WEEKLY MACRO NOTE - Can Bears Swim?

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A slightly longer article than usual, you can skim through the sections that are least relevant to you.

LIQUIDITY - CAN BEARS SWIM?

Over the past few months, while I was hyperfocused on the deteriorating fundaments from both a macro and earnings point of view, I believe I missed a key input and was somewhat blinded to its impact.

Attentive readers will remember I brought this up in my Data Dive a few weeks ago

Earlier this week Powell confirmed my view and mentioned the above point explicitly in the FOMC press conference.

I will dig into the numbers below, but for those who want to skip this part and move on, the brief summary of the point I want to make is this - More liquidity has entered the global markets over the past 3 months than that which was been removed by the Fed, thus offsetting the impact of QT. In a sense, you could actually make the case we have had global QE again.

Liquidity has been flowing, hence my question Can Bears Swim?

Let’s start with CHINA

China’s PBOC has been expanding its Balance Sheet since last Autumn

They have also been adding liquidity via reverse repo operations

And their monetary supply, as measured by M2, has been expanding.

Now let’s look at JAPAN.

Since last October the BOJ has been expanding its Balance Sheet, for an equivalent in USD of about $400B, a lot of which came in Jan of this year.

The BOJ has been struggling to defend the cap it maintains on JGB yields and has therefore had to do record open market bond buying operations. Until a month ago the cap was at 0.25% on the 10Y JGB, they had to lift that to 0.50% at the start of this year, and with the market betting against them they have been struggling to defend that level ever since.

But there is another force at play, possibly the most important, at least for US equity markets. Since the US reached the Debt Ceiling Limit the Treasury has been injecting liquidity via the Treasury General Account to the tune of about $120B per month, more than offsetting the $95B of Fed QT, and the result has been that overall liquidy in the US markets has been rising.

The below chart by Fidelity quite elegantly shows the relationship between the S&P and Liquidity.

On a global scale, you can see that liquidity has risen remarkably over the past few months, particularly thanks to the PBOC & BOJ.

Another source of easing has come from a decline in the value of the Dollar, which peaked late last October. The relative strength of the Dollar is one of the most direct sources of global easing or tightening.

Now the real question is where do we stand now?
All of the above is in many respects backwards looking, and a good chunk of that liquidity has already made its way into asset prices, the fact that I have clocked onto it this late is another matter.

Gold for example, which is one of the most sensitive assets to liquidity, bottomed last October, just as liquidity did.

But, as I suggested might happen last Sunday, it has just had a bad week. The Dollar rose 1.05%, and Bitcoin and Gold, the most sensitive assets to Liquidity, were down -1.66% and -3.24% respectively.

Will liquidity continue to push global asset prices higher or will we enter a phase where other forces will once again take over the driver’s seat?

The question is multifaceted, there are many things to consider and unfortunately, I do not have the answers to all of them. I will try and address some of these with some bullet point thoughts and if you have any ideas of your own on this topic by all means feel free to write to me and share them.

• When will the debt ceiling agreement be reached? Presumably by about May at the latest? When an agreement is reached the Treasury will go back to issuing debt, actively removing liquidity from the market. So markets will have this + continued Fed QT to deal with in the back half of the year.

• Given the latest US Jobs report, will the market start front-running stickier inflation and the Fed having to stay tighter for longer, as opposed to expecting cuts as it has been until now?

• Inflation in Japan is on the rise, now at 4% YoY. For how much longer can they defend the cap at 0.50%? and even if they let it rise to 0.75% how much QE will they have to do to defend that and what will the impact be? the BOJ already owns over 50% of the Japanese Government Bonds. Consider also that there will be a change in leadership at the BOJ in a few months’ time.

• China has been easing at a record pace, will they continue to do so or will that pace slow from here? Note this in the context of the CNH - one of my top short trades for 2023 -

I will share some thoughts on how we might gauge this and potential pathways for equities going forward at the end of this article. But first, let’s get through our weekly summary.

If you are interested in digging into the weeds on global liquidity I suggest you read the following book by Michael Howell, and moreover, he deserves credit for pointing out back in November that liquidity was on the rise and it was likely to influence asset prices in a positive way.

TABLE OF CONTENTS

• WEEKLY WRAP UP

• CENTRAL BANK POLICY

• MEGACAP EARNINGS

• KEEP YOUR OPTIONS OPEN

• SENTIMENT

• ECONOMIC CALENDAR

• EARNINGS CALENDAR

• THE ROAD AHEAD

WEEKLY WRAP UP

I will keep this short and to the point, we have a lot to get through today.

FX - Dollar up!
USD (DXY) +1.05%
EUR -0.67%
GBP -2.72%
CHF -0.56%
AUD -2.61%

US EQUITIES up!
SPX +1.62%
NDX +3.34%
DJI -0.15%

Volatility UP?
VIX -0.97%
VXN +3.38% (Nasdaq Implied Vol)

Liquidity down?
GOLD -3.34%
BTC -1.5%

Yields flattish.
US2Y +9bps to 4.29%
US10Y +2bps to 3.52%

US 10Y/2Y Yield curve remains inverted -76bps

BTP/BUND spread (the difference between the yield on German and Italian bonds) declined -18bps to 181bps and is at its lowest level since early last year.

