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THIS MESSAGE WAS SENT SOLELY TO CLIENTS OF FUNDSTRAT
There are some important developments taking place in financial markets this morning that warrant flagging. These are consistent with our comments from our FLASH this am, but show a more rapid and larger magnitude move in direction:
- Fed funds futures have rapidly flipped and expected March/ May hikes is now 0.68 and 0.18 hikes, respectively, down from from 1.33 and 1.08.
- That means odds of a March hike of no hike is 33% and 66% of 25bp. And roughly 80% chance of no hike in May.
- YE Fed funds now see 4.0% rate, which compares to a current effective rate of 4.57%, or a cut of ~50bp by YE.
- The VIX has surged to 29 and the VIX curve is now in backwardation, meaning the 4M VIX is greater than 1M VIX.
- Collectively, these are signs that market expectations have completely changed. As we noted last evening, we believe the trajectory of Fed rate path was to change due to SIVB failure, but today’s pricing shows this is expected to be near instantaneous.
- In short, it looks like the Fed is largely done raising interest rates. At least that is what the market is pricing for now. I think this is pretty logical actually. Especially if one doesn’t look only at lagged CPI and PCE data.
- The seismic shock from the failure of SIVB and its resulting ripple effects across start-ups and regional banks is set to lead to layoffs, credit constriction and we believe a near halt in inflation.
- Who will be asking for a raise now? VC-led start-ups are not hiring nor will there be any “job switching” and recall, these start-ups employ millions, not just tech software bros.
- Banks are surely more cautious on lending. It is even possible many granted loans are not being funded. How many expansion plans are now on hold? How many loan applications are frozen? A lot I assume.
- Who will be raising rents? Surely banks are cautious for funding and expanding credit right now. And many mortgage applications have fallen through.
- What does this mean for inflation? The Fed was concerned about a “red hot” labor market driving a wage-inflation spiral. And this causing lingering high services prices. I just don’t see how these ripples do not cause a change here. In fact, we could see this in jobless claims soon.
- Additionally, banks are not being “trusted” by equity holders as the Fed/FDIC program yesterday did not protect shareholders. And the drop in bank stocks is surely not going to make depositor feels confident. So lending is slowing.
- The bottom line is the Fed is no longer expected to hike. And the labor market probably will take a big hit. I think that will slow inflation dramatically soon.
- As for equities, as we noted last night, there will be aftershocks causing turmoil. But this is a constructive set-up intermediate term. After all, the Fed will be less focused on inflation. And if rates are falling, one is not fighting the Fed.
BELOW IS OUR FLASH FROM SUNDAY EVE/MONDAY AM
The dominant news over the coming weeks will likely be the lightning fast failure then resolution of SVB Corp ($SIVB, aka Silicon Valley Bank) and the corresponding second order impacts. The FDIC/Fed took 3 actions: (i) made SIVB depositors whole; (ii) invoked systematic rule and shutdown Signature Bank and (iii) created a new liquidity facility enabling banks to access funds at par (not marked to market) to meet liquidity needs (link).
This action alone is likely to be perceived as constructive by markets. The Fed/regulators protected depositors, reducing risks and forestall further problems with that facility. Some might even say “the Fed blinked.”
But markets will not see the auction of SIVB as the end of this episode. We see 3 lingering impacts that collectively, likely change the path of monetary policy for the remainder of 2023:
- First, US jobs growth will slow visibly in coming months. The collapse of SIVB means one of the central financial banks for VC and Silicon Valley has been impaired — this is true even an asset sale is completed. This is more than “not making payroll”. SIVB does business with 44% of start-ups and as the NVCA data shows, VC-backed startups are a primary jobs engine, growing employment 930% faster than rest of economy over the past decade.
- For the VC and start-up world, the financial system is somewhat in disarray, so this will slow capital formation and funding rounds, and naturally drive cautious behavior from businesses. We think jobless claims could start to show this impact fairly quickly.
- Second, the cost of capital of banks has risen. Financial markets work on “cockroach theory” even if $SIVB issues are idiosynchratic. The KBW Banks Index is down 18% in the past month and 10 of the 24 constituents are down ~20% or more. The 5-yr CDS for $CITI, for instance, widened dramatically at the end of last week. Higher cost of capital means banks could tighten lending given the higher associated costs. This will slow GDP growth as well.
- Investors are well aware that Fed’s monetary policy is arguably behind the growing challenges for banks. Excess savings are shrinking as Fed slows economy and employment slows. Bank’s security portfolios are harshly impacted by higher interest rates. In fact, the surge in rates in the past week (post-Powell) even hastened SIVB’s demise. The Fed has spoken of “higher for longer” which means that there is even more losses for bank’s portfolios. At the end of 2022, the FDIC disclosed bank’s unrealized losses were $620 billion. This figure could balloon in the next 12 months if the Fed raises rates.
- Third, we believe the market’s and possibly the public’s focus will shift away from inflation and overly “hot” economy to that of financial stability and safety of banks. The speed of failure of SIVB is stunning and enabled in a digital world — in fact, its collapse mirrors the implosion of FTX digital. Both happened within days. As such, trust in stability of financial systems will dominate. And this could push “inflation” and “terminal rate” to the background, to an extent.
- It might just be anecdotal, but the world seems more prone to panic since the pandemic of 2020. The rapid collapse of SIVB seems to be the latest example. And the sale of the bank will not end the lingering fears that we highlight above.
- We believe the Fed’s reaction function potentially needs to adjust. As noted above, if the Fed continues to raise rates, the stresses on bank business models will grow. And the damage to Silicon Valley/VC/Start-ups means that Fed is aware there is now further forces have been unleashed to slow employment growth (Fed focus) without having to raise rates. Similarly, slowing credit growth means slower economy.
- In other words, we think the Fed could move away from “higher for longer” to a possible pause. The Fed futures markets have already reacted with March hikes falling from 1.74 hikes to 1.33 (each 1 = 25bp) and May 1.44 to 1.06. That is roughly 20bp taken out of next 2 meetings. YE Fed funds has fallen to 4.88% from 5.56%, or down -68bp (almost -3 hikes). Fed funds effective rate is 4.57%, so the market is pricing in 1 net hike into YE.
- What does this mean for stocks? In the near-term, stocks are going to be buffetted by the aftershocks of SIVB. That is the near term reality.
- Past the shocks, the following will impact equities. Fed probably does less “higher for longer” and possibly tilting towards “pause.” The 10-yr yield has already plunged from 4.089% to 3.699% and is possibly set to fall further if Fed shifts to a slower pace of hikes. Has a recession been unleashed? Deposit holders of SIVB are likely to be made whole, which we believe, will not result in a downward cycle of contraction.
- Overall, this should be positive for stocks into the remainder of 2023, once we are past these initial after-shocks. And groups levered to lower interest rates should particularly benefit. Our work shows this to be Technology and Industrials.
DIGITAL AGE: Makes panic spread quickly
When FTX collapsed in 2022, those in the traditional financial world viewed that lightning collapse as improbable in the “real world” — but the collapses of SIVB, Signature Bank and Silvergate show this same dynamic can happen to any financial institution in this digital age:
- in a twitter poll over the weekend, 12% of respondents said they moved money away from their bank
- of course, we know twitter can be deceiving
- but still, 12% is a large figure
- another 26% were “concerned”
- recall, SIVB lost about 25% of its deposits in a single day
The KBW bank index fell 18% in the past month. So the financial markets saw risk of contagion from the collapse of SIVB. And not surprisingly, it was other regional banks.
The media has carried stories of bank runs, which likely also spurred others into action.
And no doubt, in this digital age, information moves quickly. By the way, this is also true regarding how the public perceives inflation.
- It will be curious to see in coming days whether inflations drops from the mind of consumers
- meaning, the inflation risks could abate to an extent, if it is not top of mind
EMPLOYMENT SLOWING: SIVB is the central financial institution for VC world
SVB Corp is the central financial player in VC world. As their slide deck shows, they do business with half of the VC world. And this bank has a storied 40-year history.
The failure of SVB will have aftershocks.
- This is beyond the deposits and recovering those values.
- It is that one major player with institutional knowledge and central to the ecosystem, has been “knee-capped”
- The teams and capital access are slowing for the time being.
And venture-backed companies are major drivers of jobs growth. This is why we think employment growth could slow in coming months. Perhaps we will see this in the jobless claims soon.
FED HIKES: Probabilities down sharply
As discussed above, hike expectations are down sharply for March and May.
And even the 2-year yield has fallen below the existing Fed Funds.
- In Feb, the 2-yr surged ahead, a response to hot data
But in the past two days, this has tanked.
And even into YE, Fed fund expectations are down sharply by -68bp.
- to me, this is pretty compelling evidence the trajectory of Fed funds has changed
FED PAUSE RATIONALE: If Fed keeps raising rates, this will put further stress on other banks
Another rationale for slowing is the Fed itself is contributing to the stress among banks.
- JPMorgan Strategists think SIVB is not a systematic risk, which is good
But look below, the two headwinds for SIVB are impacting all banks:
- excess savings is shrinking and deposits are moving to USTs away from banks
- higher interest rates means even more losses for banks bond portfolios
- at the end of 2022, these losses were $620 billion
- these will grow if the Fed continues to hike
Even CITI, a large bank, saw a surge in its perceived default risk measured by CDS (credit default swaps) as shown below. These are not multi-year highs, but look at that move.
And banks overall still make healthy profits. As shown below, banks earned $260 billion in profits in 2022.
- but unrealized losses were $620 billion, so its a big number.
And within Financials, only the banks have been tanking.
STRATEGY: A break in the 10-yr to lower rates is good for equities
Last point I will make here. The drop in 10-yr is good for stocks. This is the basis for looking at equity valuations.
- 10-yr is cooling for multiple reasons, with attribution weight unknown
- lower Fed funds
- lower inflation risk
- economic risk (slowdown)
- but if a recession is not in the central case, lower rates are supportive for stocks
- this lowers cost of debt for companies
- this means higher P/E
- so beyond the initial ripple effects, this is a good thing
CALENDAR: Key incoming data starting March 10
There is lot of incoming economic data this week (durable goods, housing, unit labor costs and ISM) but for the key inflation-related data, there is a bit of a dead spot until early March. As shown below, this really starts March 10th:
3/7 10 am ET Powell testifies SenateHawish 3/8 10am ET Powell testifies HouseNeutral 3/8 10am ET JOLTS Job Openings (Jan)Semi-strong 3/8 2pm ET Fed releases Beige BookSoft 3/10 8:30am ET Feb employment reportSoft
- 3/13 Feb NY Fed survey inflation exp.
- 3/14 6am ET NFIB Feb small biz survey
- 3/14 8:30am ET CPI Feb
- 3/15 8:30am ET PPI Feb
- 3/17 10am ET U. Mich. March prelim 1-yr inflation
- 3/22 2pm ET March FOMC rate decision
- 3/31 8:30am ET PCE Feb
STRATEGY: Stock uptrend remains intact despite recent sell-off in equities
Despite the recent sell-off in equities, the uptrend remains intact. While those bearish view stocks as in a downtrend:
- the chart below shows the uptrend still intact
- Admittedly, last week was a tough week
- We remain constructive on the market and expect stocks to end higher by the end of April
But the calendar remains supportive. Below is:
- the composite for the 7 precedent years when stocks >+1.4% and negative prior year
- 7 of 7 times the 8 weeks March to April positive
- Median gain is +7%
- This implies 4,250 or so on S&P 500
RALLY: 6 reasons we see a rally next 8 weeks
Here are the reason we see equities gaining in the next 8 weeks:
- The last of the “hot” inflation data was the 4Q ULC (unit labor cost) at +3.2% and beginning next week, will be incoming February economic and inflation data, which we believe will show “softer” jobs and “softer” inflationary pressures. This will reverse, to an extent, the somewhat alarming surge in inflation and jobs data of Jan (part seasonal, part noisy data).
- The bond market will likely pivot dovish in March. The “hot” Jan inflation data caused the bond market to price in higher odds of +50bp in March and April, and Fed speak seems to be pushing back against that — meaning, Fed is less hawkish than recent move in bonds.
