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More than a few of our clients have told us that “falling inflation” is consensus and therefore priced into equities and these same clients tend to lean bearish as they view the next chapter in the market narrative as “falling EPS due to Fed hikes.”
But I don’t agree that falling inflation is consensus. There are multiple reasons discussed below, but let me start with my takeaways from a dinner last week. A good friend of mine hosted a group dinner of institutional investors (including the CIO of one of the large state endowments and a PM at one of the largest asset managers in the world).
- Almost everyone at the dinner viewed inflation as a structural problem that will take years to fix.
- One cited the notion that real rates will remain high (3% or more) as the Fed wants to be certain inflation is dead and because the Fed wants 500bp of cushion for the next crisis.
- Another said they don’t see how inflation can fall with labor markets this tight and the massive reflationary impact of reshoring assets to the US.
- Others seem to say the “high prices are here to stay” which is conflating that inflation is rate of change, not the current level of prices
- Moreover, it was also consensus that because of higher structural inflation, P/E and valuations need to fall. This, of course, is counter to history that shows the highest realized P/E occur when 10-yr yields are between 3.5% to 4.5% at ~19.5X.
Overall, I could hardly say that “falling inflation” is consensus after that dinner. In fact, one doesn’t have to look far to see “sticky” inflation as the default view for many investors. Take a look at a small selection of headlines/articles/tweets over this past weekend 👇
A “pause” is a pregnant pause and a pretext to a substantial easing of financial conditions
So this remains the biggest catalyst for 2023, in our view. Inflation expectations are set to “leg down” as inflation is tracking far lower than Fed expected (“unforced error” due to Haver?) and the pace of decline in inflation likely surprises consensus (look above).
- Nick Timiraos of WSJ noted Fed officials are preparing to “slow interest rate increases” (see below) and moreover discuss the preconditions for a pause.
- This is a very “pregnant pause” in our view — only a month ago, the Fed raised its terminal Fed funds forecast because “inflation is higher than expected” (between Sep to Dec) when inflation rate has utterly tanked.
- If Fed pauses, we see equity market investors substantially repricing Fed expectations for the remainder of 2023 — ie, bond market says Fed will not get to 5% and sees lower rates by YE 2023. This is far more dovish than equity investors’ default view.
- A Fed pause is an event that likely substantially further reduces bond and equity market volatility (MOVE and VIX) and drive a further easing of financial conditions. In other words, this is tantamount to a pivot.
- On 1/27, December core PCE inflation will be released by BEA and Street is looking for +0.3% MoM. This would imply 2022 Core PCE inflation YoY of 4.4%, which is 40bp BELOW Fed forecast of 4.8%
- That 40bp delta is a substantial undercut and likely further strengthens the case for a “pause” — as a side note, we believe Dec Core PCE could be as low as +0.2% or less, which would be even more of a positive surprise.
- We have already highlighted the “rule of first 5 days” (>1.4% and negative prior year) and the median gain is 26% 12M (win-ratio 100%) 7 of 7 times since 1950. Thus, one could argue the “base case” for markets in 2023 is a gain of >20%. Yet, consensus is looking for flat markets.
- In short, the fundamental catalyst of Fed “pause” (and leg down in inflation forecasts) coupled with signs of revival of equity demand, point to S&P 500 gains far above what consensus expects in 2023.
S&P 500 seems to be more comfortable around the 200D, and if Fed dovish pause = breakout
As additional perspective, the S&P 500 seems less repelled by the 200D moving average. As shown below:
- most of 2022, 200D repelled the index
- but in 2023, after a brief pullback, the S&P 500 closed above the 200D
- if we manage >2 daily closes above the 200D, we can be sure investment sentiment will improve
- we think possible catalysts are the Dec Core PCE (1/27) and the upcoming FOMC decision (2/1).
ECO DATA: 1/27 Dec Core PCE inflation key data point
There is a lot of incoming economic data this week, but we continue to focus on inflationary and central bank-related data.
- 1/27 8:30am ET: Core PCE inflation (deflator) Street +0.30% vs +0.2% Nov
- we think this could be as low as +0.15% to +0.20%, but even Street +0.3% is dovish
- because Core PCE inflation would be 4.4% YoY, below Fed forecast of 4.8% YoY, or a 40bp undershoot.
- 1/27 10am ET: U Mich 1-yr inflation. We think this will undershoot 4% and be 3.8% or lower
The bond market is saying Fed will make a “dovish” leg down
As we have written about multiple times in the past few months, the bond market is diverging from the Fed. That is, instead of taking the Fed at face value, the bond market sees less inflation:
- this is in contrast to equity markets, which are taking the Fed at face value
- for instance, look at implied Fed funds for June 2023 and Dec 2023 at 4.9% and 4.4%, respectively
- these are below the Fed guidance of reaching 5%-5.25% by YE 2023
- the YE is 85bp below Fed guidance
And this message is seen in 2-yr yields. The 2Y yield is 4.16%, way below 5.0%-5.25% guidance by Fed
- in fact, 2Y yield is below current Fed funds
- this is the first time since March 2020 where the spread has been this negative (FF less 2Y).
- back then, the bond market was saying substantial cuts ahead
- doesn’t this seem to be the message today?
Bond market is saying Fed will allow Financial Conditions to ease
And as we wrote about multiple times in the past, equity markets take their cues from FCI (financial conditions) arguably more so than the Fed. Thus, if the Fed does indeed takes steps to “pause,” we see FCI easing and is a further catalyst for equity markets to gain.
If FCIs ease, the VIX will fall
And the VIX is sending a similar message:
- YTD, the VIX has been sinking and currently 19.9
- in 2023, the VIX averaged 25.4
- and VIX seems to be nearing levels seen near VIX lows of 2021 and arguably towards VIX levels in 2019
The behavior of VIX is important for equity markets in 2023. As highlighted below, if VIX is down in 2023 (vs 2022), equities have far greater positive return:
- if VIX neg YoY and S&P 500 neg in prior year, 12M median gain +22%
- if VIX pos YoY and S&P 500 neg in prior year, 12M median gain -23%
- this literally comes down to what the VIX does
SECTORS: Technology most levered to easing FCIs
Below we highlight sector correlation to easing financial conditions (FCI). And as shown, in the past two years:
- Nasdaq 100 $NDX and Technology are most correlated (88%)
- both have a higher correlation than compared to the past decade (80%)
- the rise makes sense as rising rates rattled investor confidence
- but easing FCIs point to lower rates (higher P/E) and lower volatility (lower risk premia)
- both should boost Technology/Nasdaq 100
STRATEGY: VIX matters far more for 2023 returns than EPS growth
Our data science team compiled the impact on 2023 equity returns from variables:
- S&P 500 post-negative year (2022)
- the varying impacts of
- VIX or volatility
- USD change
- Interest rates
- EPS growth
- All of the 4 above, positive or negative YoY
- Data is based on rolling quarters and summarized below
The surprising math and conclusions are as follows:
- most impactful is VIX
- Post-negative year (rolling LTM)
- if VIX falls, equity gain is 22% (win ratio 83%, n=23)
- if VIX rises, equity lose -23% (win ratio 14%, n=7)
- I mean, this shows this all comes down to the VIX
- EPS growth has little impact
- If EPS growth is negative YoY (likely), median gain +14.8% (win-ratio 70% n=33)
- If EPS growth is positive YoY, median gain is 15.5% (win-ratio is 78%)
- Hardly a sizable bifurcation
As the scatter below highlights, we can see the sizable influence of the VIX. Even in all years, the VIX is a key factor:
- in our view, if inflation falls sharply
- and wage growth slows
- Fed doesn’t have to cut, but this is a dovish development
- we see VIX falling to sub-20
- hence, >20% upside for stocks
And as shown below, EPS growth has a somewhat important correlation, but hardly as strong as VIX changes.
- the difference in median gain is a mere 70bp (positive vs negative) post-negative year
- the importance of EPS growth is stronger in other years
STRATEGY: Financial conditions should ease in 2023, driving higher equity prices. Technology, Discretionary and Industrials levered to easing FCI
The “base” case for 2023 should be below. That stocks gained >1.4% in the first 5 trading days, and this portends strong gains for the full year:
- Post-neg year + up >1.4% on first 5 days
- Day 5 to first half median gain is 9.5%
- Full year median gain is 26%, implies >4,800 S&P 500
- 7 of 7 years saw gains.
Those 7 precedent years are shown below.
- the range of full year gains is +13% to +38%
- so, this is a VERY STRONG signal
- the two most recent are 2012 and 2019
- we think 2023 will track >20%
The path to higher equity prices is discussed above:
- core inflation falling faster than Fed and consensus expects
- wage inflation is already approaching 3.5% target of Fed (aggregate payrolls)
- Fed could “dovishly” leg down its inflation view
- allowing financial conditions to ease
- bond market has already seen this and is well below Fed on terminal rate
BASE CASE: The “maths” for what to expect in 2023, post a “negative return” year (2022)
Question: how common is a “flat” year? Our team calculated the data and it is shown below:
- since 1950, there are 19 instances of a negative S&P 500 return year. In the following year,
- stocks are “flat” (+/- 5%) only 11% of the time (n=2)
- stocks are up >20% 53% of the time (n=10)
- yup, stocks are 5X more likely to rise 20% than be flat
- and more than half of the instances are >20% gains
So, does a “flat year” still make sense?
As shown below, these probabilities are far higher than compared to typical years:
- since 1950, based upon all 73 years
- stocks are “flat” 16% of the time vs 11% post-negative years — BIG DIFFERENCE
- stocks are up >20% 27% of the time vs 53% post-negative years — BIG DIFFERENCE
- see the point? The odds of a >20% gain are double because of the decline in 2022
37 GRANNY SHOTS: Updated list is below
The revised 37 Granny shots are shown below. The list is sorted by the most attractive (most frequently cited) to least. To be a “Granny shot” the stock needs to appear in at least two portfolios:
- $AAPL in 4 of 6 portfolios
- $GOOGL $MSFT in 3 of 6 portfolios
- $AMZN $META in at least 2
- This reinforces our favorable view of FANG
37 Granny Shot Ideas:
Communication Services: $GOOGL, $META
Consumer Discretionary: $AMZN, $AZO, $GPC, $GRMN, $ORLY, $TSLA
Consumer Staples: $BF/B, $MNST, $PG, $PM
Energy: $CVX, $DVN, $EOG, $PSX, $XOM
Financials: $ALL, $AXP
Health Care: $AMGN, $HUM, $UNH
Information Technology: $AAPL, $AMD, $AVGO, $CSCO, $KLAC, $MSFT, $NVDA, $PYPL, $QCOM
Materials: $CF, $FCX, $LIN
Real Estate: $AMT, $CCI, $EXR