US High yield spreads declined -29bps to 3.94% over US treasuries, the lowest level since Spring 2021.

Credit Default Swaps on US Investment Grade Debt declined again by -2bps, down significantly over the last 3 months

The influx of liquidity has played a huge role in dampening volatility in the Bond market, which in turn has flowed through and had a dampening effect on volatility in equities. The Move index is sub 100 and the Vix has been under 20 for the better part of the last 4 weeks.

Somewhat counterintuitively to the above, you have Credit Default Swaps on US Government Debt close to all-time highs, although this is due specifically to risks associated with the Debt Ceiling debacle.

CENTRAL BANK LALALAND

It was a busy week in Central Bank LaLaLand.

The Fed hiked interest rates by 25bps to 4.75% and signalled that they intend to do at least 2 more rate hikes this year and does not expect to cut rates in 2023.

The ECB hiked interest rates by 50bps to 3% and intends to start doing QT come March of this year. Lagarde was a little unconvincing when it came to the ECBs resoluteness to keep on hiking in 50bps increments. The Euro was down -0.67% WoW.

The BOE hiked rates by 50bps to 4%. Bailey was probably the most Dovish of all, and as I have said previously this is no surprise. What happened with UK pension funds back in late Sept 2021 showed the BOE cannot push rates much higher than where they currently stand without causing a world of damage. I suspect this is the BOE’s last 50bps hike, it’s 25bps at a time from here, and probably not that many either. The GBP was down -2.7% WoW.

Given the focus on the Fed, you would be forgiven for not having noticed that other central banks around the world also adjusted interest rates this week, and in many cases, raised them.

GHANA +100bps to 28%
KENYA unchanged at 8.75%
KYRGYZSTAN unchanged at 13%
ARMENIA unchanged at 10.75%
GEORGIA unchanged at 11%
BAHRAIN +25bps to 5.25%
UAE +25bps to 4.65%
SAUDI ARABIA +25bps to 5.25%
BRAZIL unchanged at 13.75%
HONG KONG +25bps to 5%
MACAU +25bps to 5%
ALBANIA unchanged at 2.75%
CHECK REPUBLIC unchanged at 7%
MALAUI unchanged at 18%
EGYPT unchanged at 16.25%

As a reminder, the longer the Fed keeps hiking rates the more it forces other central banks to do the same, lest their countries’ currencies weaken too much against the USD.

I listened to an interview with Nassim Taleb earlier this week and I think he described the impact of raising rates with a pretty good analogy. He compared it to bleeding, slowly taking a drop of blood away from the patient at a time.

I think this is a very good way of phrasing it.
Link to full interview below.

Central banks started tightening monetary policy earlier last year. Since then there is no doubt that economic activity has slowed, earnings have contracted and one at a time the most leveraged and vulnerable individuals and companies are being taken out (from FTX to BBBY).

But as with all things, the full effect of monetary policy takes time and moves in a non-linear fashion.

MEGACAP EARNINGS

Amazon, Google & Apple all reported earnings on Thursday, and all three missed estimates. It is worth going over their numbers to understand the trajectory of the revenues of these behemoths, as it is their first real slowdown in many years, and thus should not be dismissed lightly. Moreover, earnings are slowing nominally, imagine if you adjusted for inflation!

AAPL’s total revenues were down -5% YoY, product sales were down almost -8% YoY and services revenue grew by a disappointing +6%. Operating expenses rose by 12.5% and net income declined by almost -13%. iPhone sales were down almost -10% YoY, although as the company noted, some of this was due to supply constraints.

Remember this data set I shared a few weeks ago about smartphone shipments?

GOOG's total revenues grew by 1% YoY a major slowdown from +36% YoY growth in 2021. Operating expenses rose by over 8% YoY and Net Income was down -35% YoY. YouTube Ad revenue, just to pick one example, was down over -8% YoY.

AMZN’s total sales rose YoY 9%, led by a growth in services sales, as product sales actually decreased YoY. Operating expenses however rose 10% YoY. Net operating income was negative YoY, as Amazon went back to losing money, while net income decreased to $0.3 billion in the fourth quarter, or $0.03 per diluted share, compared with $14.3 billion, or $1.39 per diluted share, in the fourth quarter 2021. The real disappointment comes from the slowdown in growth from AWS, which went from over 40% YoY to now only 20% YoY. As a reminder, AWS is basically the only money-making operation at Amazon.

The key takeaways from the above earnings are as follows

• Operating expenses are rising

• Income growth is slowing and in some cases turning negative

• The consumer is weakening (see Apple devices and Amazon product sales)

• Companies are cutting back on Advertising (Goog)

At the end of the day, reality is catching up with the MegaCaps and investors are starting to realise that as good as these companies may be, they are not immune to macroeconomic headwinds. Thus you must ask yourself if the economy slows further in 2023, what will their revenues do?

