Step Down? Step Up!

Markets are giving their best efforts to stabilize after the brutal selloff over the seasonally weak September-October time frame. The excuse being used to explain the market's 'outside reversal'

bounce bottom was the anticipated "step down" by the Fed. As weaker economic data arrives, so the thinking goes, the Fed will back away from the 75 basis point hikes to 50 bps then 25, then 0. The psychology behind this is simple. The effects of the fastest tightening of financial conditions in thirty years are finally showing up. The Fed can soon ease off the brakes.

Unfortunately, the bond market didn't get the memo on the ending of the QE era until it was too late. Fixed income has experienced its worst total return in 40 years. The year-to-date losses on long bonds have outstripped those suffered by supposedly riskier assets, throwing the 60/40 crowd for a loop. Losing on both ends of the traditional risk-reduction hedge of 60% equity/40% fixed income is a first for many investment advisors. Those who remember the late seventies are few and far between.

But that's what you get when the Fed's micro-managing strategy falls apart like a wet paper bag. They are now scrambling to create policy on the fly, trapped by forces beyond their control (and beyond their mandate I might add). This market is undergoing a once-in-a-generation regime change to higher-for-longer yields. Positive real rates are finally on the radar for central bankers after a twenty-year experiment with zero-bound QT and its uber-easy policy. The sleeping giant of inflation, awakened by the outsized fiscal and monetary stimuli induced by the Covid crisis response has seen to that.

But herein lies the opportunity for a trade, kicked off by a bond rally. I say step up to step down. The selling exhaustion is seen in the non-confirmation of the lower price action that is not on higher volume (Chart below - CMF measure - top panel). The Fed, operating in the rearview mirror as it must, has already achieved its goal of reversing the inflationary surge, even if they don't realize it. Commodity prices are screeching to a halt everywhere you look. Supply chains are near normal after the Covid crunch. Labour markets, a lagging indicator, will be next to ease especially if a mild recession arrives as expected.

This is a golden opportunity for cash-rich portfolios to grab for a brass ring on the fixed income merry-go-round as the Fed steps back from tightening. Boring is back.

U.S. Corporate Bond ETF

Yields on U.S. corporate bonds are at reasonable spreads to Treasuries, offering a total return that should rival equities over the next 2-5 years. The cushion over riskless comps is not at recessionary wides, but in the current slow-motion slowdown, they are ample compensation for all but the sharpest of downturns. The softness of the 'landing' will determine the ultimate outcome but since they never ring a bell at the bottom it is only prudent to start now.

Corporate vs Treasury Bond Yield Spreads

(chart: J Aitkens, TD Securities)

So where does that leave equities, now that your humble scribe is talking like a newly-converted Bondie? What do I like in this market?

Bond-like equities of course! There are many investment advisors who are experts at scouring the stock lists for high-quality equities, with recession-resistant business models that offer high current yields with upside kickers. These are mostly found in the lower-capitalized world, smaller than the mega-cap darlings that dominate most passive portfolios. As I stated last time, this market will only progress if the rotation to mid-cap, stable companies expands. The higher for longer yields offered now in fixed income will drag on the valuations of the big-caps for years to come. The go-go markets of 2020-21 are not coming back anytime soon.

Investors and stock-pickers are likely to replace meme-stock influencers and momentum traders as future investment gurus. A grinding style, coupled with value-tilted discipline seems the best bet as we navigate the final stages of the bear and transition to a new market environment. Buy-and-hold to the moon!

As the third quarter earnings roll-out progresses, revealing what business was like during the summer. Unfortunately, that is not likely to provide much comfort for those looking for the start of a new bull market. If those numbers are accompanied by guidance that is materially different than expectations, then we have a trade - either long or short. This sorting-out should provide a churning sideways pattern as the puts-and-takes of the corporate drama plays out.

I can see a scenario of sharply lower energy prices generating a durable bounce from here. So far, the news is good for investors and bad for energy bulls. Warm weather and ample LNG supplies are crushing the war premium in European energy markets.

Dutch NatGas Futures

(chart: J Atkins, TD Securities)

And now that U.S. gasoline prices are back to their starting point of the year, I expect the path of least resistance for oil is lower for the near term, just from a seasonality standpoint (chart below). Seems as if Biden's SPR release ploy worked at the U.S. gas pump. I don't expect the same outcome at the ballot box as the gasoline drop hasn't translated to lower core inflation expectations as yet. But it will eventually, especially as we lap the 2022 first-quarter spike.

Crude Oil Seasonality

Now that the 'step-down' traders have the bit between their teeth, emboldened by the swiftly improving crisis in the UK bond market, the relief rally should extend into the fourth quarter. The 'bad news is good news world' is starting to shape up. The consensus for the global economy to enter a recession is now firmly entrenched. Perversely, that is bullish for equities in the short term as it reinforces the hopes for a Fed pivot - whether those hopes are prescient or not.

With sentiment and positioning both supportive for a risk asset reversal bounce, I say 'Step Up"!

Risk Model: 3/5 - Risk On

There is a window now opening for a positive risk environment as the resilience of the labour market combined with a relatively healthy consumer balance sheet are offsetting the macro worries for now. As the effects of tightening unfold over the next couple of quarters, this could change, but for now, the bulls have enough tailwinds to chase the rally higher.

Copper/Gold is indicative of a soft landing for the economy as it has stabilized above the signal line. A definitive break is pending ... one way or the other. Place your bets!

Copper-Gold Ratio