Strategy and Positioning written by Steve Orr, Chief Investment Officer; and Essential Economics written by Mark Frears, Investment Advisor

As of market close November 18, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Needed break

The Halloween rally finally ran out of steam last week. Traders had plenty of reasons to clean up trade blotters: expiration of volatility futures, stock and index option expiration and, hopefully, a light holiday week. Since options expired last week, flows suggested a lot of short positions got covered. One would expect heavily shorted stocks would have done well last week, but that was not the case. The Goldman Sachs Most Shorted index has barely budged.  

Most S&P sectors remain in overbought territory, especially energy, staples and health care. An old-timer’s view of stocks is that they run to overbought then slide to oversold. True enough, but it’s not a very helpful nostrum to someone who just wants to know what is going to happen next. Other markets suggest sitting tight and waiting for more bottom evidence. 

Who says?

Risk assets and their funding sources tend to move in tandem. So too volatility in this environment. The Goldman Sachs Most Shorted index mentioned above is a good example. Note the divergence between the S&P and GSMS index in the oval. Compare that divergence to the price action for most of this year. Over a few weeks the S&P “catches down” to the most shorted index.

Source: Bloomberg L.P., Goldman Sachs

The Yuan and Yen charts have similar divergences to stocks. Bitcoin and the VIX index have the same “gap.” These cross-asset class relationships do have a say in whether the stock rally gets back in gear.

How far?

The trading narrative in September and October bounced between the Fed not stopping and the expectation that the Fed would soon “pivot” and stop raising rates. Just as the Fed was behind in reacting to the rising CPI, Wall Street has been behind the Fed’s rhetoric. Recent FOMC speeches focus on the possibility of smaller increases but rates ultimately rising higher and staying high longer than people expect. We take the Fed at their word. 

Factoring in the six-month survey lag for home prices and rents, it is hard to see CPI inflation breaking below 5% over the next several months. Remember, too, October’s 7.7% number was reduced by 0.5% due to health care cost seasonal adjustments. Health care prices will get a booster shot next spring when higher insurance premiums are factored in. Housing lag and health care adjustments mean inflation numbers may take longer to roll over than markets expect. Add the fact that the Fed has never stopped increasing rates until the nominal Fed Fund level was above CPI. The futures pits expect Fed Funds to peak in June and for the Fed to cut rates by nearly a half of a percent by the end of 2023. That sounds like a recession to us.

Source: Bloomberg L.P.

Here is a summary of Wall Street analyst projections:

Source: Bloomberg, Firms listed

Deutsche and UBS are the most downbeat, thinking that the Fed will have to act fast in the back half of 2023 to lessen the blow of high rates. Our data puts our forecast closer to Goldman and Citi: peaking at or above 5.5% mid-2023 and staying there for most of the rest of the year.

The rest

To paraphrase Paul Harvey, “What is the rest of the story?” Yes, Fed rate increases have knocked housing down. Existing home sales are down 28% year-over-year. Mortgage origination is down over 40%. Fed rate increases affect the cost of funds for everyone and everything. The effective rate felt by the economy is a combination of the Fed Funds target range, today 3.75% to 4%, the Fed’s balance sheet reduction, lending standards and the U.S. dollar.

The Fed’s Quantitative Tightening program has dropped the bond portfolio by $400 billion this year. Still a long way to go to cut out the shutdown borrowing by Congress of $3.8 trillion, but it’s a start. QT cuts market liquidity probably close to one percent over the next year. Tighter lending standards, borrowing spreads and a strong U.S. dollar add another half percent. Back of the envelope, the economy is facing a monetary policy impact of close to 5.5% today. A research paper issued by the San Francisco Fed estimated it to be above 5.25% in September.