Since the mid-October rally in Equity markets that saw vicious cyclical sector rotation at the cost of defensive sectors, the market continues to ponder whether this rotation is set to continue or falter.
The Fed and various central banks are doing whatever they can to jump start the car (world economic growth) by stimulating their way out of yet another downward move in the cycle. After reducing their bloated balance sheet all of 2018, the U.S. Fed resorted to increasing it from the middle of September 2019 until today -- in the order of $260 billion.
We are essentially where we were at the beginning of this year. Whether they will stop or keep reducing their balance sheet is yet unknown. The Fed -- while intent on not uttering the taboo phrase "quantitative easing" -- has pretty much been doing not-QE QE for the past two months, as the repo crisis of September, when overnight rates shot up to 10%, spooked them. With this, the S&P 500 has rallied 9% over the past two months. Causation and correlation are two different things, but even this is too hard to ignore, given the timing and dovish U-turn in the Fed's actions. But now what?
The S&P 500 is up 25% in 2019, judging by the way things ended in December 2018, no one could have imagined performance such as what happened in 2019. To be fair, most of it had been dangerously range-bound and volatile, as the market reacted to every tweet and emotion shared by Trump with regards to his Trade Wars with China.
It is important to remember that we were entering a slowdown in the cycle prior to the Trade Wars. But this global uncertainty and drastic shift in global supply chains did exacerbate the slowdown, leading to some horrendously weak global PMI Manufacturing and ISM data across the board.
Whether or not we get Phase 1 of a trade deal is entirely pointless as the market has more than priced in a deal of some sort. Trump is stuck between a rock and a hard place, as he wants to go tough on China but he cannot as his window to election time is closing in -- and he cannot afford a market "correction" of any sort, since that is his only claim to fame over the past four years. China can stimulate or wait it out -- as with Trump signing the Hong Kong bill, they have even more reason to wait it out and not give in to a deal for now.
Leaving all this political drama aside, what is really happening to the economy and what does it mean for markets? November data is slowly coming in from everywhere and the market remains in a show-me-the-growth phase. China's November Manufacturing PMI came in at 50.2 vs expectations of 49.5; not only a beat but a number above the key 50 growth/contraction barrier. New Orders picked up as well and Non-Manufacturing PMI showed an improvement too, a rebound driven by services. Whether we believe the data was fudged or not, one can only take what is given and go with it. The rate of change shows an improvement, which is key.
Eurozone Manufacturing PMI has been below the 50 mark since February this year, but the November figure came in at 46.9, an improvement from the 45.9 number in October, and beat expectations of 46.6. Business sentiment turned up in Germany, which is important. This data could fuel speculation that the worst is over for the eurozone. Several other November PMI prints came in better than expected as well, with JPM Global Manufacturing PMI reporting 50.3 vs 49.8 in October. We are not out of the woods, but this all adds to the market's desire to convince it of a growth pick up.
Amidst the heavy barrage of data yesterday, a very important communique from the Fed was missed. According to an FT article, they are now considering introducing a rule that would let inflation run above its 2% target. This is a game changer.
Rather than understand why their continuous QE and interest rate cuts have refused to create inflation, as they stumble on how prices have not moved higher despite unemployment at 50-year lows, they are deciding to just let it go and print above 2% now. They are utterly scared of being Japanified. The Fed knows that with rates around 1.5%-1.75%, there is not much to play with in the event of the next downturn, so they are considering newer alternative measures. They are making it up as they go along, literally.
The Fed are going to create inflation and ignore it as it prints above their 2% target to let it be sustainably higher to avoid deflation. This can run the risk of stagflation if global growth does not accompany the increase in prices. In a world of inflation, Bond prices get killed and sector rotation changes gears favouring cyclical sectors like Banks, Energy and Commodities at the expense of Utilities, Consumer Staples and defensives. Gold will be bid as well. After its pullback from highs of $1555, it is trading near its support level of $1450-$1460 and looks increasingly compelling.
Commodities benefit in an era of inflation. With central banks putting their foot on the pedal, this can create the desired demand that had been missing all of this year. Some Commodities have ample supply and some are very tightly balanced. Copper fits in the latter category. Oil price is very well supported here as the OPEC+ alliance is pursuing an extension of the cuts in place since last year. It could all brew to be the perfect storm if global economic data keeps printing positively.
The Bond markets got a sneak preview of this as they got crushed yesterday with the U.S. 10-year yield rising to 1.85%. Let's not forget being long Bonds has been the darling trade of 2019, as close to $12 trillion-$15 trillion in global bonds yielded negative yields. Bonds are certainly starting to price in higher inflation going forward. Equities have yet to adjust for this.
Regardless of what the S&P 500 does, sector rotation will be key as money will flow into "inflation" protected sectors. Being long Gold, long Oil and Oil stocks makes sense here, especially as the latter has been the worst performer for the past few years and valuations are extremely cheap. Cheap can always stay cheap unless a catalyst can help it close the valuation gap.
Bank of America BAC may have timed this topic pretty well in their note in mid-November when commenting that the market cap of Apple $ (AAPL) is higher than the entire U.S. Energy sector combined. Something to think about.