It is the trajectory of growth that matters, not so much the absolute number or whether it is positive or negative. US GDP expanded by +5.9% in 2021, then slowed to +2.1% in 2022, and estimates for this year vary, but if we go with the IMF forecast, they expect the GDP growth rate to slow further to +1.4% in 2023. If earnings slowed with GDP going from 5.9% to 2.1%, what will they do when it goes from 2% to 1%, or if the IMF is wrong and growth is flat?

Meanwhile, a curious and not surprising stat, given the recent hype, mentions of the word AI on earnings calls have exploded.

KEEP YOUR OPTIONS OPEN

I don’t want to elongate myself excessively on something we have already discussed amply. However, it is important to note that the options mania continues.

Thursday was a record day in terms of options volume, with the most ever contracts purchased.

At the same time, it was a record day of Call buying. As a reminder Call options are contracts which represent bullish bets on equity prices rising.

The above activity generated quite the short squeeze on Thursday, resulting in one of the largest short-covering days in the last 10 years. To give you a flavour of the action, intraday the Nasdaq 100 was up +3.5%, MOON (the Moonshot ETF) was up 6.66%, and SI (Fraudulent Crypto Neobank Silvergate) was up 50%. When things like Coinbase, which had a short interest of 25% rise 50% in two days (Wed-Thur) it is not surprising short sellers are forced to cover.

Ironically, if you just take a step back and think about it, there could be no worse point to have to cover your shorts, and yet most had no choice or panicked at precisely the wrong the time.

Friday a lot of these squeezes reversed lower and closed down double digits on the day.

SENTIMENT

Sentiment reached Extreme Greed levels for the first time since late 2021 this week.

Active Investors continued to increase their equity exposure to the highest level since April last year.

The AAII survey, on the other hand, continues to lean bearish.

I ran my own survey again, and the tilt changed in favour of the Bulls. The 30% of bears remain adamant, but a lot of undecided shifted to a more Bullish stance.

I think the most telling statistic in terms of sentiment is that of retail orders as a percentage of total market volume, this just exploded to an all-time high. The last time we were at these levels was during the Covid lockdown and meme stock mania in late 2020/ early 2021.

ECONOMIC CALENDAR

A light week in terms of economic data, although we do get to hear from a few central bankers between Tuesday and Wednesday, including Powell.

EARNINGS CALENDAR

THE ROAD AHEAD

The market is an unbelievable and complex machine. At any one point in time, multiple factors interact to produce the ticking prices we see on our screens. The driving forces can range from macro and fundamental to sentiment and investor psychology, from liquidity and flows to structural dynamics and market internals, positioning, cost of capital, volatility, etc, etc, etc.

At certain times some forces will apply more pressure and matter more than others, at other times, the driving forces will change. Millions of individuals, computers and AI interact every day to try and understand these dynamics, get ahead of them and gain an edge on the market. Few succeed, which is why we have seen the explosive growth of passive investing over the last few decades.

But we are here because we are crazy enough to think that over time we can gain an edge on Mr Market, and yet I would posit that we can do so if and only if we accept that what we are doing is engaging in the art of speculation.
After all, we are forming an opinion about the future without knowing all the facts. (The Oxford Dictionary)

Many forces are colliding at the same time, pushing and pulling in various directions.

The economy is slowing and earnings are declining.
Valuations remain historically high.
The value of cash is at 20 year highs.
Monetary policy is being tightened at a record pace

and yet,

A huge wave of liquidity is entering the markets and finding its way into asset prices.
The labour market is as tight as tight can be.
Retail investors are as undeterred as ever and global participation in stock market speculation is at all-time highs.

Paradox? you see it everywhere you look.
What gives? what drives?

I don’t know, but this is how I am thinking about the next few months.

Last week we saw a frenzy, Bears capitulated and Bulls got way ahead of themselves. Most markets are overbought and sentiment is running wild.
My base case is that we should see some sort of a correction from here.

The key question is what happens after that?

I think the next CPI print on Feb 14th will be a key moment, especially as it coincides with Vol expiry and OPEX week. Unless the bears can keep the pressure on beyond that date and move the S&P back below 4000, then given the rise in global liquidity and the continued desire to front run the end of the interest rate hike process, it is plausible that asset prices continue to drift higher, possibly until late spring.

This is not my base case, but one has to keep an open mind.

Why until late spring? a few reasons.

Rate hikes will by then be done. The market at that point has to deal with reality and can no longer look forward to the Pivot.

The easiest comparisons from a CPI point of view will be over, after June it becomes harder for inflation to decline YoY, simply due to base effects.

The Debt ceiling issue will be resolved, and so the Treasury will resume selling bonds and removing liquidity from the market, while the Fed will still be doing QT.

IMO the next few weeks will be key in determining the trend for the next few months. 4000ish in the SPX will likely be the key area where the next multi-week leg will be decided.

In terms of tools, you can lean on Bitcoin, Gold & the Dollar to try and understand how liquidity is trending.

So to sum it up

Short term, 1-2 weeks, overbought and due a pullback
Medium term, 1-3 months, depends on what happens post-OPEX week
Longer-term, 3 months and beyond, no change in my view that we are in the process of popping a bubble of historic proportions and we have yet to see the bear market lows.

Thank you for reading,

Antonio