“Otherside”

Otherside NewEdge Wealth Weekly Summary
October 14, 2022

Weekly Summary: October 10 – October 14, 2022

Key Observations:

  1. Turmoil in the UK continued to have “spillover” effects to many financial markets, including U.S. bond markets, which in turn affected U.S. equities and currencies.
  2. This week’s financial markets volatility was a rather clear illustration of the need to try to determine what assumptions are “priced in” to financial assets.
  3. We believe that many components of official U.S. inflation data are lagging indicators. The prime example of this is shelter costs, which lag many private market surveys of the current state of rental markets.
  4. The Federal Reserve (Fed) appears “anxious” to get to the “otherside” of inflation – a “compelling” trajectory of lower inflation to its targeted 2% level and a more restrictive level of the federal funds rate.

The Upshot: Our general investment approach remains the same as depicted in last week’s commentary. We maintain our preference for big cap high quality stocks with good balance sheets, relatively stable cash flows and stable margins. Volatility across sectors continues to be supportive of a well-diversified portfolio for long term investors. On a selective basis, we remain favorably disposed towards energy, health care, financials and growth stocks – including selected high quality tech stocks. For those so inclined, the 10-year Treasury bond could be an attractive hedge in a diversified portfolio for the possibility of a U.S. recession. In our opinion, it appears that the Fed will push the federal funds rate to a higher than necessary rate before it pauses its rate hikes. The Fed has not exhibited any patience in waiting for its tightening monetary policies to work their way through the system. We also believe that many official inflation indicators are lagging in their showing of decelerating selective inflation trends.

We were convinced that at the low opening prices on Thursday after the unexpectedly high Consumer Price Index (CPI) was released, the risk/reward was compelling to purchase U.S. equities for at least a significant bear market rally. It was a confluence of many factors that led us to this conclusion. We highlight many of these factors in our commentary this week. Many of these factors helped us decipher what was priced into financial markets. The 10-year Treasury’s yield ability to remain at or below 4% was a critical component of our conviction. The equity rally appeared ready to extend into Friday with the help of many better-than-expected earnings reports from some major U.S. banks. But the turmoil in UK financial markets and the upward reversal of its gilt (UK government bonds) yields precipitated U.S. Treasury yield to rise as well, which led to a decrease of U.S. equities and an increase in USD. In our opinion, the bond markets continue to be the catalyst for most financial market movements. Origins of market surprises should remain unpredictable. Global financial markets are very interconnected. We suppose that illiquid and volatile markets could be the source of more surprises.

We assume continued volatility across virtually all financial markets. We maintain our belief that selective stock picking will continue to play a critical role in outperformance. Seasonal factors could also affect financial markets’ behaviors. We anticipate that downward revisions ibn Q3 results could further pressure equities.

 

Getting to the “Otherside”

Financial markets continue trying to anticipate when we get to the “otherside.” When we view financial markets through this perspective, we are reminded of Red Hot Chili Peppers’ song “Otherside.” “How long, how long will [equities] slide?” Like many investors and analysts, we try to look forward in our assessment of economic data and financial market dynamics. “Once you know you can never go back; I gotta take it on the other side.” We interpret the “otherside” as when inflation has a “compelling” trajectory to the Fed’s 2% inflation target and when the Fed “pauses” its hikes in the federal funds rate. The path to this side has proved to be a very treacherous and winding path for consumers, businesses, government officials and financial market participants. We have highlighted previously the interrelationship between relatively low liquidity in many financial markets and volatility. Extreme volatility in this environment has raised our concerns about potential market dislocations and financial stability. As we have underscored in our last two commentaries, the precise manifestation of a market dislocation should prove very difficult to predict. But we expect that rapidity of change to continue being a hallmark of our current environment that started with the pandemic, and that was exacerbated by the Russia-Ukraine war and the ramifications thereof.

