LD Capital Weekly Macro Report (12.11): Will the FOMC cash in on gains?

Market at a glance

Last week, European stocks and U.S. stocks performed strongly, and the larger-than-expected non-farm payrolls only fluctuated slightly, and in the end, U.S. stocks closed up on the same day; Chinese and Japanese stock markets have lagged behind, mainly because China has been downgraded by Moody’s, and Japanese stocks have appreciated sharply because of the yen; The Fed’s imminent pivot to interest rate stability could be a catalyst for a winner-to-laggard rotation this year, with Magnificent 7 gains trailing small-cap stocks by 7% over the past three weeks, and a large valuation gap creating a catch-up opportunity for lagging markets:

The decline in bond yields has been accompanied by an improvement in economic growth expectations in risk asset markets, and equities, including crypto investors, do not seem to equate further Fed easing with increased odds of a recession, with recent goldiloc sentiment spreading, while lower real yields and stronger equity pricing in economic growth typically lead to the strongest equity return cycles.

However, due to the weak economy heading into early 2024 and the overpriced interest rate market, risk appetite is likely to fall first and then rise. Bonds and their alternatives, such as traditional defensive sectors, will emerge as the economy weakens in early 2024 and then re-emerge as growth returns, with opportunities in small-cap and growth stocks likely to re-emerge at a later date.

Last week’s best performers continued to be in highly dependent on loans, which are interest-rate sensitive, with optional consumption and real estate:

In recent weeks, the relationship between cyclical and defensive equities has been at an impasse, with US equities slightly outperforming the world:

In recent weeks, the trend has reversed in both growth and value stocks. Growth stocks are starting to fall, and value stocks are starting to rebound. However, such a reversal of momentum is not as obvious as the trend reversal of large-cap stocks and small-cap stocks, combined with the position data, we can experience that the market is very risk-taking, is covering the small cap, and is unwilling to give up for high growth:

The S&P 500’s 11% rise in the latest month was largely due to valuation expansion, not to improving earnings fundamentals. SPX Equal P/E from 14x to a modest 15x; The standard price-to-earnings ratio went from 17 times to 18.7 times, just below the July high. ：

Declining real yields: As real yields (i.e., inflation-adjusted interest rates) fall, the cost of funds in the market becomes cheaper, pushing up stock prices:

Historical data shows that valuations and prices typically rise after the Fed ends its rate hike cycle, but economic growth remains the determining factor. In the past eight Fed rate cut cycles since 1984, the S&P 500 has typically risen 2% in the first 3 months after the first rate cut and 11% in the 12 months that followed. Expectations that the Fed is about to cut interest rates mean that the stock market usually rises before the first rate cut. However, the results were widely distributed, ranging from +21% (1995) to -24% (2007) over the next 12 months.

The economic background of the United States in 1995 was:

• Economic growth slowed but was good in absolute terms, with GDP growth falling to 3.0% from 4.0% in 1994.
• Inflation rose but not in absolute terms, with CPI growth rising to 3.0% year-on-year from 2.8% in 1994.
• The unemployment rate has declined, from 5.5 per cent in 1994 to 5.2 per cent.

U.S. Economic Background in 2007:

• Economic growth slowed, with GDP growth slowing to 2.2 percent from 2.6 percent in 2006.
• Inflation rose, with CPI rising to 4.0% year-on-year from 3.2% in 2006.
• The unemployment rate has increased, rising to 5.1 per cent from 4.6 per cent in 2006.

Compare the 2023 economic background

• U.S. GDP growth is expected to be 2.1% in 2023, unchanged from 2022;
• U.S. CPI 2023 year-on-year growth is expected to slow to 3.3%, down sharply from 7.9% in 2022
• The U.S. unemployment rate is expected to be 3.9% in 2023, essentially unchanged from 3.8% in 2022

The Federal Reserve began raising interest rates in February 1995 to curb inflation. However, as signs of slowing economic growth became more apparent, the Fed stopped raising interest rates in July 1995 and began cutting rates in August 1995, and the overall economy was relatively healthy, and there were major technological advances (computing and the internet) in the mid-90s, so the stock market rose sharply before and after the rate cut. Expectations of interest rate cuts earlier in 2007 boosted market sentiment, which, combined with the housing bubble, led to a sharp rally in the stock market in the first half of 2007. However, with the onset of the subprime mortgage crisis and recession, investors began to realize that cutting interest rates would not solve the underlying problem, so the stock market began to decline.

