What I think of markets now — being contrarian in 2023
The last time I penned my thoughts on markets was way back in May 2020, citing “What I think of Global Markets now”. Coming close to 3 years (if you round it up), so much has happened since then. Multiple Covid variants, Suez Canal blocked by an Evergreen container ship, Europe and the Americas reopening and no-mask policies, the Ukraine-Russian war and the Europe energy crisis.
During that time, I took a leap of faith at the peak of the Covid Economy to enter the crypto industry as a research analyst but unfortunately did not survive the layoffs. Thereafter, I took a career break to travel, spending a month abroad and having a rethink about my career and the things that interest me. I concluded with the 2 things that interest me:
- Writing code, getting better at full stack web applications and data analytics (python, SQL, JavaScript, et al)
- Understanding financial markets from a top-down approach (Like it or not, Bitcoin is a macro asset now)
Here I am now, back and time to hone my writing skills so here’re my thoughts for the current market.
Where we are, Expectations vs Reality
At present, we have runaway (soon-to-be controlled) inflation over the past 6 months. The market economy’s SP500 index peaked in Nov 2021, 2022 was a year of hurt for all risk assets, and the Federal Reserve has hiked rates by multiple times (in multiples of 75bps) leaving policy rates standing at 4.25–4.5%.
With my humble understanding of economics, the initial roadmap at the peak of the cycle (pre-hike environment) which I thought would make sense qualitatively were:
- Fed Policy guidance on initial rate hike at the peak Covid economy cycle
2. With the glut of liquidity in the market economy, it is only logical that we would have runaway inflation in the event of a poorly timed rate hike (hindsight is always 20/20, don’t @ me).
3. As with all business cycles, the mandate of the Federal Reserve is to manage price stability and employment levels.
Expectation: what happens in an inflationary cycle
During rate hike cycle aimed at tackling inflation, the real economy generally goes through multiple phases.:
a) Inflated costs — Businesses pass higher costs to consumers due to runaway inflation
b) Higher interest rates and demand destruction— Businesses anticipate higher policy rates in the hike cycle adjust their expectations and forecasts accordingly, this reduces B2B demand across multiple industries
c) Widespread Layoffs — After adjusting business expectations and forecasts, it leads to layoffs due to lower output and reduced production. Layoffs result in reduced consumer demand in the economy. This would lead to restructuring within businesses and eventually deleveraging in the financial ecosystem.
Reality: What we got
Regrettably, the conscientious rate hikes and the typical inflation tackling playbook from the Fed Reserve didn’t occur — instead aggressive 75bps rate hikes occurred in a “better late than never” aggressive approach — I recall a conversation with a friend where we both agreed that the Fed should frontload rate hikes early to avoid ‘transitory inflation’; then again I’m no central banker. Against a deteriorating macro backdrop and a policy rate hike cycle, markets went ahead and repriced towards the downside accordingly. Outside of the macro markets, crypto markets were busy fighting their own war, having rugs pulled and frauds committed. All in all, everyone lost money (except for traders who were net-short for the whole of 2022).
Fortunately, on boxing day, slightly before the 2023, China, the world’s largest producer of goods, announced they’re open for business again to bring in the Lunar New Year, bolstering both supply and demand-side support for the ailing global economy which sees recession bells & warnings from macro-economists ringing louder than ever. If any, one thing I learnt about markets for sure — when the average Joe (including myself) on the street is talking about something, we’re sure to know the peak of the event has arrived and being a contrarian has a relatively higher payoff than following the herd and joining the already crowded trade (all about the probability, son).
Market Catalysts and drivers
As with my previous piece, the focus is on the US economy which would have passthrough effects to the rest of the world. This year’s narrative revolves around a slowing rate hike, a pause or even a rate cut depending on how fast inflation declines. In order to understand the direction where the narrative is going, I’ll be listing all the economic indicators first. As I’m no professional economist, I turn to JPM’s 2023 outlook for a sanity check (Gotta make sure I’m not writing rubbish). JPM suggests that the Federal Reserve is expected to pause rate hikes in 1Q2023.
Understandably, the financial markets is a game filled with the opinions of the many participants, hence we look at the markets’ expectations by observing at the Fed 30D Futures and the other is looking at the FedWatch tool provided by CME.
