As Binary As It Gets: Bulls, Bears and the Pivot
It’s a binary world. To an extreme extent, opinions on the market are divided, and they are split on one key issue: Will the Fed have to “pivot” toward easier monetary policy in the next few months, or won’t it? This question vitiates investment decisions in almost any asset you care to mention. Everywhere you look, choices are contingent on that central call of whether the Fed has to reverse. Meanwhile, prices of most assets are set at some mid-point, based on a set of conditions nobody expects.
Absolute Strategy Research Ltd.’s latest quarterly survey of global asset managers, managing $4.3 trillion, suggests “bulls” and “bears” are almost exactly in balance. Overall, optimism is low. The survey’s composite optimism indicator, based on answers to several questions about the economy and markets, is just above 50% and barely higher than it was three months ago:
But this conceals deep differences. First, although there is much pessimism or bearishness about the economy, that doesn’t translate into similar negativity toward markets. To quote Absolute Strategy’s David Bowers:
There still seems to be something of a disconnect between respondents’ macro assumptions and the readthrough to financial markets. Investors expect the world to be in recession a year from now (probability 62%); the US unemployment rate to be higher (probability 76%); and Global monetary conditions to be tighter (probability 71%). These parameters do not spell soft landing.
The contradiction is resolved to an extent by a belief that bad news is good — that the economy will be slow enough to push the Fed into reversing course early and starting to cut rates. In such circumstances, markets can prosper despite a poor economy. Those who feel that way make a narrow majority in what Bowers calls a “bimodal” or tribal division.
Absolute Strategy’s Charles Cara breaks down the survey responses using machine learning to find clusters of opinions. Usually, there are several distinct schools of thought. This time:
Our panel divides neatly into just two groups. But the debate has moved on from being about the severity of any upcoming recession, to being about when the recovery in the economy and risk assets might occur. It may seem a cliché, but the hackneyed labels of “Bulls” and “Bears” do, for once, seem appropriate. Most respondents are “Bulls” but it is a narrow majority, with just 57% of the panel. This group sees business confidence higher in 12 months’ time, but they are not confident that there will not be a recession and they still think unemployment will be higher next year.
Broadly, the bulls think that there will be a recession, but a shallow one that is already over by the end of 2023 thanks to the Fed. Bears think the Fed will still be tightening the screws a year from now and that the economy will be slow. “Bears” by this definition have grown in strength over the last few weeks. Also, note that the Absolute Strategy survey was taken just before last week’s awful inflation report for August. Judging by the fed funds futures market’s implicit projection of the rate as of the end of 2023 which briefly hit 4%, the latest CPI could have shifted opinions significantly:
How seriously should we take the bullish case that the Fed will not need to force the economy into recession to bring inflation down? It’s maddeningly difficult to dismiss. Despite contemporary fashion for hurling abuse at our fellow humans, both bulls and bears have good arguments on their side. This is from one bull, Brent Schutte, chief investment officer at Northwestern Mutual Wealth Management:
Do you believe that the Federal Reserve has to eviscerate the economy to get inflation back down? I don’t. I think a lot of inflation is still tied to the aftershocks of Covid and will naturally wear off as time passes by as spending shifts from goods and services, as the inventories are rebuilt, as the consumer pulls back spending, which is exactly what has happened... The question to me is how much more does the Federal Reserve have to go? And those rate hikes to me are largely geared towards making sure they don’t lose their inflation fighting credibility, which I don’t see any evidence that they have lost any inflation fighting credibility.
For this week, less important for the broader asset allocation picture, swaps continue to price in a 75 basis-point hike, with some betting on a full 100 basis points. Once again, it’s binary. This is from Tom Hainlin, national investment strategist at US Bank Wealth Management:
We’re thinking this is setting up to be a fairly binary outcome next week. 75 basis points would confirm that we’re on a tightening path that’s much more aggressive than we anticipated at the start of the year but consistent with recent Fed messaging. And we think the capital market participants would sort of take that in stride. The other side of that binary outcome, which would be the much less sanguine, would be the 1%. And given the improved but still weak consumer confidence number... sluggish retail sales and concerns about global growth, we think that part of the binary outcome would not be digested well by capital market participants. And you have a potential further leg down for riskier assets like equities.
Beyond the Federal Open Market Committee meeting on Wednesday, the critical issue is how long rates keep rising, and when they start falling. This creates problems for investors. Generally, when investing you want an “edge” — a reason to believe you know better about what you’re investing in than the rest. That’s not possible on an issue where so much information is publicly available as is the case for the Federal Reserve. And it’s easy to be wrong for the right reasons, and vice versa. You never want to be in a position where a macro call makes so much difference, but it’s unavoidable.
It’s cowardly not to make a call, so I’ll make one. I believe that inflation is too well entrenched for the Fed to be able to ease much if at all by the end of next year, so that makes me a “bear.” But it’s a low conviction call as I could very, very easily be wrong. It’s possible to hedge bets in finance, and more or less all of us should be doing that. It hurts not to put all the money on the winning side, and sometimes it can hurt not to go along with the rest of the tribe. But in this case, it’s the right course.
