Split Camp

In the early going of 2023, stock market bears are finding it hard to keep the faith. Most of them have been in the imminent recession camp, with the hostile monetary backdrop as their 'reason d'êtra'. Well-espoused negatives such as the Tech valuation crash, China shutdowns, and a Eurozone energy crisis have been core values for the perma-pessimist. But in the early going of the New Year, we are seeing a surprising re-emergence of the bull case. Goldman, ISI Evercore, and HSBC are no longer calling for a recessionary collapse in Europe, and China is suddenly reaccelerating. The U.S. job data was stubbornly strong on Friday. The previously accepted narrative is changing fast.

I'm as guilty as anybody of falling for the previous consensus. I didn't expect the China policy change to happen as fast as it did. And who among us forecasted the warmest winter in years, allowing the European economy to soft-land on a cushion filled with surplus natural gas? But does Morgan Stanley's view of a recessionary bear market for equities resulting in a 2800 S&P 500 look less likely? Yes, it does, given the crowded consensus from just a scant three weeks ago.

Evidence is multiplying for a complete reversal of inflationary expectations - a bullish development. Commodity prices have dropped precipitously as the effect of Covid on supply has reversed and demand has ebbed. More importantly, service inflation expectations have now peaked as evidenced by tame wage data reported in last Friday's U.S Employment Report. Although Federal Reserve's moral suasion is still focused on the hawkish argument, the market smells a pivot and is acting accordingly. The Fed rearview mirror approach of driving the economy works both ways, apparently.

The bears are still stubbornly clinging to the recession/bear market call, citing the inverted yield curve persists and falling earnings expectations. And, tied firmly to that bet, they have stayed out of the various rallies recently experienced in select markets. Copper, European Banks, and Chinese equities are all up 20% to 40% from their October lows. Currency markets have reversed as well, offering more ammo for the soft landing case.

But the U.S. stock market, despite the putative bear phase we have experienced, is now more expensive vis-a-vis bonds than it was over a year ago (chart below). If there is any wiggle room in the market to deal with any negative surprises, I don't see it. Maybe a regime change is at work here. Is this a recalibration of the relationship depicted below? After the synchronized bear market of last year, is the relationship between bonds and stocks now in a new normal? Are people fed up with bonds and still unrepentantly enamored of stocks? It would seem so.

Equity Risk Premium

chart ; J Aitkens, TD Securities

I have advocated a bottom-fishing approach since the October lows, as I thought many value-oriented risk assets had reflected all the negatives. I also continued to avoid the growth and theme-based assets, as the reckoning was incomplete and their valuation compression remained unfinished. Until we see major outflows from popular funds such as ARKK, I won't be convinced that true capitulation has occurred.

Recessionary forces are still building strength, as companies are suddenly losing pricing power precisely at the point that labour costs are still rising. The split camp of performance between Value and Growth styles has been a notable feature of recent equity performance (chart below). The elastic band between Tesla and Ford has snapped back and may have further to go (second chart below).

iShares Value vs Growth

TSLA vs F

Another split camp is developing between U.S. and Foreign asset market performance. The reversal of the dire pessimism over Europe and the sudden and unexpected re-opening and stimulus in China is driving a shift in focus from last year's U.S. asset dominance. The peak in the Greenback is also supportive of this move. The sharp reversal of the downtrend in European financial stock performance has caught many investors off-guard.

Europe vs US Financial Stocks

Base effects in the price of commodities and goods markets should continue to generate sudden 'positive' inflation reports in the next few months. Those tailwinds will be needed to incentivize people to stay invested. Resilient job markets in the near term will keep a consumer-led recession at bay, even though labour income growth should slow. Perversely, the recent loosening of financial conditions from tighter credit spreads and stronger equity prices is encouraging risk-taking behaviour. These can be powerful offsets to the inverted yield curve argument that I have been espousing and can forestall the recessionary implications of this historically prescient tool.

But a recession forestalled, is not a recession avoided. I, therefore, propose another split camp. Most people expect a first-half recession followed by an easing of monetary policy and a 2024 recovery. My camp proposes the opposite: a near-term economic bounce based on lower inflation and higher spending by a resurgent consumer who benefits accordingly. This will be followed by a prolongation of Fed tightening into the secondary acceleration of prices later this summer. The lagged effects of higher for longer rates will depress risk asset valuations into the second half after a Q2 peak. The economy finally succumbs to the tighter conditions and renewed monetary contraction and a 2024 recession develops.

How's that for a contrarian call? Oh, by the way, it looks a lot like the 1980-81 experience that I first experienced as a budding equity analyst, but you weren't around then so I don't expect you to remember it.

If you want to plot a course for the year ahead using currently popular inputs from the talking heads and strategists, good luck finding a consensus. The split camp is widening the range of projected outcomes for both the economy and the market. This dispersion of views is unhelpful in predicting a particular path forward. Choppy upward progress until spring is my call.

But ultimately, the task of investing will not be trying to time the market. I recommend one should buy and hold high-quality, reasonably-priced companies and ignore the broad averages. You don't need to choose a camp if you do that.

Risk Model: 4/5 - Risk On

Low volatility and a neutral price level are lulling investors into a dangerous complacency. But if the model says to 'stay long', who am I to argue? Goldilocks-style risk environments are not unheard of, but they make old guys like me squirm a bit.

3 Month Volatility

As for the 'China induced' Copper rally, the signal bounced back to positive after a whipsaw year-end. It is in a confirmed uptrend still and gives hope for the soft-landing crowd. But a stronger commodity market negates the early 'Fed pivot' bull case that is currently supporting the market. Any recovery in inflationary expectations only reinforces my second-half recession call as the Fed would be forced to stay hawkish longer than the markets currently expect.

Copper:Gold