Top Things to Watch this Week

“Not everything that counts can be counted, and not everything that can be counted counts.” – Albert Einstein
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Macro Corner
Months before inflation took off, we pointed to various factors that could prolong headline numbers to catch up with underlying price appreciation. Components such as OER (owners’ equivalent rent) would only show up months after they were present in the real economy.

We found ourselves at a crossroad between tightening while economic conditions were still favorable and keeping the spigots open. Central banks chose the later and the meme train kept going.

As the set of choices became increasingly narrow, attempts to talk down inflation sounded ever more desperate. From removing transitory from the Fed’s language basket to pointing to longer-term inflation expectations continuing to stay well anchored.

While a floor beneath risk assets felt good in the moment, we are yet to witness the consequences of leaving policy accommodation in place when economic optimism was available in abundance.Do not miss Tuesday’s market video titled: Buying Opportunity of the Year; We Can Only Hope For Such Carnage.

A Regime Shift III
Since writing to you last week, we have seen a lot of volatility on a daily basis, but not a lot has changed in regards the economic backdrop we are seeing. If anything, inflation has surprised to the upside and the Fed may turn on the autopilot when dealing with inflation.

The Fed and central banks globally face nothing but a very difficult backdrop when it comes to tightening policy: the world has never been as addicted to liquidity and we are about to find out just how much risk assets depend on investors out on the risk curve.

In addition to this transition to a more “normal” state, investors appear to come with a recency bias where this correction may resolve in just as fast of a snap-back as we saw on the back of March 2020. But if you zoom out and reflect on what the conditions were back then, we are indeed in a very different environment; potentially, one with inflation settling in at a higher rate for longer, therefore jeopardizing future return expectations across the board.

We also talked about hard choices that policy makers are facing at this point. As they chose to push tough decisions further into the future, we have increasingly put ourselves in a corner. With debt levels where they are, inflation where it is, and growth slowing, this train becomes a multi-variate problem to maneuver. Just how tough the landing will be is going to depend on the degree to which the Fed is willing to stay its course. Whether an early pivot would be positive in the long-run is questionable as well.

Just like inflation months ago, pressures on risk assets are broadening. We have highlighted high yield two times before and will continue to monitor the space. Similarly, financial condition indicators are growing increasingly aware that the Fed might have to play substantial catch-up. As financial conditions continue to tighten with record high debt levels, it is hard to get a tell on where exactly this will stop. One can make the case that the Fed will end up being much less aggressive than its current rhetoric — one has to wonder about the consequences such pivot would lead to (Fed credibility, the Dollar’s status, etc.)?

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Inflation Expectations, Financial Conditions, Recession Indicators
Breakeven Rates and Inflation Expectations

Source: Bloomberg

The last bullet left in the Fed’s revolver was inflation expectations remaining relatively anchored at the long-end of the curve. Precisely because the Fed has committed to staying behind the curve for so long are we now seeing an acceleration there. Should they not settle in after peak headline inflation, the Fed may have to become incrementally more hawkish — we are going to watch market signals in that regard as it’s not the Fed but rather market expectations doing the policy work for the Fed.
The other option is an early pivot that would favor certain asset classes like Gold in the midst of purchasing power erosion.

Deteriorating Financial Conditions

Source: Bloomberg

Financial conditions are nearing 2018 levels where the Fed pivoted last time — we haven’t begun to hike rates and one could make the case that the correction in risk assets has been front-loaded. The other side of the coin: a substantial inflation backdrop that may be more structural than initially thought.

Structural Factors 7 years of underinvestment in oil exploration & developmentOnset of a multi-decade onshoring trendHousing (Population growth – housing; Housing units built via Statista)
Business Environment & Health of the Consumer
We have also been highlighting a slower economy – first indicated by the Eurodollar curve, – as reflected in NFIB numbers. Slower growth, higher inflation, and lots of inventory orders that were placed in the midst of supply chain disruptions — this is not a favorable backdrop for business confidence going forward.