 

Spillovers from UK Turmoil

The UK government announced on September 28 a new fiscal plan promulgated by its new prime minister Liz Truss. This new fiscal plan included unfunded tax cuts. Since that date, there have been extreme price movements in the British pound, as well as long dated gilts – UK government bonds – and their yields, especially 10-year and 30-year gilts. As we have summarized in our last two commentaries, the Bank of England (BOE) felt compelled to attempt stabilizing gilt yields and the British pound by a temporary “financial stability” program whereby it would buy mostly 30-year gilts to lower their yields. The BOE warned of “material risks” to UK financial stability: “Dysfunction in this market, [long dated gilts] and the prospect of a self-reinforcing ‘fire sale’ dynamics pose a material risk to UK financial stability.” The BOE’s actions were meant “to restore orderly market conditions by temporarily absorbing the selling of … gilts in excess of market intermediation capacity.” This week, BOE extended the purchase program to include certain inflation-linked bonds. The extreme and rapid moves in these UK yields exposed UK defined benefit plans that held Liability-Driven Investments (LDI’s) to the risk of default. Many of these LDI’s were bought on margin and were supposedly within hours of default before the BOE acted to stabilize the yields. Many smaller UK pensions held their leveraged LDIs in pooled investments with others. The BOE reiterated that this special purchase program would end this week and that it would not be extended. The BOE urged those holding at risk leveraged LDIs to take advantage of BOE’s bid for these securities and sell this week. The Wall Street Journal reported on October 11 that some U.S. collateralized loan obligations suffered a downturn in their prices as some UK pensions sold these securities to raise needed cash. This was a noted “spillover” effect of the British crisis. On Thursday, media reports surfaced that the Truss government was considering undoing at least part of its tax cut plans. In pre-market trading before the September U.S. CPI announcement, gilt yields dropped significantly and the pound appreciated against The U.S. dollar (USD). With the UK crisis apparently “solved,” U.S. Treasury yields traded lower, equities traded higher and USD was lower as well. The slightly larger-than-expected U.S. initial jobless claims and continuing claims were announced at the same time Thursday morning as the CPI announcement. These all-but-ignored claims data indicated a slightly less tight labor market – supposedly “good” news for financial markets.

 

More UK Turmoil on Friday

On Friday, Liz Truss fired her finance minister Kwasi Kwarteng and scrapped parts of their tax cut package. Truss admitted that her proposals had gone “further and faster” than markets would accept. She added: “We need to act now to reassure the markets of our fiscal discipline.” According to a Reuters October 14 report, Truss was in a “listening mode” and “consulting lawmakers to gauge which parts of the programme they would support in parliament.” With no clear new plan proposed by Truss, financial markets were losing confidence in the UK government and its ability to deal effectively with the current crisis. In reaction, the British pound traded lower versus USD and both the 10 and 30-year gilt yields gained over 30 basis points (bps) as they reversed from lower to higher yields on the day. U.S. Treasury yields also reversed from lower yields to gains in yields on the day, as the 10-year yield once again slightly exceeded 4%. Spillover effects from the UK were clearly on display. The downturn in U.S. equities on Friday also was a clear illustration that bond yields continue to be the driving force behind equities as well as currencies.

 

Stronger than Expected U.S. PPI

In our opinion, the UK crisis and BOE’s actions in response, as well as UK interest rates and currency moves in reaction to BOE’s actions, were all instrumental in leading up to Thursday’s CPI announcement and the market’s reaction to that data. We also considered the stronger-than-expected U.S. September Producer Price Index (PPI) data announced the prior day and financial markets’ reactions to that data to be critical factors in Thursday’s market action. Both the headline and core PPI measures exceeded expectations. According to the Bureau of Labor Statistics (BLS), two-thirds of the monthly rise in PPI was attributable to the 0.4% increase in services. Other than the 1.2% month-over month (m/m) gain in food prices and the 0.7% increase in energy prices, the goods component of PPI was relatively flat m/m. We viewed the rather muted financial markets’ reaction to the stronger-than-expected PPI data as a relative positive sign for markets – U.S. equities were lower marginally, the U.S. dollar index (DXY) was little changed and U.S. Treasury yields traded lower. In general, when equities don’t trade significantly lower on “bad” news, we understand that most of the “bad” news is already reflected in prices.

