The action across asset classes in May suggests that markets may be at an inflection point. Fixed income markets appear to be signaling that inflation has peaked, and perhaps we have reached peak hawkishness. The 10YR has come in 36 bps, the 2YR peaked at 2.86 percent and has come in to 2.54 percent. The 5YR break-evens have moderated below 3 percent. There is some evidence of peaking inflation, wage inflation has moderated to 3.8 percent annualized over the past 3 months, used car prices are rolling over (Manheim index down 5.8 percent since Jan), shipping costs are moderating (Cass Freight down 0.5 percent Y/Y), regional ISM prices paid appear to have peaked, and earnings from retailers indicates that inventory levels are rising which will lead to discounting. Rising mortgage rates caused a massive 16.6 percent decline in new home sales last month. Money supply declined for the first time since March 2010, and the year-over-year growth was the slowest since February 2020. Energy prices are high and are likely to remain so. The Fed will raise rates by 50bps in both June and July. I suspect after that it will become data dependent, to see where we stand prior to the September meeting. At this point, so much tightening is priced into markets that even a moderation in tightening plans by the Fed will be taken by the market as a positive.
The dollar also appears like it is topping out. If that is the case, this will go a long way to improve financial conditions. In recent weeks we have seen outperformance in many foreign markets, including China. While Europe and the US are tightening policy, China is easing policy. China cut mortgage rates during the month. Chinese Vice-Premier Liu He made comments urging decisive action on economic growth during the month. Bloomberg reported that China plans to pump $5.3 trillion into its economy this year to bolster growth. That’s roughly one third of the country’s economy. This will have global implications. It will benefit export oriented European economies, the commodity and materials names, and semiconductors.
The sell-off finally hit the defensive names and sectors, including names such as Apple, Target, Walmart, Costco, and Microsoft. At the same time, you started seeing outperformance in areas that have led the sell-off, including emerging markets, small caps, Europe, financials, and certain high growth tech names. Many of these areas peaked over a year ago in February 2021. Relative outperformance might be an indicator that the sellers in these areas are exhausted. Positioning and flows into tech and many defensive sectors such as staples still remain high making it vulnerable to further selling. Unwinding of positioning built up over the last decade plus in tech and defensive sectors that benefit from deflation has exacerbated the sell-off. Value areas are still cheap, have limited positioning, and should benefit from a higher steady state inflation rate. Take small caps (IWM) for instance, they trade at just 12.60x earnings, and are expected to have 13 percent earnings growth. Small caps give you faster earnings growth at a cheaper price than the S&P at 17.6x for 10 percent earnings growth. Banks trade at just 10x earnings and are expected to have 14.5 percent earnings growth in 2023. JP Morgan at its investor day boosted its net interest income expectations, while guiding to 17 percent return on tangible equity. JPM went onto say that the credit outlook remains positive and consumer and wholesale balance sheets are strong. After the tech run up in the late 1990s, the S&P was essentially flat until the financial crisis, while you saw outperformance in emerging markets, banks, small caps, and other value areas of the market. Every cycle has new leadership, after over a decade of essentially being dead money, it might be value’s time.
Looking forward, the market will focus on the Fed, economic data, the war, and the latest out of Washington.