became broad, markets recovered. And value stocks led the way. This signals that money is not running away from the stock market, it’s simply moving (from overvalued, to undervalued). That’s very positive.
Still, some think the decline in stocks to start the year may influence the Fed’s current path of monetary policy. That’s highly unlikely. Back in 2016 and 2018, a falling stock market caused the Fed to do an about-face on its plans for hiking rates — but the economy was weak and fragile, and inflation was soft.
This time, the Fed is dealing with a 5%+ growth economy, and 7% inflation. They won’t be altering the path. That said, Jay Powell would be smart, in this Wednesday’s post-FOMC press conference, to make it uneventful (i.e. give markets nothing new to chew on).
Yesterday we talked about the vulnerability in bitcoin. And we looked at this big trendline.
This line broke today. Bitcoin was down 10%.
As we discussed yesterday, an unraveling of the private crypto bubble would be powerful enough to create some waves in broader markets. And we may have had a catalyst for it, with the Fed’s release of its Central Bank Backed Digital Currency report yesterday (i.e. the CBDC, a potential private digital currency killer).
On a related note, remember we looked at this chart below last week, which shows the relationship between the bets on the “companies of the future” (Cathie Woods’ ARK Funds) and the “money of the future.”
Both ARKK and Bitcoin have been investments that have been based on qualitative theories about the distant future — with valuations driven by the gush of liquidity (monetary and fiscal),rather than fundamentals. The liquidity spigot is now closed, and these trades are being unwound.
It’s probably no coincidence that the top in the Nasdaq (highly valued tech) and the top in Bitcoin came in the second week of November.
That was when it became clear that a change in the direction of both fiscal and monetary policy had arrived. Just over the course of a few days (in November), the Fed’s stated condition for rate liftoff was seemingly met (with a booming job report) and Congress passed the $1.2 trillion infrastructure bill.
This change in direction from easing to tightening is a signal for value stocks to outperform growth, which is underway. And historical studies suggest this value stock outperformance can hold for the next decade. It’s a buy the dip — on value.
The Fed released its report on a digital dollar this afternoon. Stocks had been in rebound mode for much of the day, but went south when the report hit.
The Fed was due to deliver this report, on the viability of a central bank-backed digital currency (CBDC), back in September. It never happened.
And throughout this period, when Jay Powell was being scrutinized for re-nomination, the Fed Chair carefully avoided taking a position on it. His talking point has since been, that it will be a decision made by all stakeholders (namely, Congress). Today’s report said the same.
On that note (a decision for Congress – those in power), we have some clear direction. They want it. And they want to kill private digital currency. Remember, back in June, Elizabeth Warren held a hearing on this. Warren made it clear that a central bank-backed digital dollar would “help drive out bogus digital private money (bitcoin, stablecoins, etc.).“
It’s not only U.S. officials that may be challenging the rise of private money. Just as the “build back better” and clean energy transformation is an agenda highly coordinated by major global economic powers, so is the concept of CBDCs. The BIS (Bank for International Settlements) consists of 63 global central banks, and nearly 90% of them are having conversations about adopting a CBDC.
With the drop of this new report today, Bitcoin swung from a positive day, to close down, and on the lows. And as you can see in the chart above, the future of bitcoin mania may hinge on this big trendline.
Why would stocks get hit on this currency report? Maybe it was just an additional catalyst in a market that has already been unwinding overvalued/bubbly tech stocks. And now we may see an unwinding of a bubble in private crypto.
The former, has been orderly, with money moving from growth to value stocks. The latter may create some waves.
Nonetheless, the technical picture in the big stock indices became considerably uglier by today’s close.
As you can see, the S&P 500 has clearly broken the big trendline from election day, and is testing the 200-day moving average (the purple line).
The support has already given way in the Nasdaq.
This brings us back to the discussion we had yesterday, on the Fed meeting next week. Through the post-financial crisis era, the Fed’s hand was forced, more than once, by instability in stocks. As we discussed yesterday, we should not expect the Fed to react, in this environment.