- Falling VIX. If the incoming data tilts the way we expect (“softer”), then bond volatility should fall, which supports a stock rally in March to April. This means VIX could fall, and a falling VIX is supportive of higher equity prices.
- Seasonals are also a strong argument. We have been using the composite of “rule of 1st 5 days” using the 7 precedent years where gains >1.4% in the first 5 days (ala 2023). This composite implied market gains into Feb 16 and a consolidation thru early March (3/7). 2023 is following this pretty closely.
- This same composite now implies March to end of April will be the strongest 8 week period for 2023 with a median gain implied of 7%. If 2023 follows this path, the S&P 500 could reach 4,250-ish by the end of April. By the way, this lines up with the ~4,300 level in the coming weeks.
- I am not sure I agree with those who say the stock market is expensive. I think many cite this as another “confirmation bias” to stay on the sidelines.
- As highlighted earlier this week, ex-FAANG, the P/E (2024) of S&P 500 is 14.8X. And sectors like Energy are 10X and Financials 11X. These are not demanding valuations. And consider the fact that the US 10-yr at 4.0% yield is an implied P/E of a bond of 25X. Yup. The bond market is still far pricier than stocks.
PAYBACK (aka Calendar): Feb = payback, March+April = Fire
As you know, we are using the composite of the “rule of 1st 5 days” as the template for 2023 — this is a calendar template. The other is the breakaway momentum (see note Sunday). And as we flagged earlier this year, Feb is a “payback” month:
- of the 7 precedent instances, Feb is up only 57% of the time, which is worst of any calendar month
- median gain of +0.2% is the worst of any month
- hence, Feb is not a month that investors can arguably see gains
- Feb 2023 sort of validates this template still valid
Next 8 weeks is “buy the dip”
But this same template says March + April should be very good months for stocks:
- win-rate is 100% or 7 of 7 times March is a gain
- Median gain of March and April are the strongest
- Even stronger than January
- Hence, we think the next 8 weeks is a period of “buy the dip”
For those tactically focused, this composite below shows March 7 is the ideal window:
- this coincides with Mark Newton, Head of Technical Strategy, who sees markets chopping here near term
- but this softness is a buy the dip moment, as the next 8 weeks should be among the strongest
VALUATION: Ex-FAANG, S&P 500 P/E is 14.8X, hardly demanding
We hear investors say the market is too expensive. But this is distorted by the higher multiples of FAANG, and we think the higher multiples of FAANG are justified.
- ex-FAANG, P/E is 14.8X
- this is hardly demanding
- Energy is 10.5X, whoa
- so, still think the equity market is expensive?
TECHNOLOGY: Still our favorite Sector pick for 2023
As we noted in our 2023 outlook, Technology is our top sector pick, which we expect to be led by FAANG.
- Technology and FAANG are now established meaningful breakouts as shown below
- this after sliding down the slope of hope in much of 2022
- this reversal has fundamental arguments
TECH EPS: Bottoming before the overall market
The two best performing sectors YTD (as of end of Feb) are:
- FAANG +1,180bp outperformance (vs S&P 500)
- Technology +210bp
- Defensives have been terrible, despite those arguing for a recession
- Tech/FAANG EPS has been slightly better than the overall market
- Thus, leadership is coming from groups with EPS bottoming
7 of 14 sub-groups in Technology seeing upward bias in EPS revisions
Take a look at 2023 EPS in the 14 sub-groups (GICS 4) of Technology.
- Half, or 7 of 14 are seeing upward bias in 2023 EPS revisions
- So, those saying Technology is a “sell” are overlooking that EPS momentum is turning positive
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 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. The list of tickers and their respective themes is shown below.
Communication Services: $GOOGL, $META, $OMC
Consumer Discretionary: $AMZN, $GRMN, $TSLA
Consumer Staples: $BF/B, $KO, $MNST, $PG, $PM
Energy: $DVN, $EOG, $MRO, $OXY, $PSX, $VLO, $XOM
Financials: $AXP, $JPM
Health Care: $AMGN, $HUM, $ISRG, $MRK, $UNH
Industrials: $GD, $JCI
Information Technology: $AAPL, $AMD, $CDNS, $CSCO, $KLAC, $MSFT, $NVDA, $PYPL
Real Estate: $AMT