We have been noting for months that leading economic indicators have all been pointing to inflation cooling, money supply tightening, hiring plans dropping and growth going lower. However, these variables take time to cycle through an economy before showing up in a backward-looking CPI metric. To that end, some positives are finally showing for inflation bears. October’s inflation report noted substantial declines in utility bills (it was a warm October, helping to bring down natural gas prices), used car and truck prices (new automobiles are finally arriving, lowering the need to buy used) and medical care services (which was expected due to new calculations).
In totality, it was still a very high number, with inflation running at 7.7%. Core inflation (excluding food and energy) also came in below estimates, but is at an elevated 6.3%. Both are nowhere near where the Fed wants to see them, but clearly show that inflation has peaked and is trending in the right direction. The Nasdaq, S&P and Dow Jones rose 7.4%, 5.4% and 3.7% respectively.
By sector, Technology, Discretionary and the interest-rate sensitive REIT sector all bounced 8%+. Energy and defensive areas like Consumer Staples and Healthcare “only” rose ~2%. Clearly a risk-on market where defensive stocks and energy plays, which held up best during the bear market, were shunned in order to buy deeply beaten down cyclical stocks. A basket of the most shorted stocks in the market bounced 12%.
In fixed-income land, interest rates collapsed. The 30-, 10- and 5-year Treasury yields were each down 25 – 35bps, but still hovering around 4%. Those are massive moves for bonds, which are supposed to lower volatility in portfolios. The U.S. dollar also took it on the chin, breaking through important support levels and showing signs of rolling over. A continuation of lower rates and dollar declines is a perfect scenario for stocks to keep reverting back towards resistance levels seen in August, at 4,300 or 10% higher from here. Even with the massive move yesterday, the S&P is still down 17% and the Nasdaq has fallen 30% this year.
Although extremely welcome news, investors should be cognizant of what Fed officials have been saying for months. They want to see consecutive months of good data, not just one report that is better than expected. They need a clear indication that inflation is heading back to 2%. They also need to see labor and wage inflation data to decline. Again, the mistake of the 70’s inflation spiral was easing too soon and not beating inflation quickly. A rapid rise in stocks and decline in bond yields is not going to make the Fed’s job any easier, since wealthier consumers are more apt to spend. Similar to the summer rally, I would not expect Fed officials to suddenly pivot in the coming days and give the all-clear signal.
On the positive front, this reinforces the theme from last week. Fed Chairman Powell’s slight pivot to forward-looking indicators, less emphasis on backward-looking employment and CPI reports, and a gradual slowdown in the pace and size of rate hikes is showing as a key change. The slower the Fed goes, the more likely a soft landing is possible. Following this report, it looks like 50bps is a foregone conclusion in December and gets the Fed off their aggressive 75bps pace. Another update like this and February’s meeting confirms a 25bps expectation, if any. By the following meeting in March, it could be the end of this cycle. Something to look forward to as we hit the final weeks of a really tough year for stock and bond investors alike. This does not mean that the Fed will reverse course. Higher interest rates are here to stay and will be a problem for companies overloaded with debt. There is a real cost to money in 2023. Inflation is not going to be the major concern over the coming months, but will be replaced by a possible major recession.
We would take this bounce and reevaluate current holdings. The yield curve is still inverted. Housing prices are coming down. Mortgages are over 7%. Consumer incomes are not keeping up with inflation. Credit card debt is at new highs. Corporate margins are coming down. Are your companies positioned for a new normal with higher inflation, higher interest rates and no more free money? Do they have a lot of debt on their balance sheet coming due next year? Are they negatively impacted by geopolitical events which could get worse? That and many more questions must be answered. A massive move like this gives everyone another opportunity to reposition into higher-quality holdings that can last through next year’s slowdown.
Bitcoin (crypto) was born over a decade ago and came with great technology along with a true use case, the anti-establishment currency that processes transactions without banks, governments or financial institutions. It was expected to be cheaper, more secure and a real alternative to traditional currencies which get devalued over time. For a while, the idea was working, at least for early investors. Zero interest rates and investor euphoria created another massive bubble highlighted by Dogecoin. Dogecoin was formed as a joke but later turned into an $85 billion entity.
Not only were thousands of currencies created out of thin air, but exchanges were built. These exchanges are set up for investors to hold, buy and sell various crypto coins. They make their money by taking a commission on every trade but also have the ability to leverage client assets. Needless to say, the speed of this massive crypto world created logistical and oversight nightmares. When that happens, regulatory rules are late to the game. If Bernie Madoff’s Ponzi scheme can be missed by the SEC, imagine what can occur in a new industry based in Bermuda.
As soon as the Fed started pulling the punch bowl, crypto prices around the globe started to fall back to earth. Warren Buffett’s famous quote applies, “It’s only when the tide goes out that you learn who has been swimming naked.” Many crypto prices have gone to zero, where they belong. Bitcoin, the most well-known, has gone from $64,000 to a low of $16,000 this week following another exchange-related disaster, causing ripple effects throughout the industry and likely impacting the stock market. The Bermuda based exchange operator, FTX, was the culprit, but details are still sketchy.
FTX is a large exchange provider which also had their own exchange token. Their customers deposited real money in order to buy/sell over 300 different tokens. FTX partnered with Alameda Research which also invested heavily in their token. In simple terms, those tokens were given an inflated value while the 2 largest holders used them as collateral to borrow millions of dollars based on client asset values on their exchange. When prices started coming down, including FTX’s own tokens, it created a massive valuation hole. Consider this like a margin call, but it is just regular investors trying to withdraw their personal assets which are no longer there. This is a Lehman type event but in the digital/crypto world and on a much smaller scale.
It is estimated that there are over $2 trillion in losses from crypto alone this year, amplified by FTX going bankrupt this week. Who else is involved on the other sides of these trades could be that Black Swan event investors have feared during this massive tightening phase the Fed has created. We already know that BlackRock, SoftBank and Sequoia Capital are among investors in FTX. They now have to take massive write-downs. Remember, when margin calls occur, you have to sell something. Stocks are usually a key piece of those liquidations. This is not the end of crypto/exchange headlines.
As noted above, this rally provides another opportunity to reassess positions. The most beaten down stocks provide the biggest, initial pop off lows. From there, real businesses take over. Yesteryear’s leaders are unlikely to be the same over the coming decade.
Leonardo DiCaprio turns 48 today. Demi Moore is now 60, and Stanley Tucci, 62.
James Vogt, 610-260-2214