 

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Source: JP Morgan, US: PPI beats expectations but has softness on core goods (10-12-2022)

 

Market Reaction to Selected Earnings Reports

Prior to the release of latest CPI data, we also were encouraged by markets’ reaction to a few earnings announcements. Principal among these was Applied Materials, Inc.’s (AMAT) very muted lowered stock price in reaction to its lowered Q4 guidance. Earnings per share (EPS) guidance was lowered from the expected EPS of $2.02 to a range between $1.54 and $1.78. We surmised that most of the “bad” news was therefore already reflected in AMAT’s stock price. Additionally, we were also impressed by the markets’ very favorable response to better-than-expected earnings reports from Delta Air Lines, Inc. (DAL) and Walgreens Boots Alliance, Inc. (WBA). We appreciated that the very favorable stock price reaction is a strong indication that “good” news was not reflected in these companies’ stock prices and that their prices reflected too much pessimism. Again, all of these reactions were prior to the CPI announcement. On Friday, favorable earnings reports from JP Morgan Chase &Co. (JPM), Wells Fargo & Co. (WFC) and Citigroup Inc. (C) all were met with a favorable market price reaction in each case. In contrast, Morgan Stanley missed expectations and saw its stock price trade lower in reaction. All of these stocks had substantial gains the day before. Morgan Stanley roughly gave back its prior day’s gains.

 

Role of Hawkish Fedspeak in Market Expectations of Inflation

We also thought that recent very hawkish Fedspeak we summarized in our commentaries, along with the expected hawkish minutes of the FOMC’s September 20-21 meeting, was instrumental in setting the stage for an expected very “strong” CPI report. Fedspeak continued to be very hawkish this week. Perhaps most notable were the Cleveland Fed president Loretta Mester’s comments. On October 11, she indicated that the Fed yet had to make a dent in inflation and that there has been “no progress on inflation.” She also indicated her dissatisfaction with the Fed’s path. “I don’t think it’s aggressive relative to where inflation is and how fast inflation has moved up.” She added that “there is no evidence that there is disorderly market functioning going on at present.” Charles Evans, head of the Chicago Fed and a nonvoting member of the FOMC, remained steadfast in his commitment to fighting inflation as the Fed’s top priority – even if that meant job losses. Vice chair Lael Brainard was somewhat more measured than most of her Fed colleagues. Although Brainard remained committed to maintaining restrictive rates for some time, she was also cognizant of attendant risks. She stated that “concurrent rate hikes by central banks [CBs] abroad as they all fight local outbreaks of inflation was creating an impact larger than the sum of its parts” that posed potential risks that U.S. officials needed to monitor. Brainard continued to recognize evolving risks, including possible stress in financial markets. She acknowledged that globally, “uncertainty remained high” and that a sharp shift in sentiment “could be amplified, especially given fragile liquidity in core financial markets.” We see most of the recent hawkish Fedspeak as supportive of markets’ expectations of a strong CPI report.

 