NFIB Small Business Metrics

Source: Bloomberg

Adding to the potential challenges of the business environment and therefore CAPEX in the real economy is the consumer. Consumer credit in absolute $s has gone down drastically and so has consumer confidence. In the meantime, the energy goods expenditures are close to exceeding 2008 levels.

Consumer Credit, Consumer Confidence, Consumption Expenditures on Energy Goods

Source: Bloomberg

Food Prices

Source: Bloomberg

Recession Indicators

The conversation is more and more shifting towards inflation’s economic impact. As purchasing power erodes and the consumer gets hurt, we will see inflation as a primary talking point heading into the midterm elections in the fall. You cannot rule out transfer payments to lower-income families in some form whose Dollars will buy more stuff.

10s – 2s Yield Curve

Source: Bloomberg

The Eurodollar curve has been our leading indicator when it comes to guiding us through economic growth figures. This week, we note a substantial shift upward across the curve, most likely attributed to increased fears around broadening inflation.

Eurodollar Forward Yield Curve

Source: Bloomberg

While both the 10s-2s spread as well as the Eurodollar curve signal stop signs ahead, the New York Fed’s recession indicator is extremely subdued. If the Fed is going to use whatever indicator fits the narrative, we may be in for a worsening of conditions and a prolonged period in which returns are low.

New York Fed Recession Indicator

Source: Bloomberg

Keeping an Eye on High Yield

CDX High Yield

Source: Bloomberg

High Yield OAS Across Sectors

Source: Bloomberg

CDX EM Spread (Emerging Market Debt)

Source: Bloomberg

US Corporate High Yield | EM USD High Yield

Source: Bloomberg

US Corporate Baa-10yr Spread & US Corporate High Yield Average OAS

Source: Bloomberg

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Economic Calendar

U.S.

Data Release Times (E.T.)

China

Data Release Times (E.T.)

Eurozone (decreasing importance of events from top – bottom)

Data Release Times (E.T.)

Food for Thought

Geopolitics | Russia-Ukraine, Iran, Venezuela

The more Russia has pursued this war in Ukraine, the clearer it becomes that we are in the process of a tectonic shift in global power structures. The western hemisphere on the one end, a set of relatively neutral states in the middle, and a strong China-Russia coalition on the opposite end.
From an investment perspective, the likelihood is geared towards onshoring and a focus on resiliency over efficiency. We will further dive into the implications of an economic de-coupling next week.

Weekend headlines that will affect markets starting Sunday night:

France, UK, Germany say Iran deal could collapse on Russian demands – Reuters

Missile target US consulate in north Iraq, no casualties – AP

Options Market

SPX 25delta Put IV – 25delta Call IV

Source: Bloomberg

Crude Oil Forward Curve

Source: Bloomberg

When producers think about future production and the type of ROIC they will receive, one has to consider forward contracts.

EarningsSentinelOne (S) reporting after the close on Tuesday:Consensus: EPS est. ($0.18); Revenue est. $60.66 millionCommentary on the following will be monitored: Cybersecurity trends amidst geopolitical tensionsPrivate vs. public institutions cyber-threatsAddressing the fragmentation of the cybersecurityAI-detection and response to cyberthreats

Black Rifle Coffee Company (BRC) reporting before the open on Wednesday: Consensus: EPS est. ($0.02); Revenue est. $69.03 million Commentary on the following will be monitored: Community engagement of Black Rifle’s customers across social media channelsInflation pressures and pricing of their coffee (pricing power)Coffee bean shortages and whether it affects the company

Dollar General (DG) reporting before the open on Thursday:Consensus: EPS est. $2.56; Revenue est. $8.69bnCommentary on the following will be monitored: Inflation on goods at Dollar GeneralCustomer appetite for lower priced goods

FedEx (FDX) reporting after the close on Thursday:Consensus: EPS est. $4.70; Revenue est. $23.42bnCommentary on the following will be monitored: Inflation pressures and labor shortages leading to delivery delaysDisruption risks by competitors (Amazon)

Top Things to Watch this Week

Bill Baruch

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