From Tony Pasquariello, Goldman head of hedge fund coverage
Cat and Mouse
A brutal week in the markets, with no shortage of blame to go around: the persistence of global central bank hawkishness, gathering recession concerns, ongoing retail liquidation (and, an element of reflexivity).
Here’s the central question that I’m trying to work out: if the interest rate market is correct, and terminal Fed Funds rate is going to be somewhere around 3%, at what point is that fully priced into the broader markets?
On one hand, there’s already been a very significant tightening of US financial conditions, so you could argue that we’re getting close.
- Said another way: you know that financial markets live in the future … so, when the day comes where everyone can clearly see the end of the tightening cycle, the trading community will be ahead of it and assets will already be on the move.
- On the other hand, the target rate is still south of 1% and core PCE is still north of 5%, so you could also argue that we’re still much closer to the start of this tightening cycle than to the end of it [for a more detailed discussion, see “The Fed Has Crossed The “Hard Landing” Rubicon So How High Will It Hike? One Bank Crunches The Numbers“].
- Said yet another way: as long as inflation is running hot and the labor market is too tight … again, the inconvenient truth is the Fed has more wood to chop and the markets have more risk to sort out.
In a related vein: at what point does the FOMC view an easing of financial conditions and decide that they DON’T need to beat it back?
In that spirit, cue Bill Dudley (link): “the Fed has to be happy with the fact that financial conditions have tightened … they’re getting traction … they still have to do what they said they’re going to do.”
With apologies for thinking out loud here, it’s these type of cat-and-mouse questions that illustrate the difficulty of assessing the current interplay between the Fed and the asset markets.
To be sure, the task of culling jobs is hugely unenviable, but the Fed is still so far off the inflation mark; at the very least, they need to demonstrate the trajectory of core inflation is clearly headed lower, even if they ultimately lose their nerve before reaching 2.0% [maybe the Fed is not so far off: see “Fed Mission Accomplished: Real-Time Indicators Show The Labor Market Just Cratered“].
On that last point, as Joe Briggs in GIR pointed out to me, the FOMC actually sent a similar signal with their March SEP dots, which showed 3½ hikes in 2023 and 0 hikes in 2024 … despite median inflation forecasts of 2.6% in 2023 and 2.3% in 2024.
Here’s where I’m going with all of this: even though financial conditions have tightened considerably … and, even though this Fed will likely back off once the jobs losses begin to mount (they’re the same folks who ran the AIT play, after all) … the fact is there’s still a lot of ground to cover before they can declare victory over inflation … which should keep some pressure on risk assets a bit longer.
To add another layer of complexity: as Dominic Wilson in GIR pointed out to me, the stock market usually bottoms when the Fed flinches (see early ’16, early ’19) … or, if there’s a real growth problem, when the second derivative of economic activity turns (see Mar ’09, Apr ’20).
In that context, again my instinct is we’re just not there yet — not only does the Fed put feel both smaller and farther out of the money than we’ve been accustomed to for a long time (arguably since the post-1994 era began), but the longer the tightening cycle rolls along, and the higher the unemployment rate goes, the more the markets will rightly worry about a recession (even if you believe, as I do, that the US economy is durable with plenty of nominal GDP still sloshing around).
I’ll conclude this narrative with a chart, to followed by quick points and more charts … I can find no better illustration of what’s currently challenging the stock market than this (link):
1-a. on the positioning front, the glaring wedge between hedge funds and households persists:
- i. GS Prime Brokerage data reflects some of the largest reduction of leverage on record (link). n/b: I suspect the huge underperformance of implied volatility traces back to this point (which, for those watching, has been an immense oddity — over the past 15 years, there have been 36 daily selloffs of 4% or more, and the VIX was never as low as it was on Wednesday).
- ii. that said, I continue to worry about the impact of US households de-risking. here’s one way to frame it: total fund inflows from November of 2020 through March of 2022 were $1.34tr … since the tide turned seven weeks ago, we’ve only unwound $47bn.
- iii. given immense ownership differentials — see chart 11 below for an illustration of how huge households are — to my eye this nets out in favor of the bears. now, if there’s a group who can help diffuse the supply/demand problem, it’s US corporates (yes, buyback activity through our franchise has picked up meaningfully over recent weeks).