So recession is still the key issue: when a recession occurs shortly after the first Fed rate cut, equities have historically underperformed, which has been the case in 3 out of 8 cycles:

Historically, there is an 8/12 probability that yields will fall three months after the rate cut, with an average drop of 34bp, and an average drop of 15bp in the three months before the rate cut, which shows that the asset is more certain:

At the end of last week, market yields rebounded slightly due to the larger-than-expected NFP and consumer confidence surveys, and the yield curve inversion deepened, and the dollar received some help, but the Bank of Japan raised interest rates, and the yen once strengthened sharply by 4% to put a lot of pressure on the dollar index, but because many people are not optimistic about the negative impact of the Japanese economy and interest rate hikes, USDJPY fell only 1.14% for the week:

Digital currencies continued to be strong, but the ALTS rose (+8%) more than BTC and ETH (+6%) last week for the first time in four weeks, indicating that the originally concentrated hype has spread; Gold fell 3.4% for the week, and oil prices recorded a downward trend again, but coal, iron ore, and lithium ore rose, and China’s lithium carbonate futures contract rose for two consecutive days, and it seems that there was a short market:

The net shorts of large speculators in BTC futures decreased slightly, but remained at an all-time high, and the net shorts of market makers refreshed their all-time highs last week, in contrast to the highest all-time net longs in asset management:

Interest rate expectations

The interest rate market currently predicts that the probability of an interest rate cut in March next year will reach 71%, and the probability of a rate cut in May will reach 100%, and 120bp will be 5 times throughout the year, which is a bit extreme, compared to the 150bp expected by the market panic during the banking crisis in March this year:

The fall in market interest rates has pushed the Financial Climate Index to its lowest level in four months:

Extreme expectations are not unfounded. The current degree of lower-than-expected inflation is far from the broad expectations earlier in 2024, especially as the trend in Europe suggests the risk of potentially dramatically lower-than-expected inflation in Europe, the chart below shows the 2-year inflation expectations in Europe and the United States based on Zero-Coupon Inflation Swap derivatives, with the US approaching 2% and Eurozone inflation expectations already below the ECB’s 2% inflation target of only 1.8%:

On the US side, if the lagged effect of housing costs is removed, the core CPI (consumer price index) has reached the 2% set by the Fed in the past two months, as the sharp decline in new rental price increases should pull down housing inflation for most of 2024; The biggest uncertainty comes from oil prices, but it seems that oversupply is still the theme for now:

The job market has cooled modestly

Last week’s data was focused on employment, with the data providing a mixed bag and not reversing the cooling trend that had already occurred, which is a situation that the Fed likes to see:

• The U.S. economy added 199,000 jobs in November, slightly higher than expected, the unemployment rate fell to 3.7% (a four-month low), and the labor force participation rate rose, all of which point to a healthy labor market. However, the return of striking auto workers and film and television workers increased wages by 47,000. Therefore, when we look at the three-month and six-month averages, the real growth level is basically stable.

• Job openings fell for the third month in a row in October (8.733 million), a larger-than-expected decline to the lowest level since March 2021, but still above the pre-Covid average in 2019 (~7 million) and above the total number of unemployed (6.5 million). At the same time, the number of resignations has remained stable, which also indicates that the tightness in the labor market has eased. Historically, the quit rate has led wage growth, and the latest data is the lowest in nearly two years, suggesting that wage growth will be difficult to improve in the future.
• In terms of structure, education added 99,000, government employees added 49,000, and leisure added 40,000, and the sum of these three sectors accounted for almost all of the new jobs in November. This is also the characteristic of the US job market this year, with a cumulative increase of 2.8 million in the past 12 months, of which 2.2 million are from these three industries, including 1 million in education, 640,000 in government employees, and 530,000 in leisure. The number of people employed in the private sector, excluding government employees, has reached the lowest level of the previous cycle.

The stock market is rising, the number of job openings is falling, which is not often seen in history these days:

Funds and Positions

Goldman Sachs PrimeBook data shows that hedge funds (HF) are net buying US equities for the first time in four weeks, mainly in macro products. However, individual stocks saw a net sell-off for the fifth week in a row, despite the aggressive buying by retail investors. Short-term trading continues to increase. Most investors are on the sidelines, reluctant to trade on a large scale in the face of next week’s CPI data and the Federal Reserve meeting. But some long-term investors are starting to buy the tech sector on a small scale.

The recent decline in options buying in the retail market suggests that the peak of short squeeze may have passed:

Cumulative net trading flows showed that cyclicals fell to new lows overall, mainly due to net selling in the energy and financial sectors, and technology, media and telecommunications (TMT) stocks: TMT stocks were net sellers for the fourth consecutive week, led by short selling, but the pace of selling slowed significantly compared to November, which was dominated by long-term selling. After Big Tech has been actively sold in recent weeks, The Mag 7 collectively has collectively net bought this week and has been net buying on a daily basis for the past three trading days:

Equity and high-yield bonds have maintained inflows over the past week, but there have been large outflows from investment-grade bonds and government bonds. This suggests that investors are shifting from safer assets to more speculative ones.