Role of Hawkish FOMC Minutes in Market Expectations of Inflation

As we stated above, we viewed the FOMC minutes released on Wednesday as hawkish in line with expectations, and as having little or no impact on financial markets. The minutes indicated that Fed officials have been surprised at the pace of inflation. As a result, Fed officials noted that with inflation “showing little sign so far of abating … they had raised their assessment of the path of the federal funds rate that would likely be needed to achieve the Committee’s goals.” Fed participants noted the housing market downturn and the easing of some supply bottlenecks, but also that “constraints on production were increasingly taking the form of labor shortages rather than parts shortages.” Fed officials remained focused on the need for labor markets to “soften” in order to “ease upward pressures on wages and prices.” But they observed that at least some businesses might be less willing to reduce their workforce as the economy slowed due to the challenges in hiring. Several participants noted that tightening monetary policies of many other countries could also affect financial markets and economic growth and could have “spillover” effects into U.S. markets. In light of this, several participants noted that “it would be important to calibrate the pace of further policy tightening with the aim of mitigating risk of significant adverse effects on economic outlook.” Participants reiterated their commitment to maintaining a “restrictive” policy stance for some time. But they also indicated clearly when they might contemplate cutting rates. “Many participants indicated that, once the policy rate had reached a sufficiently restrictive level, it likely would be appropriate to maintain that level for some time until there was compelling evidence that inflation was on course to return to the 2 percent [inflation] objective.” Although most participants acknowledged that interest rate sensitive sectors, such as housing and business fixed investments, had started to respond to tightening financial conditions, “a sizable portion of economic activity had yet to display much response.” Participants also acknowledged that “a significant reduction of inflation likely lag that of aggregate demand.” Many participants made clear their preference for erring on the side of hawkishness as they “emphasized that the cost of taking too little action to bring down inflation likely outweighed the cost of taking too much action.” We regard these minutes as supportive of strong CPI report expectations.

 

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Source: Goldman Sachs, US Daily: An Encouraging Week for Labor Market Rebalancing (10-8-2022)

 

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Source: Goldman Sachs, What’s Top of Mind in Macro Research: US progress towards a soft landing, bleaker equities outlook, China’s 20th Party Congress (10-12-2022)

 

Consumer Inflation Expectations

Although we think that the New York Fed’s latest consumer expectations survey released this week had little, if any impact on this week’s trading, we still maintain that it is important to understand whether consumers’ inflation expectations are well “anchored” as well as their spending plans. Consumers’ one-year inflation expectations decreased to 5.4% in September from an expectation of 5.7% in August. The September reading was the lowest in one year. One-year inflation expectations peaked at 6.8% in June. The three-year inflation outlook increased to 2.9% versus the 2.8% expected in August. Five-year inflation expectations increased 0.2% to 2.2% in September. We consider these readings as indications that consumers’ inflation expectations are well “anchored.” Expectations for household spending over the next year decreased from August’s reading of 7.8% to 6% in September. This represented the biggest one-month decline in the survey’s history and was the lowest reading since January. The preliminary University of Michigan’s (UM) October consumer sentiment index was released Friday and seemed closely aligned with the New York Fed survey. One year inflation expectations in the UM survey increased to 5.1% from its previous reading of 4.7%. Last month, long run inflation expectations fell below the 2.9% – 3.1% range for the first time since July 2021. This month they rebounded back to 2.9%.

 

Stronger than Expected September U.S. CPI

We feel that we can now turn to the very strong September CPI numbers announced on Thursday. Headline CPI increased 0.4% m/m versus a 0.3% expected growth for the month and a 0.1% increase in August. The y/y growth rate was 8.2% versus 8.3% for August and the June peak of 9.1%. The core CPI (excluding food and energy) rose 0.6% m/m compared to an expected monthly increase of 0.4%, and rose 6.6% y/y compared to a 6.3% gain in August. This was the highest y/y reading since 1982. Increases in shelter, food and medical care were the largest contributors to the headline readings. The energy index was 2.1% lower m/m versus 5.0% lower in August. The September energy index included a 4.9% m/m decline in gasoline prices. The food index rose 0.8% m/m, matching the increase for August, and medical care costs rose 1% m/m. Core services rose 0.8% m/m, which was its largest monthly gain since 1982. But perhaps the most troublesome core inflation component was that for shelter costs. Shelter costs make up about one-third of overall CPI and roughly as much as 40% of core CPI. The rent component of shelter costs rose 0.84% in September versus 7.4% in August. The owners’ equivalent rent (OER) component of shelter rose 0.81% in September and increased 0.71% in August. We view this CPI report as a very strong inflation report. We find the core and services components especially troublesome. However, as we have highlighted in our previous commentaries, the official government figures of shelter costs lag many of the more-up-to-date private surveys of rental trends. Based on data reported by Zillow, J.P. Morgan observed on October 13 that rent inflation should moderate but may not be reflected in CPI shelter data for at least several months. Also on October 13, Realtor.com indicated that its September rental report showed that rental growth continued to “cool” as it slowed to a single-digit growth rate for the second consecutive month. The 7.8% y/y growth rate of rents was the lowest growth rate in 16 months. Realtor.com sees that as a “more typical seasonal cooling is returning to the rental market.”