At time of writing, the market expects a 25bps hike at the next meeting which takes place on 1 Feb 2023. Comparing against the 30D Fed Futures, it seems the market expects terminal rate to be around 5%, leaving room for a 50bps hike (unlikely) or 2 more rounds of 25bps. To back our narrative of what’s to come, we turn to a few Macroeconomic indicators which may offer clues to why a hike pause or rate cut might be coming.
Since Bernanke’s introduction of QE1 in November 2008, changes in Fed Reserve’s balance sheet observed seem to correlate with the Consumer Price Index (CPI). CPI can be read as a measure of broad-based demand across the economy. In the chart above, the green line represents the change from year ago for Total Assets on the Central Bank’s Balance sheet. Barring any external supply shock to the economy such as Covid-19, a change in the 2nd order derivative of the Total Asset value for the Central Bank’s Balance Sheet will see or lead to a change in the CPI as well. Without diving deep into the CPI components, it can be said that broad-based demand is declining and the central bank is achieving what it set out to do in a post-Covid economy.
In business cycles, there will be peaks and troughs. For central bankers, the ideal time to hike rates will be when the economy peaks — to prevent overheating.
According to BIS’ definition, the Credit-to-GDP gap is defined as
the difference between the credit-to-GDP ratio and its long-run trend, and captures the build-up of excessive credit in a reduced form fashion.
Generally speaking, trend growth in the economy is driven by credit expansion — a declining Credit-to-GDP ratio or gap can be implied as lower growth in the future. This supports the contrarian narrative where it is in the Central Bank’s and Government’s interest to spur growth.
Finally, we look at USA’s consumers’ Personal Savings rate and the 2s10s yield curv.
According to BEA’s definition, it is defined as:
Income left over after people spend money and pay taxes is personal saving. The personal saving rate is the percentage of their disposable income that people save. This rate is followed to learn about Americans’ financial health and to help predict consumer behavior and economic growth.
Further, USA remains largely reliant on private consumption (a consumption based economy).
- United States Private Consumption accounted for 68.1 % of its Nominal GDP in Sep 2022, compared with a ratio of 68.2 % in the previous quarter. (source: CEIC)
The Personal Savings rate hit a low — just slightly above the 2005 level — suggesting that consumers will find it difficult to squeeze out additional coffers against looming inflation. As if high inflation and low personal savings aren’t bad enough, the 2s10s yield curve inverted in 1Q2022. The 2s10s yield curve is a subtraction of the 2 year yield on US govt bonds from its 10 year counterpart. A 2s10s inversion reflects that investors have a negative view on near term economic fundamentals but whether it signals a recession indicator is entirely debatable. At present what I think matters is the increased cost of borrowing to small medium businesses. With limited coffers, declining consumer demand and higher short term borrowing rates, near term outlook looks bleak for the global economy (think passthrough effects).
Long story short, the American economy relies on its consumers, and if their consumers are running out of money, there will be passthrough effects on domestic consumption and the real economy. With inflation lurking around (despite a decreasing rate of increase), the US government and the central bank will have to figure out how to bolster demand without fanning the inflation flames.
Looking ahead
In any chess game (I’m no chess wiz), both players think multiple moves ahead and tend to engage in a game theory-like behaviour, mapping multiple possible outcomes with the various moving parts (less than Dr. Strange for sure). Despite the indicators and the baselines provided, not all is bleak — we can expect limited upside when it comes fed funds hikes.
With the Supply chain shock fading (can be tracked from the Department of Transportation Indicator), we’re likely to see further easing of CPI and broad based demand. This provides headroom for policy makers for some form of stimulation without poking the monster called “inflation”. Further, having China return to normalcy means additional global output to cushion any downside risks.
Depending on the timing of the policy response from policymakers in the driver’s seat, the market economy might be at an inflection point where going up pays better than going down. My take is we get a “talking about talking about rate cut” in 2H2023 and the outlook for risk assets will start to look positive again and fingers crossed we don’t see a “Stairs up Elevator down” scenario in the near future.
Again, these are my thoughts, anything can happen in the current state.