1-b. A related point: as detailed by the WSJ (link) and our own team (link), the retail investor is quickly exiting the call option party. to make the point: in the pre-COVID era, average daily notional in call options on US single stocks was around $100bn. At the peak in November of 2021 — which is when a number of high velocity stocks put in their highs — it was around $500bn. Fast forward to today, and we’re back down to $185bn/day.
2. The recent period has been a textbook illustration of the stark difference between volume and liquidity: volume in cash equities has never been higher (e.g. an average of 12.7bn shares per day in 2021, which is nearly 2x the run rate of 2019) … yet, top-of-book liquidity in S&P futures registers in just the 3rd percentile of the past six years.
3. despite the ongoing selloff, the past few weeks have also brought moments that illustrate the difficulty of trading stocks from the short side, even if this is a bear market. see chart 12 below, or witness daily price action in a custom basket of popular shorts, ticker GSCBMSAL. For the most short-term macro traders amongst you, if you want to play S&P from the short side, my sincere advice is to go home flat each night and reassess tomorrow morning — this is a market to be traded, aggressively, but with extreme discipline. An alternative to this ultra-tactical approach is to utilize put spreads or 1-day gamma (ideas available).
4. I’m no expert in crude oil, but I’ve probably spent 10,000 hours with those who are, so here’s a bullish take: despite a record SPR release, a very strong dollar, shutdowns in the second largest economy on the planet and a break lower in most all risky assets, crude oil has largely stood its ground … you can probably see where I’m going with this. For the take of an expert, this note is worth a glance, the (surprising) punch line as I read it: “own commodities as financial conditions tighten. in the past, spot and roll returns performed well when real rates rose, and particularly when financial conditions additionally tightened” (link).
5. US consumption: again, I worry a lot about building pressures on the low end consumer. While parts of this week’s data set were encouraging — namely HD and government retail sales data — what we heard from WMT and TGT was brutally clear: in addition to shipping and inventory issues, the cost of food and fuel is impinging on the US consumer. This, as much as anything, was THE story of the week. On the other end of the spectrum, high end consumption is still off the charts (witness recent news stories on Manhattan real estate, art or fine wines). I continue to think the medium-term reckoning of this wedge takes the form of … higher taxes.
6. on US housing, I admit that a profoundly positive story has gotten a lot more complicated. On one hand, supply/demand favors ongoing strength. On the other hand, affordability seems to be a serious issue, and the move in mortgage rates is very significant. Where do we come out? As Jan Hatzius in GIR put it to me, informally, there’s not necessarily a clear conclusion: “We cut our forecasts on homebuilding activity and house prices modestly, but the shortage of houses and overall tightness of the market should substantially dampen pressure on the sector.” If you’re interested, we have some interesting charts on this topic.
7. China: the data is so bad, it’s simply eye-popping (witness the worst IP print on record). In fact, GIR has cut our expectation of 2022 Chinese GDP growth to just 4%, which ex-2020 would be the slowest growth rate since … 1990 (link). for the sake of balance, Shanghai is set to reopen on June 1st and I suspect foreign trading length is approaching rock bottom. For a balanced and comprehensive assessment of the regional economic outlook, this is worth a glance: link.
8. This is, if nothing else, some interesting brain food. I asked Daniel Chavez in GIR to mark the moves in the COVID era in some popular assets. There are a lot of ways to approach this choose-your-own-adventure; the way we cut it was total returns from the lows of March 2020 to the highs (in NDX) of November of 2021 … then from the November highs to today … and then from the pre-COVID highs to today. A few things stick out to me, here’s one: point-to-point across the full COVID era, US energy stocks have far outperformed the stay-at-home stocks:
9. In a related spirit, and with credit to sales & trading colleague Brian Friedman, if you look the overlay of NDX P/E (white) with inverted 30-year US real yields (yellow), equities are doing what the move in real rates would suggest they should be doing:
10. With credit to David Kostin in GIR, here’s a bigger picture on tech. For all of the recent troubles, you still have to marvel at the sustained growth of US mega cap names. now I suppose the mega question is … would you be willing to fade the broad pattern of this chart:
11. Another level set from GIR … which, again, illustrates the size of households vs hedge funds (** 2% **) in the domestic equity market:
12. with credit to a client, an analog from the aftermath of the immediate aftermath in the LEH period, which again illustrates the difficulty of being short in the middle or late stages of a bear market:
13. Finally, and to continue the recent thread, this is a powerful chart of de-globalization … If this were a chart of a security, I’d be inclined to sell it (link)