— Assistance by Isabelle Lee
Questions of Timing
Now that we’ve identified just how pivotal monetary policy is to the stock market outlook, it’s worth looking at attempts to quantify it. History offers some clues. Ned Davis Research has published an analysis of past Federal Reserve tightening cycles dating back to 1955 to determine the time horizon between the beginning of an easing cycle and the end of a bear market. (Tightening cycles are defined as three or more hikes without an intervening cut, whereas as easing cycles are two or more cuts without an intervening hike. Full cycles include both tightenings and subsequent easings.)
On this basis, NDR found that the market and the Fed lined up perfectly only about half the time. The table below shows the start and end dates of tightening cycles compiled by the firm. The main takeaway for stocks: Bear markets roughly end about the same time as easing cycles — the timing just widely varies, sometimes differing in years. The main takeaway for those hoping for an imminent pivot by the Fed is that (again with much variation), rates tend to stay at the top for eight months before cuts start:
This year saw only the fourth time that the bear cycle in equities started even before a rate increase (indeed, it started as the Fed was still buying bonds). On average, bear markets don’t start until a median of 6.8 months after the first Fed hike, making this one very different.
After two consecutive 75 basis-point hikes, the Fed has raised rates by 225 basis points already since kicking off its most aggressive tightening campaign in decades in March. The hike that the FOMC will announce on Wednesday will lift the benchmark target rate to either 3.25% or 3.5%.
On the crucial question of how the equity market interacts with the finish of tightening cycles, NDR found that bear markets end a median of 13.6 months after a cycle has ended. Only three times in the past have bear markets ended before the tightening cycle: 1978, 1987 and 2016. In those cases, another bear market ensued before the subsequent easing cycle had finished. So the historical precedent strongly suggests that the low for the equity market is probably not yet in.
This bears repeating: For each of the three bear markets that ended before the completion of the tightening cycle (which needs to be the case this time for the low really to be behind us), there was a second bear before the subsequent easing cycle had finished. “The implication is that even if the June low was the start of a cyclical bull market, history suggests the Fed will inflict more pain on equity investors,” Ed Clissold and Thanh Nguyen added. Still, they found that bear markets in the past have ended even before easing cycles finished in all but one case: 1960. “As of today, the end of the easing cycle seems a long way off, but it is important to keep in mind moving forward.”
Amid all the numbers and dates to digest, NDR warns “not all tightening cycles are created equal.” Equities, they noted, have seen downturns sooner during fast tightening cycles (Fed raising rates at most meetings) compared to slow ones. They also take longer to recover:
This is, of course, a fast cycle so far. Probably best not to bet too much on an imminent Fed pivot.
— Assistance by Isabelle Lee
Last week’s anniversary of sterling’s 1992 ejection from the European Monetary System’s exchange rate mechanism, a key moment in British history, has brought some interesting analysis in its wake. I find the chart below from Adam Cole of RBC Capital Market particularly interesting. The general belief at the time was that the pound was unrealistically high. Thirty years later, with the pound its weakest against the dollar than at any time since 1985, the conventional wisdom is that it’s undervalued.
In nominal terms, Cole’s chart shows, that’s broadly true, albeit somewhat overstated. But in real terms, adjusting for changes in inflation, the picture is different. The real effective exchange rate in the following chart is calculated comparing increases in unit labor costs in the UK and the rest of the world. British labor costs have risen much faster than in the rest of the world since the Global Financial Crisis (because productivity hasn’t improved as much as it has elsewhere), and that leaves the pound very overvalued:
This casts Britain’s pursuit of austerity since 2010 in a negative light. It has rendered the country much less rather than more competitive. Cole also points out that in 1992, the UK’s current account was close to balance, compared to a deficit of 4% of gross domestic product in the last four quarters. This again suggests overvaluation now compared to then.
Just as overpriced stocks can grow more overpriced, overvalued currencies can grow richer. But valuation cannot be ignored. To quote Cole:
Valuation alone is not a reason to be bearish GBP and deviations from competitive fair value can be sustained for long periods without correcting. But looked at through the most meaningful measures, it is clear that the current level of GBP is not an impediment to further significant falls.
The best solution for the UK at this point is to improve its productivity and competitiveness. As that’s very difficult, we should assume that another course is more likely — that the pound will fall further.
Monday will be a national holiday in Britain for the funeral of Queen Elizabeth II, while much of the world will be watching on television. For all the pageantry, and the diplomacy on the edges, it is at its core about the universal attempt that we all make to come to terms with mortality. As such, here are some suggestions for music that attempts this. For contemporary music, I think by Arcade Fire, their debut album written when several of them were suffering family bereavements, remains a remarkable statement; for the most mesmerizing musical meditation on mortality I know, I find it impossible to get beyond the minimalist composer Arvo Part’s Cantus in Memoriam Benjamin Britten; for more traditional religious reconciliations with death, try this version of the by Geoffrey Burgon (slightly incongruously written for the BBC’s great dramatization of John Le Carre’s Tinker Tailor Soldier Spy), or other versions by Orlando Gibbons, or Rachmaninov (in Old Church Slavonic), or Arvo Part again, or Palestrina. Or you could watch the entire 90-minute service of remembrance for the Queen staged Sunday at Christ Church, Oxford. Or you could tap into another great religion’s relationship with mortality and listen to the beginning of Leonard Bernstein’s Kaddish Symphony (as performed at Hiroshima on the 40th anniversary of the first use of a nuclear weapon).
Have a good week, everyone. And farewell Queen Elizabeth.
Bloomberg News provided this article. For more articles like this please visit bloomberg.com.