But, more pain in stocks from here would likely get a fiscal response. We’re already seeing some signs that “Build Back Better” will be carved up and done in pieces. I suspect we would see a deal like that, where the clean energy piece (wish list), was approved. My view: That would be the shock absorber for markets, if needed.
We are a week away from the Fed’s first meeting of the year, and as it stands, they will be contemplating a 10-year yield that has gone from 1.45% to 1.90% since they last met (a month ago!).
And that has translated into a sliding stock market: Rates up, lower valuations on the high growth (especially no EPS) stocks.
The Nasdaq index, full of the much-loved “companies of the future,” is down 8% to open the year.
The question is, what would make the Fed balk on the guidance it’s given to exit emergency policies?
It’s a question that markets have been conditioned to ask. After all, we’ve seen an about-face more than once from the Fed, in the years emerging from the financial crisis. Lower stocks has equated to a Fed response (a lifeline).
Consider this: They began rate liftoff in December of 2015, with the guidance of four rate hikes through 2016 — only to pause, and return back to damage control just a month after the first hike.
Will it happen this time? The short answer is, no.
As we discussed yesterday, the policy error from the Fed emerging from the financial crisis, was acting too soon. The policy error now, is acting too late, too slow.
We can see the difference in these two environments through the sector performance in this recent decline in stocks. In a sea of red (from the sector level), financials and energy are green on the year. Energy is up, as a result of undersupply in a hot economy with hot demand. And financials are up, as a supplier of credit, winning from a hot economy and prospects of more profitable lending. Bottom line, post-financial crisis is not an analog for post-pandemic.
Of course, an easy differentiator is the $5 trillion in new, excess liquidity added to the system over the past two years. That has slowly turned the tide in what has been a long bear market in commodities, into a young secular bull market in commodities.
With that, let’s revisit this chart we’ve looked at many times in my Pro Perspectives notes … the commodities/stocks ratio.
As you can see, commodities are coming out of a roughly 12-year period of significant underperformance, relative to stocks. In fact, commodities haven’t been this cheap, relative to stocks, in 50 years.
Back in December, we talked about the potential for the Fed to start moving on rates by March.
Just 30 days later, and the market has gone from a 30% chance to about 90% chance we will see liftoff … in March.
Also back in December, we looked at past tightening cycles, and we talked about the prospects of the Fed moving in 50 basis point increments, instead of 25 basis points, as markets are expecting. After all, with the latest inflation reading of 7% and the Fed Funds at near zero, the Fed is way, way behind. The longer that gap persists, the more the inflation situation is left to intensify.
Again, if we look back at the past five tightening cycles by the Fed (’87, ’94, ’99, ’04 and ’15), the Fed has averaged about 50 bps a quarter.
With the above in mind, over the weekend, billionaire investor Bill Ackman said this …
Add to this, the Wall Street Journal ran a piece this afternoon quoting a former “top Fed staffer” as saying that the Fed needs to start preparing markets for the possibility of a 50 basis point March hike.
Just like that, the rate outlook is looking quite different. And the events of the week ahead should only exacerbate it:
First, we’ve talked about the impact of rising oil prices on inflation. Though the Fed likes to pretend it doesn’t get too worried about “volatile oil prices,” history suggests they do worry, and they tend to act when oil prices are making big adjustments (up or down). On that note, oil broke out to $86 bucks today. That’s a 7-year high and up 62% over the past twelve months. The Fed should be worried.
Secondly, we get Q4 earnings from 35 S&P companies this week. As we discussed in my Friday note, we should expect to a lot of chatter about labor costs. Already, to kick off the week, Goldman Sachs took a chunk of money that could have (should have) gone to shareholders, and disbursed it to partners and employees (“wage pressure”). The Fed should be worried.
This all raises the specter of inflation pressures, and therefore underpins the prospects for a more aggressive rate outlook. In the short term, that is driving the continued unwind of positions in high growth, high multiple stocks.
Still, unlike the taper tantrum of 2013, where stocks sold off on a Fed that was prematurely removing emergency policies in a slow-growth/low inflation/fragile economic recovery, in this environment the bigger risk to stocks is a Fed that is moving too slowly to remove emergency policies. A more aggressive Fed should be a welcome force for market and economic stability.
