What Financial Markets Are Telling Us: Don’t Fear The Fed, Just Hold Tight As Summer Unspools And World Leaders Do Their Worst
Mistakes among global leaders are horrifically consequential for those without wealth, but for global investors the only world leaders capable of surprising are Kim Jong Un and Jerome Powell. The former seems ensnared in his nation’s health disaster and that leaves investors to fret whether Jerome Powell will overstep his own instincts and crater markets. Judging by yesterday’s reaction there is little fear of Powell doing any more than the minium to quell inflation. The volatility risk premium points to a higher market over the next few days (though volume may be light since the VRP could easily reverse and catch investors offside), but my technical reading of key stocks in the S&P 500 is neutral. Yesterday's cross-asset action brought several positive factors for US stocks. The US yield curve is falling and in the current context that is bullish. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. But there was also one negative factor across global asset classes. Copper is pointing to declining global GDP expectations. Expect the S&P 500 to be range-bound over the next few days before beginning a final capitulation selloff through month-end.
Powell is the issue rather than broader economic and geopolitical issues, since balance sheets are strong enough to set a floor on consumption among both workers and the wealthy. Global trade is set to decline but cascading effects are limited as long as both Powell and Kim act within expected parameters. By contrast the markets have already discounted incompetence by Biden, malevolence by Putin and Xi and their autocratic brethren, worker strikes and the modest possibility of financial contagion from overleverage in assets real and imaginary. Moderation across the commodity complex (agriculture and soft commodities, industrial and precious metals, fossil fuels) just as global equities have rallied since Monday shows the economic effects of geopolitical, fiscal and monetary policies are more certain than uncertain.
Case in point is the diverse action in currencies. Mexican peso strength vs. Korean Won and the Rupee complex weakness reveals it’s not fears of deep global recession but the composition of trade and interest rate differentials driving investor action. Nations too dependent on energy imports and global trade and with low interest rates are vulnerable, while those with stricter monetary regimes and domestic commodity production are performing better. A deep global recession is not in the cards unless the Fed overshoots, a possibility discounted heavily by the recent treasury market rally.
Even fears of a cascading downturn driven by the unholy mix of declining trade, declining wealth and margin calls on overleveraged investors seem minor, as evidenced by action in the equity derivatives markets. While volatility as measured by the VIX is elevated that hasn’t led to volatility in volatility itself, as measured by a bullish reading on the VVIX, or heavy buying in out-of-the money options, as measured by SKEW. Actual volatility in equity markets is high because investors are trying to gauge whether Jerome Powell is up to a task that only Paul Volcker ever handled with aplomb. As long as Powell stays true to his roots as a market follower rather than a leader, the likelihood is the Fed doesn’t overshoot, but rather communicates poorly. That will keep volatility high and drive markets lower, but not to the depressionary depths imagined when the pandemic first emerged or when Lehman collapsed in the GFC.
Consequently I see a capitulation selloff taking the S&P down to 3400, and we are not far from those levels. The current bullish sentiment enfolding markets likely dissipates next week, setting up a wild but productive waterfall by month-end.
Yesterday I sold my position in the levered ETF SPXU, and consequently my current positions are a large cash position, Goldman Sachs (GS), 3M (MMM), Pfizer (PFE), Starbucks (SBUX), Titan Machinery (TITN) and the levered ETF UPRO.