Notably, despite the tumble in Chinese equities, public market funds saw their biggest weekly inflows in 11 weeks:

Emotions

The Goldman Sachs sentiment indicator remained at an “excessive” level of 1.0 or above for the third week in a row

The BofA Market Sentiment Indicator (Bull & Bear Indicator) rose sharply to 3.8, indicating that investor pessimism is improving significantly. However, the indicator is close to the neutral zone, which means that the market sentiment is no longer in favor of risk assets.

AAII Investor Survey Bearish Sentiment Slightly Decreased, Bearish Sentiment Rose Slightly:

The CNN Fear and Greed Index remained at its highest level since early August, with little change last week:

Institutional perspectives

[GS: Optimistic scenario has been reflected in the price, consider downside protection]

The S&P 500’s overall price-to-earnings ratio is only 5% below Goldman Sachs’ optimistic scenario. Goldman Sachs’ optimistic scenario is based on a real yield falling to 1.5% and a price-to-earnings ratio of 20x. The current real yield is about 2%, and the price-to-earnings ratio is close to 19 times. GS believe that there are three possible scenarios in the future:

• If real yields fall further modestly due to falling inflation and Fed easing, the P/E ratio could reach 20x.
• If real yields rise modestly due to the elasticity of economic growth, the P/E ratio could be 18x.
• If real yields fall further sharply due to economic growth concerns, the P/E ratio could be 17x.

In addition, it is important to take into account:

• Markets are already pricing in a 130 basis point Fed rate cut in 2024, higher than Goldman Sachs economists expected. Banking strategists see it difficult for the market to price in a more optimistic rate cut.
• The Goldman Sachs sentiment indicator rose from a neutral reading in October to a “streched” status of +1 standard deviation today. Suggests that investors have re-added their exposure to risk in the recent rally.

In summary, considering that the optimistic scenario may already be reflected in the current stock price, GS suggests that investors may need to buy downside protection, for example by constructing a put spread:

• Buy put: Investors can buy a 3-month put option with a strike price 2% below the current level of the S&P 500.
• Sell put: At the same time, an investor can sell a 3-month put option with a strike price 7% below the current level of the S&P 500.

The difference between the two strikes is 5%, and the potential maximum return of this 5% wide put spread is in the 95th percentile over the past 28 years, indicating that this spread strategy has had high potential returns relative to other strategies in the past (this strategy is based on the belief that a normal pullback in US stocks is generally no more than 5%):

The advantage of this strategy is that if the market falls, the put option bought increases in value, but if the market falls by less than 7%, the put option sold lapses, at which point the benefit is maximized. Therefore, the overall loss is only the net premium. Whereas, the risk that investors who buy a single put option is the premium they pay.

[GS: Bet on high-growth companies next year]

According to GS macro model, growth stocks outperform value stocks when economic growth is close to trend levels, economic growth slows, and interest rates and inflation fall. Goldman Sachs economists expect US GDP growth to be 2.1% in 2024, and interest rate strategists expect interest rates to have peaked, which will be an environment conducive to growth stocks outperforming value stocks. If interest rates fall further due to weak data, growth stocks are also expected to lead unless the economy enters a recession. Significant acceleration in economic growth can also cause value stocks to outperform growth stocks. But Goldman Sachs thinks that scenario is unlikely.

The chart below is a GS selection of stocks with high growth and reasonable valuations relative to their industry peers. These stocks rank in the top 20% of their industry in terms of growth, but are not ranked in the top 40% or bottom 20% of their industry in terms of valuation:

Follow next week

The last meeting of the European and American central banks of the year. Recent weaker economic data has supported the Fed to downgrade its economic outlook, including interest rate forecasts in the dot plot, but Powell’s speech is likely to remain hawkish in an effort to preserve the Fed’s credibility. If this happens, it will not be negative for the market at least, but given the recent surge in sentiment, it is not ruled out that there will be a sell-in to cash in on the recent gains. The biggest surprise may be the lack of downward adjustment in the dot plot, such as the dot plot’s forecast of a rate cut of less than 50bp by the end of next year, which could lead to a big disappointment in the market. At present, most institutions are predicting interest rate cuts of more than 100bp next year, for example, ING forecasts 150, UBS forecasts 275, Barclays predicts 100, and Macquarie 225.

December inflation data will be released on the eve of the FMOC meeting, and analysts expect the core CPI, which excludes food and energy, to stabilize at 4% y/y and 0.3% m/m, essentially unchanged from 0.2% in October; The cost of cars, electricity and heating, as well as the price of gasoline, have dropped significantly. Overall, the data is likely to show that inflationary pressures are significantly abating. With nominal CPI coming in at 0% m/m last month, a drop to negative numbers would be a bit of a boost to risk sentiment.