In my July 2020 Pro Perspectives note, I said “with the Fed absorbing all credit risk, and flooding the country with money, the banks are profit printing machines.”
With that in mind, three of the big banks reported on Q4 this morning, kicking off Q4 earnings season. All beat earnings estimates, again (as they have throughout the pandemic environment). All are buying back stock.
For the full year 2021, Wells Fargo made $21.5 billion (net income). Citi made $22 billion. JP Morgan made $48 billion.
Combined, that’s better than the total economic output of 70% of the countries in the world.
So the banks win in crisis, as policy makers intervene to backstop risk.
And the banks win in recovery, as a tight labor market and strong consumer and business balance sheets lead to hotter demand for bank products — add to that, rising interest rates, where banks benefit more profitable lending spreads.
That said, bank stocks remain cheap. Against last year’s earnings JP Morgan trades at a P/E of 10. Wells Fargo at a P/E of 11.8, and Citi at a P/E of 6.6 (the cheapest of the big banks). Compare that to a broad market P/E of 29.
What’s showing up early in the earnings calls? Last year it was the supply chain disruption and inflation. This year it’s labor costs.
With that, a bigger move in wages is coming this year.
Few are more in tune with the economy and political agenda than Jamie Dimon (JPM CEO), and he said today that they are willing to squeeze margins in the name of pay. And he also sees a far more aggressive Fed this year than is anticipated (he thinks 6 or 7 hikes).
The SCOTUS decision on the Biden vaccine mandate for the private sector was a huge hurdle cleared today. This should bolster an already tight employment situation.
And with that, we may see the upward pressure on wages pickup. The wage reset has already happened at the low end. The higher earners are next, and are well positioned to command higher wages.
Hotter wage growth will only add fuel to the inflation fire.
With this, the inflation situation and (consequently) the interest rate outlook haven’t been a good formula for the high multiple tech stocks.
On that front, let’s take a look at a victim of this environment, and a potential destabilizing force to keep an eye on for markets: Cathie Wood’s infamous ARK ETFs.
As you likely know, she has been a financial media darling (likely thanks to a well compensated PR agency), as a leading investor in the “companies of the future.” Just a year ago, she had amassed more than $60 billion in ETF assets. It’s since been cut in half.
As the tide is going out on the growth trade, people are realizing that the structure of an ETF isn’t a fit for a private equity-like investment process.
What does that mean? The ARK ETFs give intraday liquidity to investors investing in long-term structural themes. It’s a mismatch. And that can create forced buying when things are going higher (over inflating some of these tech stocks, as we’ve seen), and forced selling when things aren’t working (which can spiral to the downside).
We’re seeing the latter. As you can see in the chart below (the orange line), some of the excess from the “companies of the future” has been rapidly unwinding. And as you can also see, it may be a bad influence on the “money of the future.”
On Friday we talked about the set up for a dollar decline, to reflect 1) U.S. government spending recklessly beyond a rational crisis response, and 2) a Fed that denied the inflationary impact of such a fiscal response for too long.
And we looked at the long term cycles for the dollar. We are about 70% of the way (in time) through a very shallow bearish cycle, which argues that we could have a very steep drop in the dollar over the next two years.
With that in mind, we looked at a shorter term chart of the dollar yesterday. The dollar looked vulnerable to a break-down (lower).
Here’s an updated look…
Indeed the dollar broke to two-month lows today – and it looks like this technical break will get the ball rolling.
This comes on a day when the inflation report showed a 7% year-over-year increase in prices (the highest in 20 years).
With that, notice in this chart the clear trend in CPI, and where it started in March of last year.
I focus on March of last year, because that’s when the word “transitory” started showing up in the Fed lexicon. Clearly, they were wrong.
As important, that language gave the politicians on Capitol Hill the cover of a “no inflation problem” to push through another $1.9 trillion in spending, a $1.2 trillion “infrastructure” package, and advance the dangerous (and massive) clean energy and social agenda spending plan, which finally fell flat, ONLY when Jay Powell did an about face on the inflation view.
Bottom line: The dollar may be in the early innings of paying the price for the monetary and fiscal policy errors of the past year.