 

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Source: JP Morgan, US: And yet another upside surprise for the CPI (10-13-2022)

 

Dramatic Equity Market Reversal in Response to CPI Data

The higher-than-expected CPI September data initially had the expected market reaction – severe U.S. equities downturn, higher Treasury yields and a higher USD. The S&P 500 was down initially over 2% and closed over 2% higher. This was the largest intraday range in the S&P 500 since March 2020. We were convinced that the initial financial markets’ reaction presented a compelling risk-reward entry point to purchase U.S. equities for at least a significant bear market rally. It was the confluence of all the factors discussed above that led us to this conclusion. We also surmised that most market participants were assuming a strong CPI number and had positioned their portfolios accordingly. Market “sentiment” was very gloomy as well. Additionally, we also suspected that a more favorable aspect of seasonal patterns was about to “kick in.” October has been historically the most volatile month, and typically has rebounded from low levels. A critical component of our conviction that the opening prices of many equities presented compelling buying opportunities was the ability of the 10-year Treasury yield to hold roughly the 4%-level and then to trade lower. The ability to hold this level contained the USD ascent and then precipitated its downturn. We believed that prior to the CPI report, many indications enumerated above were positioned for an equity rally. We understood that most of the “bad” news was already factored into market prices. We, along with many financial market participants, anticipated a strong CPI number. The severe equity downturn merely presented a compelling risk-reward opportunity to buy into a significant equity rally. For the time being, we are assuming that this will be a bear market rally. Incoming economic data and a less-hawkish Fed could change our views. In the meantime, during his CNBC appearance on Thursday, Paul Hickey of Bespoke investment Group commented that the S&P 500 reversed from at least a 2% decline to at least a 2% gain on only three prior occasions – once in 1997 and twice in 2008. On all three occasions, the S&P 500 was positive both after one week and one month. Admittedly, this is a very small sample.

 

Bottom Line

For the time being, we are maintaining our basic investment approach as expressed in last week’s commentary. We continue to prefer high quality big cap stocks that offer good balance sheets, as well as relatively stable cash flows and profit margins. A well-diversified portfolio for long term investors will be most likely the preferred approach.

We assume continued volatility across virtually all financial markets. We would only buy selected stocks during market downturns. We remain concerned about relative illiquidity in many financial markets. We remain focused on the many ramifications of the sharp appreciation of USD relative to many currencies. We are apprehensive over the possibility of a financial market “dislocation” attributable to extreme volatility and relative illiquidity. We remain wary of a “loop” developing between illiquidity and volatility.

We remain hopeful that the 10-year Treasury yield will be constrained at roughly the 4% level. We would become somewhat less inclined to buy equities on downturns if this yield were to rise substantially above the 4% level. This would be especially true for growth stocks. The UK turmoil has put a spotlight on potential spillover effects from other countries. In our opinion, the bond market continues to be the principal driver of many financial markets. We will continue to monitor financial market reactions to various types of news and changing assumptions in an effort to decipher what’s priced in so that we could better take advantage of the market’s volatility. It was this approach that led to our high level of conviction that opening equity prices on Thursday presented compelling risk/reward opportunities to purchase selected equities.


 

Definitions

Federal Funds Rate – The term federal funds rate refers to the target interest rate set by the Federal Open Market Committee. This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

Producer Price Index (Headline PPI) – The headline producer price index (PPI), published by the Bureau of Labor Statistics (BLS), is a group of indexes that calculates and represents the average movement in selling prices from domestic production over time. It is a measure of inflation based on input costs to producers.

