In last week’s commentary, we mentioned we were looking for a pullback in the dollar and a bounce in equities.
In the early part of last week, the dollar cooperated, falling approximately 1% (a decent-sized move for a currency). But equities refused to join the party–despite several valiant attempts to rally–seemingly held back by interest rates pushing to their highest levels since the fall.
Thursday’s economic data didn’t help matters, as productivity numbers came in well below expectations while labor costs were materially higher than estimated–raising the specter of an entrenched wage-price spiral.
Initially, equities didn’t take the Thursday data well. The S&P 500 fell as low as 3925 that morning, 6.7% below its intraday high on February 2nd.
But, as so often happened last year when equities looked to be in danger of falling into the abyss, the Fed came to the rescue. This time it was Atlanta Fed President, Raphael Bostic, on Thursday afternoon who calmed the market’s nerves by saying he was “firmly” in favor of a 25 basis point rate hike at the next Fed meeting (March 22nd).
When that news hit the market, equities took off like a rocket and barely looked back, rallying nearly 3% from Thursday afternoon into Friday’s close.
For the week, U.S. equities were up 2%, while the dollar fell 0.5%. For those bullish equities, the strong bounce off technical support (delayed though it may have been) was heartening. It suggests the rally off the October lows might still be in progress.
By far the most interesting data point to us, however, was the Fed stick-save–yet another instance where the Fed has talked hawkishly when equities are at multi-month highs (over 4000) and dovishly when equities appear in need of a lifeline.
This repeated pattern suggests to us that the Fed doesn’t want equities to crash or soar.
Crashing equities would likely preempt their rate hiking cycle, worsen U.S. fiscal deficits via lowered tax receipts, and as a result blow up the bond market.
Soaring equities would loosen financial conditions and make inflation that much harder to tame (and thus blow up the bond market from higher-for-longer interest rates).
The Fed appears stuck.
Several commentators have noted that the Fed raising rates has led to bigger budget deficits, which have led to more inflationary spending into the economy–nearly $600 billion worth of additional interest payments to bondholders–on par with past quantitative easing and fiscal stimulus episodes.
Lynn Alden summed it up well on Twitter:
If the Fed truly is between a rock and a hard place, with bond market turbulence almost a certainty, it probably does not want to inflame equity markets unnecessarily at the same time (especially as we get closer to the 2024 election cycle).
Thus, we might expect equities to trade in a range that slowly drifts higher (right now that range appears to be somewhere between 3900 to 4300 on the S&P 500).
From a positioning perspective, we got another installment of the Commitments of Traders Report dated to the second week of February (still three weeks delayed). At that time, the smart money was still selling the dollar strongly and was beginning to sell equities into the early February highs (but not enough to flip relative sentiment anywhere near bearish). The smart money also repositioned itself in a bullish way for non-U.S. equities (after having turned temporarily bearish).
One interesting development was that commodities stopped going down last week. Consequently, commodities sentiment rebounded into a zone that tends to have beneficial effects for equities.
The commodities rebound also suggests that the “growth scare” we warned about last week may not materialize. Indeed, reports indicate China is going all out to stimulate its economy and that will likely have global implications (China’s PMI readings have recently reached their highest level in more than a decade).
The Bull Case
The bull case for equities is that growth is picking up, earnings have bottomed (as have profit margins), and inflation has peaked. With institutions still more relatively bullish equities and bearish the dollar than retail traders, the historical odds appear to favor a continuation of the rally off the lows.
The Bear Case
The bear case for equities is that valuations imply meager long-term equity returns (~3% annualized). As a corollary, a big disconnect exists between price-to-earnings multiples and the level of real interest rates.
We continue to lean toward the bullish case for equities. The combination of institutional positioning, a potential reignition of global growth, and the apparent desire of the Fed not to see equities suffer, suggests to us that equities may continue to grind higher within an upward sloping channel for the next few months.
Given the potential for inflation to remain sticky and the difficulty the Fed will have in keeping rates higher for longer without causing a crisis, we believe real rates will eventually have to turn negative, which will make equities (particularly energy stocks), gold, and commodities particularly attractive while making long-duration bonds virtually uninvestable. Consequently, our portfolios are tilted heavily toward the former and away from the latter.