Barclays with the big issue of circulation. The key point of the resolution is the US work. If the 5 million missing workers don’t stem wage growth as stocks produce their own soft landing, then it will continue. If wages and inflation hold up, longer interest rates will end the rally and end the cycle.
Prices and shares do not match, probably spelling problems with shares
The string of recent positive economic data (retail sales, payroll data, etc.) and signs of slowing disinflationary momentum have forced bond markets to significantly recalibrate policy expectations. In fact, growth is picking up in all major economies, increasing the pressure on central banks to go further. For example, Fed fund futures markets are now pricing in a 5.3% peak interest rate through year-end 2023, up from under 5% less than a month ago. Similarly, short-term interest rate markets have eliminated much of the policy easing over the next year
Higher expectations of a more aggressive Fed should weigh negatively on equities. In fact, higher rates should compress valuations, and this would happen especially at a time when negative operating leverage (ie margin compression) is increasing. Should the Fed indeed react harshly to the latest economic data, tightening could increase the risk that the Fed “exaggerates the rate shock” and “slams on the brakes too hard”.
While the above points to heightened downside risk for stocks, options appear to be at odds. For example, the options implied probability that the S&P will fall below 3200 by Dec 23 (Barclays Bear Case price target, see Earnings Learnings: Red Lights, 02/21/23) is now ~10%, unchanged from the a= level month ago. Interestingly, the S&P is now 1.5 times more likely to be seen at or below 4200 (Barclays soft landing scenario price target) than a month ago (44%). In our view, this suggests that equity markets are not in line with what rates markets are signaling and any convergence of views is likely to hurt equities.
It almost feels like 2022 again
In particular, equity sectors/pocket stocks, which suffered the most in 2022 and have seen the strongest recovery rally year-to-date, are in our view the most vulnerable to the type of policy-induced sell-off seen over the past year. Notably, among US equity ETFs with liquid options, Semis (SMH/SOXX)/Comm. Service (XLC) and Disc. (XLY) is likely to suffer the most from a correction similar to 2022. To hedge stocks, we repeat the trades we recently recommended (see Hope for a soft landing, hedge against the harsh reality, 2/7/23). Chart 4 also shows that small-caps (IWM) stand out as particularly cheap options from a volatility perspective given the YTD rally. As such, we continue to find IWM puts attractive (see Fade the recent Smallcap Rally with Options, 01/24/23).
David Llewellyn-Smith is Chief Strategist at MB Fund and MB Super. David is the Founding Editor and Editor of MacroBusiness, and was the Founding Editor and World Economy Editor of The Diplomat, Asia Pacific’s leading geopolitics and business portal.
He is also a former gold trader and economic commentator for The Sydney Morning Herald, The Age, ABC and Business Spectator. He co-authored The Great Crash of 2008 with Ross Garnaut and was editor of the second Garnaut Climate Change Review.
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