The Market: Back to Squeeze Mode or on Fumes?
Executive Summary
Powell was more neutral than I had forecasted, but more hawkish beneath the surface of his typical smooth, seemingly dovish talk.
A decisive drop in VVIX and HY CDX in the wake of Powell supports the prospect of more SPX squeezing before a large-scale correction into the September/October danger zone. But…
The economy MUST thread the soft landing needle for a sustainable squeeze.
A near-term correction into August to reset bullish sentiment remains the more likely outcome.
Discussion
Powell. I was tied up yesterday afternoon (always am on FOMC days, which is supremely irritating), evening (Red Sox game with a phone barely alive), and so far this morning (meetings), so I have not had a chance to write up my post-Powell thoughts in detail, but two things very briefly. 1) He was more neutral than I thought he would be given how hawkish the communication was pre-FOMC, and this likely explains the decisive plunge in VVIX and HY CDX into the market close yesterday (I referenced The Kitty in a Market Journal post yesterday, and the bottom line is I fought him and lost - I over-read the pre-FOMC communication evidence). However…
2) Powell was still quite hawkish beneath the “Teddy bear” surface (as David Tepper likes to call it) of his delivery. A) He made September a “live” meeting, to the hawkish surprise of Bill Dudley; b) yet again he provided a far more hawkish definition of a soft landing (i.e. not as bad as the worst recessions in history) than the broad market consensus (i.e. no recession); made it clear broad financial conditions must tighten enough to bring down inflation; and lastly, socialized the fact QT can continue even if the Fed is in the process of normalizing interest rates back down to around neutral.
Earnings. I cannot go into detail on individual companies, but at a very high level the stock price reactions to earnings so far this earnings season, combined with falling estimates, tells me the “we’re in a new earnings upswing” leg of the new bull market thesis is weak if not broken. Any SPX upside from here must come from the economy threading the soft landing needle (which is not positive for earnings but rather multiples).
Soft Landing. As illustrated with this morning’s move in rates in response to the downside surprise in initial and continuing jobless claims, failure to thread the soft landing needle risks the bond market choking off SPX’s ability to sustainably squeeze from here. And this has been my point all along with the communication coming out of the Fed heading into this FOMC - if the Fed were to truly “go for” the soft landing as defined by consensus (i.e. no recession), as it appeared they would just a couple of weeks ago, they would allow the economy to continue on a reacceleration path while they wait for inflation to come back to 2% by 2025, and the bond market would coast along nicely with muted reactions to better-than-expected growth and labor prints, providing little to no problem for equity market multiple expansion. But the Fed is not going for a consensus-defined soft landing - they are ruthlessly data dependent, which means the economy needs to thread the soft landing needle for stocks to sustainably squeeze from here. That threading of the needle entails sustained core disinflation of consistent 20-30 bps MoM readings alongside a gentle rebalancing of the labor market via 50-100k monthly NFP prints and little to no upward movement of inflation expectations.
Outlook. Adding it all up: With a disappointing earnings season, full positioning, elevated valuation, the bond market telling us a highly data dependent FED is likely to respond to better-than-expected labor market data with more hikes, and TIPS break-evens threatening to break out, this rally is running on fumes.
Exhibits
VVIX and HY CDX fell materially in the immediate wake of Powell and into today, supporting the prospect of further SPX squeezing, perhaps in response to softer-than-expected PCE data tomorrow.
2023E SPX EPS is coming down as earnings season progresses, and overall, stock price reactions to earnings have been less than robust.
With the earnings leg of the bull market stool knocked out, sustainable upside from here must come from a threading of the soft landing needle. With the 2-year UST note yield and 3y/10y UST curve telling us the Fed will respond to better-than-expected data (such as this morning initial and continuing claims data) with more hikes, a data dependent FED creates a very high bar to threading this needle.
With positioning full…
…Valuation extended…
…And TIPS break-evens threatening to break out, the set-up for a near-term correction to reset bullish sentiment for a more sustainable squeeze to new rally highs remains in place.