Core Producer Price Index (Core PPI) – The core producer price index (PPI), published by the Bureau of Labor Statistics (BLS), is a group of indexes that calculates and represents the average movement in selling prices from domestic production over time that excludes food and energy prices, which are the more volatile parts of inflation.

Headline Consumer Price Index (Headline CPI) – Headline inflation is the raw inflation figure reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics (BLS). The CPI calculates the cost to purchase a fixed basket of goods to determine how much inflation is occurring in the broad economy. The CPI uses a base year and indexes the current year’s prices, according to the base year’s values.

Core Consumer Price Index (Core CPI) – Core inflation removes the CPI components that can exhibit large amounts of volatility from month to month, which can cause unwanted distortion to the headline figure. The most commonly removed factors are those relating to the costs of food and energy. Food prices can be affected by factors outside of those attributed to the economy, such as environmental shifts that cause issues in the growth of crops. Energy costs, such as oil production, can be affected by forces outside of traditional supply and demand, such as political dissent.

Liability Driven Investment (LBI) – The amount retirement plans are expected to pay out to their members in the future are also known as liabilities, and so-called “liability-driven investing”, or LDI strategies, aim to match the value and time horizon of their current assets to those future liabilities.

Defined Benefit Pension Plan – A defined benefit pension plan is a type of pension plan in which an employer/sponsor promises a specified pension payment, lump-sum, or combination thereof on retirement that depends on an employee’s earnings history, tenure of service and age, rather than depending directly on individual investment returns.

Margin Call – A margin call occurs when the percentage of an investor’s equity in a margin account falls below the broker’s required amount. An investor’s margin account contains securities bought with a combination of the investor’s own money and money borrowed from the investor’s broker.

Hawkish – Hawks are seen as willing to allow interest rates to rise in order to keep inflation under control, even if it means sacrificing economic growth, consumer spending, and employment.

Goods Inflation – Goods inflation is an instance where there is an increase in prices for goods that is the primary driver for inflation.

Service Inflation – Services inflation is an instance where there is an increase in prices for services that is the primary driver for inflation.

S&P 500 – The S&P 500 is a total return index that reflects both changes in the prices of stocks in the S&P 500 Index as well as the reinvestment of the dividend income from its underlying stocks.

Growth Stock – A growth stock is any share in a company that is anticipated to grow at a rate significantly above the average growth for the market. These companies generally do not pay dividends, instead growth stocks tend to reinvest any earnings they accrue in order to accelerate growth in the short term.

Fed Speak – Fed speak is a technique for managing investors’ expectations by making deliberately unclear statements regarding monetary policy to prevent markets from anticipating, and thus partially negating, its effects.

IMPORTANT DISCLOSURES

The views and opinions included in these materials belong to their author and do not necessarily reflect the views and opinions of NewEdge Capital Group, LLC.

This information is general in nature and has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy.

NewEdge and its affiliates do not render advice on legal, tax and/or tax accounting matters.  You should consult your personal tax and/or legal advisor to learn about any potential tax or other implications that may result from acting on a particular recommendation.

The trademarks and service marks contained herein are the property of their respective owners. Unless otherwise specifically indicated, all information with respect to any third party not affiliated with NewEdge has been provided by, and is the sole responsibility of, such third party and has not been independently verified by NewEdge, its affiliates or any other independent third party. No representation is given with respect to its accuracy or completeness, and such information and opinions may change without notice.

Investing involves risk, including possible loss of principal.  Past performance is no guarantee of future results.

Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No assurance can be given that investment objectives or target returns will be achieved. Future returns may be higher or lower than the estimates presented herein.

An investment cannot be made directly in an index. Indices are unmanaged and have no fees or expenses. You can obtain information about many indices online at a variety of sources including:  https://www.sec.gov/fast-answers/answersindiceshtm.html or http://www.nasdaq.com/reference/index-descriptions.aspx.

All data is subject to change without notice.

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