Eye on the Markets
Eye on the Markets - 2022
Bears in Control
By Ketu Desai
In markets, often it is the direction of travel that matters more than the absolute level. The market, both equity and fixed income, for a couple of months now have thought that inflation has peaked. We got a number of data points this month backing that up, including CPI, PPI, PCE, import prices, ISM prices paid, regional manufacturing prices paid, and consumer inflation expectations. Break-evens across the curve are moving lower. One-year break-evens are now below 2.5%. While growth looks to be weakening, the employment numbers are still strong with 528k jobs added in July. The direction of travel is also important as it pertains to the Fed. Despite a hawkish speech at Jackson Hole by Chair Powell, we are moving closer to the end of the hiking cycle. Goldman expects that the Fed is likely to slow down rate hikes to 50 bps in September from 75 bps the previous two meetings, and probably 25 bps in November and December. Bond markets expect that we should be close to the end of the hiking cycle by year-end.
The rally off the lows has been a combination of short covering, CTA’s increasing exposure, buybacks, and retail. The nature of the buyers has benefited tech and growth stocks. Positioning and sentiment remain very negative. Trading in recent weeks has been technical. The S&P rallied to the 200-day moving average and has corrected in recent days. It found support around a Fibonacci level. Volume has been low, as you would expect at the end of August. Despite the end of the month sell-off, the VIX has rallied to only the mid-20s. The bears are in control right now, the burden of proof is on the bulls. From a technical perspective, the bulls need the VIX to continue to fall into the low 20s and below and they need to get back above the 200-day moving average. This would bring in vol-targeting funds, quant, and momentum funds. From a fundamental perspective, inflation needs to keep moving lower to improve sentiment of discretionary investors as they rush to make their year.
While many asset classes, including fixed income, credit markets, and commodities have gone the way long equity investors want, the dollar has not. The dollar continues to stay stubbornly well bid. Continued dollar strength will likely cap any rally and serve to tighten financial conditions. The Fed will ramp up quantitative tightening in September which will likely also tighten financial conditions. When money was easy, many asset classes performed well, as there was plenty of money for a lot of things. As money becomes tighter, money will mostly flow to quality assets and areas where there is a clear supply / demand imbalance. One area that has a clear supply / demand imbalance is across the energy spectrum. The energy markets remain extremely tight. Oil prices have fallen recently due to tapping of the SPR, China’s zero-COVID policy, and financial participants liquidating positions. Most of these are set to reverse, including SPR releases ending in October. An embargo on all Russian oil kicks in December, among other sanctions. China is consuming about 13 million barrels / day, by the end of the year it is estimated that they could be back up to 14.5 million barrels / day. Oil analysts estimate that in the fourth quarter about three million barrels / day will be lost just as we approach winter. Domestic natural gas prices hit double-digits during the month, and European natural gas has gone parabolic. Oil and gas equities continue to be very cheap at just 7.7x forward earnings, 15% free cash flow yield, 3.5% dividend yield, and are expected to have the highest earnings growth in the S&P. Lastly, these stocks are probably the most effective geopolitical risk hedge. The clean energy trade is a long-term growth trade, which will likely be volatile along the way. There are various estimates of the amount of investment that needs to be made in clean energy. The International Renewable Energy Agency estimates $27 trillion of investment to reach objectives of the Paris Agreement. There are various ways to play it, from solar companies such as Enphase, copper companies such as Freeport, the myriad of autos, hydrogen companies such as Linde, lithium companies such as Albemarle, utilities such as NextEra. It depends on your time horizon and risk tolerance. Investments related to the energy transition seem like a winner as money gets tighter.
Looking forward, the market will focus on the Fed meeting, geopolitics, and the latest economic data.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. email@example.com