Into Thin Air

Jon Krakauer's 1997 book of the same title is haunting. Reading that gripping, real-life drama described so brilliantly made a huge impression on me. It was truly terrifying. This morning, Mike Wilson of Morgan Stanley rekindled those fears in describing the current state of the stock market. He contends that due to valuation and facing increasing earnings deterioration the positioning/sentiment rally in stocks is about to end with a sharp reversal. Dutifully, the markets have responded by backing down this morning, aided by tepid profit forecasts from retailers and geopolitical fears. Will markets - like Krakauer before it - be able to return to base camp safely? After a four-month ascent from the October lows, it's now a long way down.

Last week saw a reinforcement of the soft/no-landing scenario held dear by some supportive economic data. The resurgent bulls, who have pushed equity prices to these recovery highs, are hoping for an immaculate disinflation outcome to the Fed's attack on inflation. Seems plausible, given the strength of real income growth and January's unexpected consumption resilience. But with the Fed now expected to increase rates by a further 75 basis points will remove even more oxygen from the system. The risk of economic hypoxia is rising sharply.

I have argued for a choppy upward bias to markets to continue until there is evidence of a slowing in the labour market that leads to sustainable disinflation. So far, only goods prices (and last year, stock prices) seem to have gotten the Fed memo. A structurally tight employment market is acting like a thick down-filled sleeping bag, protecting labour from the cold blast emanating from the Federal Reserve. Equity optimism has recovered from a long dormancy as investors, armed with excess cash, began climbing the equity summit.

The Fed's favourite inflation gauge of price pressure, the PCE deflator is due out this Friday. I have no idea what it will show, but it seems likely to produce a 'hot' print, given the January retail sales report. And although the numbers may have been aberrantly high due to seasonal impacts, the data dependency of our monetary leaders bodes ill for the markets. A surprise 50 bps is now being floated by some Fed speakers. Markets won't like that, having priced in a pivot that seems increasingly far away.

And the brilliant economic commentator Mohammed El Erian has postulated a higher terminal rate to inflation due to intransigent supply constraints in the post-Covid world. If that world unfolds and migrates into higher inflation expectations, no amount of verbiage from Jay Powell about a 2% normal rate will be credibly regarded. Bonds will get crushed again and he will, once again, be behind the curve.

The recent positive correlation between bonds and stock prices has exacerbated the valuation risks to this market as Mike Wilson has pointed out once again. Higher stock prices and lower rates tend to happen when equity investors ignore the messages from their fixed-income brethren. Just as climbers gripped with summit fever, they can't stop continuing up with their goal so close at hand. But most alpinists die on the way down, not the on the ascent.

As I said, it's now a long way down.

ERP Model - Morgan Stanley

Risk Model: 5/5 - Risk On

I wonder about a model with no element in 'sell' mode, and yet we are seeing a suddenly deteriorating market. The S&P 500 actually topped out on Groundhog day and failed in the retest of the highs on Valentine's day - last Tuesday at 11!

What are we to make of this reading? The risk-on signals caught the rally, but now seem likely to miss this pull-back. The 200 dma readings got to a mildly overbought 5% - no biggie. The RSI similarly reached the 70 line but no further. The Vix has been crushed since last year's elevation in the 25-35 range, but is now rising again. Copper/Gold has been driven higher by the soft landing/ China reopening narrative that seems increasingly suspect. The AAII herd all seemed to move at once after the no-recession narrative started to circulate. Feels like we have gotten too high and are running out of oxygen.

With the model unhelpful as it seems to be, I guess it's like economic data. This year should see a choppy set of conflicting signals until all the indicators start to head in one direction. It will take time, given the multiple cross-currents and uniqueness of the inputs to this economic scenario. Patience my friends. It will come soon enough. The inverted curve isn't wrong, it's just an early warning device. Just like this one: