Gold and stocks jump as Treasury yields plunge

The Fed is talking down the strong January PCE inflation result:

Feb 29 (Reuters) – “I expect things are going to be bumpy,” Atlanta Federal Reserve Bank President Raphael Bostic said during an interview at a banking conference in Atlanta, Georgia, after a Commerce Department report showed the core personal consumption expenditures price index rose more than 5% on an annualized basis….Bostic said his eye remains on the longer-term trends and repeated his view that he sees the U.S. central bank beginning to cut rates “in the summer time,” if the economy evolves as he expects.

Cleveland Fed President Loretta Mester, speaking with Yahoo! Finance later in the day, said three rate cuts is still her baseline view…..Mester said she expects employment and wage growth to cool in coming months, easing price pressures and giving her more assurance that inflation is headed sustainably back to the Fed’s goal.

Chicago Federal Reserve Bank President Austan Goolsbee also shrugged off January’s inflation data as indicative of a setback, and said he believes the disinflationary effect of last year’s supply chain improvements and immigration-fueled rise in labor supply have a “decent chance” of continuing into this year. And that, he said, means there is still scope for the U.S. economy this year to continue on what he has dubbed the “golden path” of falling inflation alongside a robust labor market and economic growth, a historically unusual pattern.

March 1 (Bloomberg) – The S&P 500 topped 5,100 — hitting its 15th record this year. Traders looked past weak economic data amid bets policymakers will be able to cut rates as soon as June. US two-year yields sank as Fed Governor Christopher Waller noted he’d like a shift in the central bank’s holdings toward a larger share of short-term Treasuries…

The 2-year yield is testing support at 4.5%.
10-Year Treasury Yield

10-Year Treasury yields broke support at 4.20%, closing at 4.18% on Friday.

10-Year Treasury Yield

The S&P 500 broke resistance at 5100 — our target from December 2023 — to make a new high at 5137. Trend Index troughs above zero flag strong buying pressure.

S&P 500

Russell 2000 Small Caps ETF (IWM) closed above resistance at 205 but we expect retracement to test the new support level.

Russell 2000 Small Caps ETF (IWM)

Gold

Spot Gold shot up to $2083 per ounce. We expect retracement to test support at $2060 but respect would be a strong bull signal, confirming a target of $2100.

Spot Gold

Financial Markets

Commercial bank cash assets, consisting mainly of reserve deposits at the Fed, continue their up-trend with an increase to $3.6 trillion.

Commercial Bank Cash Assets

Reverse repo (RRP) balances at the Fed declined to $570 billion as money market funds switched into higher-yielding T-Bills. The outflow cannot continue at the same rate for long and the Fed is likely to reduce the level of QT — from the current $95 billion per month — in order to offset this.

Fed Reverse Repo (RRP)

Moody’s Baa corporate bond spread fell to 1.55% — the lowest level in more than twenty years — indicating abundant liquidity in credit markets.

Moody's Baa Corporate Bond Spread

Europe

DJ Stoxx Euro 600 — the top 600 stocks in Europe — is making new highs as well.

DJ Stoxx Euro 600

Australia

In Australia, the ASX 200 broke resistance at its previous high of 7700, offering a target of 8000.

ASX 200

Crude Oil & Commodities

Nymex light crude is testing resistance at $80 per barrel. Breakout would confirm a fresh advance, with a target of $90.

Nymex Light Crude

Brent crude is also testing resistance at $83 per barrel. Narrow consolidation is a bullish sign (in an up-trend) and breakout would offer a target of $93.

Brent Crude

Copper continues to test resistance at $8500 per metric ton despite weak manufacturing activity in China.

Copper

China Beige Book

Conclusion

The bond market is getting excited about rate cuts around mid-year after plenty of dovish guidance from Fed officials. Ten-year Treasury yields broke support at 4.2%, warning of a decline to test primary support at 3.8%, but retracement is likely to test the new resistance level.

Strong growth in average hourly earnings, CPI and PCE inflation in January, warn that early rate cuts would be premature. Investors are piling into real assets as a hedge against an expected resurgence of inflation.

Stock indices broke to new highs, including the S&P 500, DJ Stoxx Euro 600, and the ASX 200 in Australia.

Gold jumped to $2083 per ounce. Retracement that respects support at $2060 would confirm an advance to $2100 per ounce.

Crude oil threatens a breakout that would likely see a $10 rise in the price per barrel, increasing expectations of a sharp rebound in inflation.

The Fed is under pressure to support the Treasury market, lowering long-term yields to reduce rising debt servicing costs for the US Treasury. Latest CBO projections show how interest servicing costs (pink) are likely to expand deficits in the years ahead.

CBO: Budget Deficit (% of GDP)Treasury debt held by the public is projected to rise to a precarious 160% of GDP by 2050.

CBO: Debt/GDP

As we mentioned in a recent post, the only way to solve this is through high inflation — which would expand GDP relative to nominal debt — and negative real interest rates.

Our long-term outlook is overweight real assets — stocks, Gold, critical materials, and industrial real estate — and underweight long-duration financial assets like USTs.

Acknowledgements

ASX 200 tests support

The ASX 200 retreated from resistance at the high of 7600 and is now testing support at 7400. Breach would warn of a correction to test primary support at 6750.

ASX 200

The Financials Index has similarly retreated from resistance at 6800. Reversal below 6650 would warn of a correction.

ASX 200 Financials

The A-REIT Index would likewise warn of a correction to test 1200 if support at 1440 is breached. The recent rally was in response to falling long-term bond yields.

ASX 200 REITs

The correction in yields is secondary in nature and is unlikely to reverse the long-term up-trend. Further increases in long-term yields are expected to weaken A-REITs.

10-Year AGB Yield

Healthcare also rallied strongly in the past two months but could reverse if long-term bond yields strengthen.

ASX 200 Healthcare

Consumer Staples are in a strong down-trend. Breach of support at 11500 would warn of another decline.

ASX 200 Staples

Discretionary has surprised to the upside, breaking resistance at 3200. A Trend Index trough at zero indicates buying pressure. Retracement that respects the new support level would signal a further advance.

ASX 200 Discretionary

Energy rallied to test resistance at 11000 but a Trend Index peak below zero warns of selling pressure. Another test of primary support at 10000 is likely.

ASX 200 Energy

The All Ordinaries Gold Index fell sharply as the US Dollar strengthened. Follow-through below 6500 would warn of another test of support at 6000.

All Ordinaries Gold Index

The ASX 300 Metals & Mining Index is falling sharply as China’s recovery falters. Another test of primary support at 5600 is likely.

ASX 300 Metals & Mining

China

Rate cuts and measures to stimulate the Chinese economy have been modest as the PBOC is trying to protect the Yuan from further depreciation against the US Dollar.

ASX 200 Discretionary

The result is slowing growth and deflation as weak demand persists.

China & India Inflation

Conclusion

Falling long-term bond yields have boosted Financials, REITs, Health Care and Consumer Discretionary sectors but the correction in yields is secondary and we expect this to reverse in 2024.

The Metals & Mining sector is falling sharply as China struggles to overcome weak demand while at the same time protecting the Yuan from further depreciation against the Dollar.

Our overall outlook for the ASX 200 remains bearish. Breach of support at 7400 would warn of a correction to test primary support from the October 2022 low at 6750.

Santa rally: Monetary easing offsets China woes

China’s economy is struggling despite injection of moderate stimulus and efforts to support a collapsing real estate sector. Shrinking demand from China threatens a global economic contraction. G7 central banks have responded with monetary easing, causing a broad rally in stocks. This is most likely a bear market rally, with far shorter duration than a bull market.

China’s Shanghai Composite Index is testing primary support at 2900, warning of an economic contraction. The Trend Index peak near zero confirms selling pressure.

Shanghai Composite

Copper, however, has penetrated its descending trendline. Follow-through above 8500 would test resistance at $8750 per metric ton, threatening a wide double-bottom reversal with a target of $9500. Breakout above $8750 would signal global economic recovery, while reversal below $7800 would warn of a global recession.

Copper

US Stocks

The S&P 500 is testing it 2022 high at 4800, buoyed by injections of liquidity into financial markets.

S&P 500

The equal-weighted S&P 500 broke resistance at 6300, suggesting a broader rally than just the top 7 stocks. Retracement that respects the new support level would confirm the target at 6665.

S&P 500 Equal-Weighted Index ($IQX)

The Russell 2000 small caps ETF (IWM) threatens a similar breakout above 200, offering a target of 240. Breakout would confirm that investors are growing more aggressive (risk-on) and downplaying risks.

Russell 2000 Small Caps ETF (IWM)

Interest Rates

Ten-year Treasury yields are retracing to test resistance at 3.9% or 4.0%; respect is likely and would confirm the target of 3.5%.

10-Year Treasury Yield
An increase in supply of Treasury Notes will test bulls’ conviction next week:

A raft of fresh, post-Christmas government bond supply will put that comprehensive bullishness to the test. Next week, Treasury will auction $57 billion, $58 billion and $40 billion in two-, five- and seven-year notes, respectively. That’s up 20%, 15% and 7% from their average sizes over the past four monthly auctions. (Grant’s Current Yield)

The 2-year Treasury yield (purple below) is falling in anticipation of Fed rate cuts next year. A peak in the 2-year tends to lead the first rate cuts by 6 to 9 months. The signal misfired with the SVB banks crisis in March but the October peak warns of Fed rate cuts in Q2 or Q3 of 2024.
Fed Funds Rate Minimum Target & 2-Year Treasury Yield

International Stocks

The FTSE 100 is testing resistance at 7700, with a Trend Index trough at zero signaling buying pressure.

FTSE 100

The DJ Stoxx Euro 600 — reflecting the top 600 stocks in Europe — broke resistance at 470. Follow-through above 480 would test the 2022 high of 494.

DJ Euro Stoxx 600

Japan’s Nikkei 225 is testing long-term resistance at 33750. Breakout would signal a fresh primary advance but declining Trend Index peaks show a lack of commitment from buyers.

Nikkei 225 Index

The ASX 200 is testing resistance at 7600, buoyed by strong iron ore prices and falling long-term bond yields. A sharp rise in the Trend Index indicates buying pressure but reversal below 7400 would warn of a correction to test support at 7000.

ASX 200

Gold & the Dollar

The US Dollar Index respected resistance at 102.50, confirming the target at 100. Trend Index peaks below zero signal strong selling pressure.

Dollar Index

Gold broke through resistance at $2050, closing at $2053 per ounce. Expect retracement to test the new support level; respect would confirm another attempt at $2100. A falling Dollar and increased bullion demand from central banks is expected to maintain upward pressure on Gold prices.

Spot Gold

Conclusion

Stocks are rallying in response to falling long-term Treasury yields and in anticipation of Fed rate cuts next year. But falling LT Treasury yields is a medium-term rally in a long-term bear market, with LT yields expected to rise in 2025. Fed rate cuts are also a bearish sign, normally preceding a recession by several quarters — falling earnings are definitely not bullish for stocks.

Investors will need to be agile, to take advantage of the current bullishness in stocks while guarding against:

  • a trend reversal in long-term yields; and
  • signs that the broad economy is falling into recession.

Vacation

This is our last newsletter of the year as we close our office for two weeks over Christmas and the New Year.

We wish all our readers peace and goodwill over the festive season and hope for a less tumultuous year ahead.

The Magpie by Claude Monet

The Magpie by Claude Monet

Moody’s negative outlook and falling consumer sentiment

Ten-year Treasury yields continue to respect support at 4.50%. We expect another test of resistance at 5.0%.

10-Year Treasury Yield

Moody’s kept their AAA rating for the US government but changed their outlook from stable to negative. The reasons cited  — large deficits and a polarized ineffective Congress — are strong arguments for higher Treasury yields:

Moody's Rating

Japan has also broken above 150 yen to the Dollar, increasing pressure on the BoJ to relax their cap on long-term JGB yields. Any move to relax yield curve control would be likely to cause an outflow from US Treasuries and the Dollar, driving down prices.

USDJPY

Inflation

Inflation expectations are rising, with University of Michigan 1-year expectations jumping to 4.4% — and the 3-month moving average to 3.9%.

University of Michigan Inflation expectations 1-Year

Five-year expectations are also rising, reaching 3.2% in October, with the 3-month moving average at 3.0%.

University of Michigan Inflation expectations 5-Year

Higher inflation expectations add to upward pressure on long-term yields.

Financial Conditions

Financial conditions remain loose — despite the strong rise in long-term yields — with the spread between Baa corporate bonds and the equivalent Treasury yield at a low 1.84%.
Moody's Baa Corporate Bond Spreads

Economic Outlook

Low consumer sentiment, with the University of Michigan Index at 64, continues to warn of a recession.
University of Michigan Consumer Sentiment

Heavy truck sales — a reliable leading indicator — are falling steeply. A fall below 35,000 units would be cause for concern.

Heavy Truck Sales

Stocks

The S&P 500 ended the week stronger, with a bullish candle testing resistance at 4400.

S&P 500

Small caps continue to warn of weakness, however, with the Russell 2000 iShares ETF (IWM) likely to test primary support at 162. Trend Index peaks below zero warn of strong selling pressure. Small caps tend to outperform large caps by a wide margin in the first phase of a bull market — clearly not the case here.

Russell 2000 Small Caps iShares ETF (IWM)

Global Economy

Copper is retracing for another test of primary support at $7800 per metric ton. Breach would warn of a global recession.

Copper

Gold

Gold broke support at $1900 per ounce, indicating a test of $1900. Rising long-term interest rates are undermining investor demand for Gold.

Spot Gold

But Gold is supported by strong central bank purchases, led by China.

Central Bank Gold Purchases & Sales

Australia

The ASX 200 retreated below 7000 on Friday but a bullish close on the S&P 500 should see retracement to test resistance. Declining Trend index peaks, however, warn of rising selling pressure.

ASX 200

Conclusion

We expect upward pressure on long-term Treasury yields to continue, boosted by Moody’s negative outlook for the US, a weakening Japanese Yen and rising inflation expectations.

Declining heavy truck sales and weak consumer sentiment are bearish for the economy. The S&P 500 remains bullish but small caps are more bearish, warning that this is not a broad-based recovery.

Copper breach of $7800 per metric ton would warn of a global recession.

We remain overweight cash, money market funds, short-duration term deposits and financial securities (up to 12 months), defensive stocks, critical materials and gold.

Acknowledgements

A bi-polar world

There is much talk in the media of a multipolar world, with the split between the West and the BRICS, led by China & Russia. That may be relevant in the long-term but the immediate challenge for investors is a bi-polar world, where some markets are rallying strongly while others are collapsing. Even within the US market, we have some sectors rallying while others are collapsing.

The S&P 500 is still in a bear market but the index has rallied to test resistance between 4200 and 4300. Breakout would confirm the bull signal from 250-day Rate of Change crossing to above zero.

S&P 500

The big 5 technology stocks — Apple, Amazon, Alphabet (GOOGL), Meta Platforms, and Microsoft — have all rallied strongly since the start of 2023.

Big 5 Technology Companies

Volatility is elevated but declining peaks on Twiggs Volatility (21-day) suggest that this is easing.

S&P 500 & Twiggs Volatility

However, the rally is concentrated in big tech stocks, with small caps struggling to hold above support. The Russell 2000 iShares ETF (IWM) is testing the band of support between 164 and 170. Breach of support would signal a second downward leg in the bear market.

Russell 2000 ETF (IWM)

The Treasury yield curve is also inverted, with the ever-reliable 10-Year minus 3-Month spread at its lowest level (-1.49%) since 1981. Recessions tend to only occur after the spread recovers above zero — when the Fed starts cutting short term rates — which tells us that the recession is only likely to arrive in 2024.

Treasury Yield Spread: 10-Year minus 3-Month

The longer than usual lag may be the result of the “pig in the python” — a massive surge in liquidity injected into financial markets during the pandemic.

Commercial Bank Deposits/GDP

We are already seeing cracks in the dyke as liquidity starts to recede. Regional banks are in crisis, caused by the sharp hike in interest rates and the collapse in value of their “most secure” assets. Risk-weighted capital ratios are meaningless when bank investments in Treasury and Agency securities — which enjoy the lowest risk weighting — fall sharply in value. True levels of leverage are exposed and threaten bank solvency.

The S&P Composite 1500 Regional Banks Index ($XPBC) is testing support at 75 after a sharp decline. Not only do regional banks have solvency problems, caused by losses on Treasury and Agency investments, many are also over-exposed to commercial real estate (CRE) which faces a major fall in value, primarily in the office sector as demand for office space shrinks due to the shift to work-from-home after the pandemic.

S&P Composite 1500 Regional Banks Index ($XPBC)

There is always more than one cockroach — as Doug Kass would say — and regional banks are also threatened by a margin squeeze. Short-term rates have surged to higher than long-term rates, pressuring net interest margins. Banks are funded at the short-end and invest (and lend) at the long-end of the yield curve.

The Fed is unlikely to solve the regional bank problem easily, especially with the political impasse in Congress — needed to support any increase in deposit guarantees.

Commodities

Falling commodity prices warn that the global economy is contracting.

Brent crude is in a bear market, testing support at $70 per barrel. But US cude purchases — to re-stock their strategic petroleum reserve (SPR) — may strengthen support at this level.

Brent Crude

Copper broke support at $8500/tonne, signaling another test of $7000. Sometimes referred to as “Dr Copper” because of its “PhD in economics”, the metal has an uncanny ability to predict the direction of the global economy.

Copper

We use the broader Dow Jones Industrial Metals Index ($BIM) to confirm signals from Copper. The base metals index breached secondary support, at 167, warning of a test of primary support at 150.

Dow Jones Industrial Metals Index ($BIM)

Iron ore has also retraced, testing support at $100/tonne. Breach would warn of another test of $80.

Iron Ore

Dollar & Gold

The Dollar is also in a bear trend, testing support at 101. The recent rally in our view is simply a “dead cat bounce”, with another test of support likely. Breach would warn of another primary decline in the Dollar.

Dollar Index

Gold is in a bull market as the Dollar weakens. Dollar Index breach of 101 would likely cause a surge in demand for Gold, with breakout above $2050 signaling another primary advance — with a medium-term target of $2400 per ounce.

Spot Gold

Australia

The ASX 200 recent (medium-term) bull trend is losing steam, with the index ranging in a narrow band between 7200 and 7400 since April.

ASX 200

Breakout from that narrow band will provide a strong indication of future direction. Breach of 7200 is, in our view, far more likely — because of weakness in global commodity prices — and would warn of another test of primary support between 6900 and 7000.

ASX 200

The All Ordinaries Gold Index (XGD), however, is in a strong bull trend. Respect of support between 6900 and 7000 would strengthen the signal, while breakout above the band of resistance (7500 – 7700) would signal another primary advance, with a medium-term target of 8200.

All Ordinaries Gold Index

Conclusion

The US market is bi-polar, with large technology stocks leading a rally, while small caps and regional banks are struggling. The lag between an inverted yield curve and subsequent recession may be longer than usual because of the “pig in the python” — large injections of liquidity into financial markets during the pandemic.

Commodities are in a bear market, with falling crude and base metals warning of a global recession.

The Dollar is weakening and we expect a primary advance in Gold — with a medium-term target of $2400 per ounce — if the Dollar Index breaks support at 101.

The ASX medium-term rally is weakening and breach of 7200 would warn of another test of primary support. Two major influences are global commodity prices and major Wall Street indices.

Our outlook remains bearish despite the rally in the US technology sector. We are underweight in growth, cyclical and real estate sectors and overweight in gold, silver, defensive stocks, critical materials, cash, money market funds and short-term interest-bearing securities.

Our 2023 Outlook

This is our last newsletter for the year, where we take the opportunity to map out what we see as the major risks and opportunities facing investors in the year ahead.

US Economy

The Fed has been hiking interest rates since March this year, but real retail sales remain well above their pre-pandemic trend (dotted line below) and show no signs of slowing.

Real Retail Sales

Retail sales are even rising strongly against disposable personal income, with consumers running up credit and digging into savings.

Retail Sales/ Disposable Personal Income

The Fed wants to reduce demand in order to reduce inflationary pressure on consumer prices but consumers continue to spend. Household net worth has soared — from massive expansion of home and stock prices, fueled by cheap debt, and growing savings boosted by government stimulus during the pandemic. The ratio of household net worth to disposable personal income has climbed more than 40% since the global financial crisis — from 5.5 to 7.7.

Household Net Worth/ Disposable Personal Income

At the same time, unemployment (3.7%) has fallen close to record lows, increasing inflationary pressures as employers compete for scarce labor.

Unemployment

Real Growth

Hours worked contracted by an estimated 0.12% in November (-1.44% annualized).

Real GDP & Hours Worked

But annual growth rates for real GDP growth (1.9%) and hours worked (2.1%) remain positive.

Real GDP & Hours Worked

Heavy truck sales are also a solid 40,700 units per month (seasonally adjusted). Truck sales normally contract ahead of recessions, marked by light gray bars below, providing a reliable indicator of economic growth. Sales below 35,000 units per month would be bearish.

S&P 500

Inflation & Interest Rates

The underlying reason for the economy’s resilience is the massive expansion in the money supply (M2 excluding time deposits) relative to GDP, after the 2008 global financial crisis, doubling from earlier highs at 0.4 to the current ratio of 0.84. Excessive liquidity helped to suppress interest rates and balloon asset prices, with too much money chasing scarce investment opportunities. In the hunt for yield, investors became blind to risk.

S&P 500

Suppression of interest rates caused the yield on lowest investment grade corporate bonds (Baa) to decline below CPI. A dangerous precedent, last witnessed in the 1970s, negative real rates led to a massive spike in inflation. Former Fed Chairman, Paul Volcker, had to hike the Fed funds rate above 19.0%, crashing the economy, in order to tame inflation.

S&P 500

The current Fed chair, Jerome Powell, is doing his best to imitate Volcker, hiking rates steeply after a late start. Treasury yields have inverted, with the 1-year yield (4.65%) above the 2-year (4.23%), reflecting bond market expectations that the Fed will soon be forced to cut rates.

S&P 500

A negative yield curve, indicated by the 10-year/3-month spread below zero, warns that the US economy will go into recession in 2023. Our most reliable indicator, the yield spread has inverted (red rings below) before every recession declared by the NBER since 1960*.

S&P 500

Bear in mind that the yield curve normally inverts 6 to 18 months ahead of a recession and recovers shortly before the recession starts, when the Fed cuts interest rates.

Home Prices

Mortgage rates jumped steeply as the Fed hiked rates and started to withdraw liquidity from financial markets. The sharp rise signals the end of the 40-year bull market fueled by cheap debt. Rising inflation has put the Fed on notice that the honeymoon is over. Deflationary pressures from globalization can no longer be relied on to offset inflationary pressures from expansionary monetary policy.

S&P 500

Home prices have started to decline but have a long way to fall to their 2006 peak (of 184.6) that preceded the global financial crisis.

S&P 500

Stocks

The S&P 500 is edging lower, with negative 100-day Momentum signaling a bear market, but there is little sign of panic, with frequent rallies testing the descending trendline.

S&P 500

Bond market expectations of an early pivot has kept long-term yields low and supported stock prices. 10-Year Treasury yields at 3.44% are almost 100 basis points below the Fed funds target range of 4.25% to 4.50%. Gradual withdrawals of liquidity (QT)  by the Fed have so far failed to dent bond market optimism.

10-Year Treasury Yield & Fed Funds Rate

Treasuries & the Bond Market

Declining GDP is expected to shrink tax receipts, while interest servicing costs on existing fiscal debt are rising, causing the federal deficit to balloon to between $2.5 and $5.0 trillion according to macro/bond specialist Luke Gromen.

Federal Debt/GDP & Federal Deficit/GDP

With foreign demand for Treasuries shrinking, and the Fed running down its balance sheet, the only remaining market  for Treasuries is commercial banks and the private sector. Strong Treasury issuance is likely to increase upward pressure on yields, to attract investors. The inflow into bonds is likely to be funded by an outflow from stocks, accelerating their decline.

Energy

Brent crude prices fell below $80 per barrel, despite slowing releases from the US strategic petroleum reserve (SPR). Demand remains soft despite China’s relaxation of their zero-COVID policy — which some expected to accelerate their economic recovery.

S&P 500

European natural gas inventories are near full, causing a sharp fall in prices. But prices remain high compared to their long-term average, fueling inflation and an economic contraction.

S&P 500

Europe

European GDP growth is slowing, while inflation has soared, causing negative real GDP growth and a likely recession.

S&P 500

Australia, Base Metals & Iron Ore

Base metals rallied on optimism over China’s reopening from lockdowns. Normally a bullish sign for the global economy, breakout above resistance at 175 was short-lived, warning of a bull trap.

S&P 500

Iron ore posted a similar rally, from $80 to $110 per tonne, but is also likely to retreat.

S&P 500

The ASX benefited from the China rally, with the ASX 200 breaking resistance at 7100 to complete a double-bottom reversal. Now the index is retracing to test its new support level. Breach of 7000 would warn of another test of primary support at 6400.S&P 500

China

Optimism over China’s reopening may be premature. Residential property prices continue to fall.

S&P 500

The reopening also risks a massive COVID exit-wave, against an under-prepared population, when restrictions are relaxed.

“In my memory, I have never seen such a challenge to the Chinese health-care system,” Xi Chen, a Yale University global health researcher, told National Public Radio in America this week. With less than four intensive care beds for every 100,000 people and millions of unvaccinated or partially protected older adults, the risks are real.

With official data highly unreliable, it is hard to track exactly what impact China’s U-turn is having. Authorities on Friday reported the first Covid-19 deaths since most restrictions were lifted in early December, but there have been reports that funeral homes in Beijing are struggling to handle the number of bodies being brought in.

“The risk factors are there: eight million people are essentially not vaccinated,” said Huang Yanzhong, senior fellow for global health at the Council on Foreign Relations.

“Unless this variant has evolved in a way that makes it harmless, China can’t avoid what happened in Taiwan or in Hong Kong,” he added, referring to significant “exit waves” in both places.

The scale of the surge is unlikely to be apparent for months, but modelling suggests it could be grim. A report from the University of Hong Kong released on Thursday warned that a best case scenario is 700,000 fatalities – forecasts from a UK-based analytics firm put deaths at between 1.3 and 2.1 million.

“We’re still at a very early stage in this particular exit wave,” said Prof Ben Cowling, an epidemiologist at the University of Hong Kong. (The Telegraph)

China relied on infrastructure spending to get them out of past economic contractions but debt levels are now too high for stimulus on a similar scale to 2008. Expansion of credit to local government and real estate developers is likely to cause further stagnation, with the rise of zombie banking and real estate sectors — as Japan experienced for more than three decades — suffocating future growth.

S&P 500

Conclusion

Resilient consumer spending, high household net worth, and a tight labor market all make the Fed’s job difficult. If the current trend continues, the Fed will be forced to hike interest rates higher than the bond market expects, in order to curb demand and tame inflation.

Expected contraction of European and Chinese economies, combined with rate hikes in the US, are likely to cause a global recession.

There are two possible exits. First, if central banks stick to their guns and hold interest rates higher for longer, a major and extended economic contraction is almost inevitable. While inflation may be tamed, the global economy is likely to take years to recover.

The second option is for central banks to raise inflation targets and suppress long-term interest rates in order to create a soft landing. High inflation and negative real interest rates may prolong the period of low growth but negative real rates would rescue the G7 from precarious debt levels that have ensnared them over the past decade. A similar strategy was successfully employed after WWII to extricate governments from high debt levels relative to GDP.

As to which option will be chosen is a matter of political will. The easier second option is therefore more likely, as politicians tend to follow the line of least resistance.

We have refrained from weighing in on the likely outcome of the Russia-Ukraine conflict. Ukraine presently has the upper hand but the conflict is a wild card that could cause a spike in energy prices if it escalates or a positive boost to the European economy in the unlikely event that peace breaks out.

Our strategy is to remain overweight in gold, critical materials, defensive stocks and cash, while underweight bonds and high-multiple technology stocks. In the longer term, we will seek to invest cash in real assets when the opportunity presents itself.

Acknowledgements

  • Hat tip to Macrobusiness for the Pantheon Macroeconomics (China Residential) and Goldman Sachs (China Local Government Funding & Excavator Hours) charts.

Notes

* The yield curve inverted ahead of a 25% fall in the Dow in 1966. The NBER declared a recession but later changed their minds and airbrushed it out of their records.

Have stock prices lost touch with reality?

Robert Shiller’s cyclically-adjusted PE (or CAPE) is at a similar level to the 1929 peak before the greatest crash in US history. CAPE uses a 10-year average of inflation-adjusted earnings in order to smooth out fluctuations in earnings. The current reading of 29.2 is almost double the low during the 2008 global financial crisis (GFC).

S&P 500

We use a different approach. Rather than smoothing earnings with a moving average, we use highest trailing earnings as the best indication of future earnings potential. Earnings may fall during a recession but stock prices tend to fall by less, in expectation of a recovery. Our projected value for the end of Q4 is based on highest trailing 12 months earnings at Q1 of 2022. At 20.16, the PE is higher than 1929 and 1987 peaks, which preceded major crashes, but still much lower than the Dotcom bubble.

S&P 500

Forward price-earnings ratio is more reasonable at 17.91.

S&P 500

But S&P earnings forecasts seem optimistic, with no indication of a recession in 2023.

S&P 500 Historic Earnings & Forecast Earnings

Declining real sales growth, in the first half of 2022, suggests that profit margins will come under pressure, with both earnings and multiples declining in the next 12 months.

S&P 500 Real Sales Growth

Shifting from earnings to a wider perspective, price-to-sales for the S&P 500 avoids distortion caused by fluctuating profit margins. Projected to rise to 2.30 in Q4 (based on the current S&P price and Q3 sales), prices are similarly elevated compared to the long-term average of 1.68.

S&P 500/Sales

Price to book value, estimated at 4.01 for Q4, shows a similar rise compared to a long-term average of 3.07.

S&P 500/Book Value

Warren Buffett’s favorite indicator of market pricing compares stock market capitalization to GDP, eliminating distortions from fluctuating profit margins and stock buybacks. The Q3 value of 2.0 is way above the long-term average of 1.03, suggesting that stocks are way over-priced.

US Stock Market Capitalization/GDP

Australia

Data is a lot more difficult to obtain for the ASX, but the ratio of market cap to GDP (Buffett’s indicator) is a lot more modest, at 0.96, indicating prices are close to fair value.

ASX Stock Market Capitalization/GDP

Conclusion

The chart below shows how rising US liquidity (black) fueled rising stock prices as reflected by the ratio of market cap to GDP (blue). The steep rise in the money stock (M2 excluding time deposits) after the 2008 GFC, created a scarcity of investment-grade assets, driving down interest rates and driving up stock prices.

US Stock Market Capitalization & M2/GDP

Central banks are now shrinking liquidity, in an attempt to tame inflation, and stock prices are likely to fall.

We estimate that US stocks are likely to fall between 30% and 50% if there is a recession next year. Australian stock prices are a lot closer to fair value and only likely to fall 10% to 20% in the event of a recession.

In our view a recession is almost inevitable in 2023 as the Fed cannot inject liquidity to create a soft landing — as it has done repeatedly in recent times — because of the threat of inflation.

Acknowledgements

  • The graphs of Robert Shillers CAPE, S&P 500 real sales growth, and S&P 500 price-to-book value are from multpl.com
  • Sales and earnings for the S&P 500 are from spglobal.com
  • All other US data is from FRED at stlouisfed.org
  • Market cap for the ASX is from asx.com.au while GDP is from the RBA.

ASX double-bottom breakout

The ASX 200 completed a double-bottom reversal with breakout above 7100, suggesting another test of resistance at 7600. The signal is strengthened by subsequent retracement that respected the new support level at 7100, as well as 100-day Momentum crossover above zero.

ASX 200

Australian Bond ETFs are forming a base, signaling that expectations of long-term interest rates have plateaued.

Australian Bond ETFs

A-REITs rallied off support at 1200, penetrating the descending trendline which suggests that a base is forming. However, the move has not been confirmed by 100-day Momentum which remains well below zero.

ASX 200 REITs

Financials have made a stronger recovery, breaking above their August high, with Momentum crossing above zero. We expect a test of 7000.

ASX 200 Financials

Housing price growth is slowing as the RBA hikes interest rates.

Housing

But low unemployment keeps bank loan impairments down.

Unemployment

Net interest margins remain under pressure, however, as liquidity tightens.

Net Interest Margins

Consumer Discretionary continues to test resistance at 3000 but respect remains likely, which would warn of further consolidation.

ASX 200 Discretionary

Staples rallied off long-term support at 12000 but Momentum remains below zero. Breakout above resistance at 13000 would signal another test of 14000.

ASX 200 Staples

A higher trough on Health Care and 100-day Momentum cross to above zero are bullish signs. Breakout above 44K would signal another advance, with a target of 49K (44K + 44K – 39K).

ASX 200 Health Care

Information Technology remains weak, with 100-day Momentum deep below zero. Expect another test of 1250.

ASX 200 Information Technology

Utilities broke resistance at 8400, signaling an advance. Momentum crossover to above zero strengthens the bull signal..

ASX 200 Utilities

Industrials are headed for another test of resistance at 6700. But further ranging between 6000 and 6750 remains likely.

ASX 200 Industrials

Telecommunications are slowly edging towards resistance at 1500 but Momentum below zero indicates weakness.

ASX 200 Telecommunications

Energy remains in a long-term up-trend, testing resistance at 12000. Retracement that respects support at 11000 would strengthen the bull signal.

ASX 200 Energy

The ASX 300 Metals & Mining index broke resistance at 5650, signaling an up-trend. Retracement that respected the new support level and 100-day Momentum cross to above zero both strengthen the bull signal.

ASX 300 Metals & Mining

But weakness in major metal groups makes us wary. Declining iron ore prices are testing support at 90. Breach would signal a test of $50/tonne

Iron Ore

Base metals are similarly testing support at 150. Breach would warn of another test of 100.

DJ Industrial Metals Index

The All Ordinaries Gold Index broke through resistance at 5500, with retracement respecting the new support level to confirm the breakout. But 100-day Momentum is a long way below zero, warning buyers to be wary. Expect further tests of the new support level.

All Ordinaries Gold Index

The Australian Dollar is ranging between A$2500 and A$2700 with no clear direction at present.

Gold in Australian Dollars

Conclusion

Growth in Australia is slowing but recession is unlikely unless there is a sharp rise in unemployment — and fall in the housing market — or a global recession.

ASX 200 completed a double-bottom reversal, offering a target of 7600, but we do not believe this to be the start of a bull market. A negative yield curve in the US, warning of a recession next year, makes a bull market unlikely. Respect of resistance at 7600 would confirm that we are still in a bear market.

Our weighting for ASX sectors (ST = short-term, LT = long-term):

  • A-REITs: ST underweight, LT overweight in industrial REITs
  • Financials: overweight
  • Staples: overweight
  • Discretionary: ST underweight, LT neutral
  • Utilities: overweight
  • Industrials: neutral
  • Telecommunications: neutral
  • Health Care: overweight
  • Information Technology: underweight
  • Energy: overweight
  • Iron ore & Base Metals: ST underweight, LT neutral
  • Critical Materials: heavily overweight
  • Gold: ST neutral, LT overweight

ASX confirms a bear market

The ASX 200 broke primary support level at 7000, confirming a bear market.

ASX 200

Long-term interest rates are rising, with bond ETFs falling.

Australia: Bond ETFs

A-REITs respected resistance at the former primary support level of 1500, confirming the primary down-trend. Trend Index peaks below zero warn of strong selling pressure.

ASX 200 REITs

Financials fell dramatically last week, testing primary support at 6000, as the prospect of falling residential property prices and rising defaults looms. Higher interest rates and wider net interest margins should offset this to some extent. Expect retracement to test resistance at 6000. Follow-through below this level would confirm a primary down-trend and strengthen the overall bear market (Financials have been one of the stronger sectors).

ASX 200 Financials

Consumer Discretionary respected resistance at 3000, signaling another decline with a target of 2600 [3000-400]. Trend Index peaks below zero warn of strong selling pressure.

ASX 200 Consumer Discretionary

Consumer Staples broke support at 13K, with respect of the new resistance level warning of another test of 12K.

ASX 200 Consumer Staples

 

Utilities continue their primary up-trend, rising Trend Index troughs indicating strong buying pressure.

ASX 200 Utilities

Industrials are headed for another test of support at 6350. Breach would warn of another test of primary support at 6000.

ASX 200 Industrials

Telecommunications broke support at 1400, signaling a primary down-trend. Trend Index peaks below zero warn of strong selling pressure. Breach of support offers a target of 1200 [1400-200].

ASX 200 Telecommunications

Health Care is consolidating below 42.5K. Reversal below 40K would warn of another test of primary support at 37.5K. A Trend Index peak close to zero would warn of fading buyer interest.

ASX 200 Health Care

Information Technology continues in a primary down-trend, with Trend Index peaks below zero warning of selling pressure. Follow-through below 1400 would offer a target of 1100 [1500-400].

ASX 200 IT

The Energy sector is advancing strongly, while Trend Index troughs above zero signal buying pressure. The prospect of Chinese lockdowns easing is likely to boost demand for oil and gas, sending prices soaring.

ASX 200 Energy

Metals & Mining respected resistance at 6250, warning of another test of 5500. Declining Trend Index peaks suggest buyer interest is fading. Respect of support at 5500 would signal that the up-trend is intact but breach seems more likely and would offer a target of the November ’21 low at 4750.

ASX 300 Metals & Mining

The broad DJ Industrial Metals Index respected resistance at 200, while Trend Index peaks below zero warn of strong selling pressure. Easing of lockdowns in China may increase demand but a bear market remains likely.

DJ Industrial Metals Index

Iron ore is also undergoing a correction. Breach of support at 125 would warn of another test of primary support at 90.

Iron Ore

The All Ordinaries Gold Index is again testing support at 6000, while Trend Index below zero warns of selling pressure.

All Ordinaries Gold Index

The price of Gold in Australian Dollars, however, is trending upwards, with rising Trend Index troughs indicating increased interest from buyers. Expect a test of A$2800 per ounce. Breakout would offer a target of A$3400 [2800 + 600].

Gold in Australian Dollars

Conclusion

ASX 200 broke support at 7200, confirming a bear market. Rising long-term interest rates and a poor global economic outlook are expected to weaken most sectors, while easing of China’s lockdown restrictions should provide some relief to energy and metals.

Our weighting for ASX sectors is:

  • A-REITs: heavily underweight
  • Financials: neutral
  • Staples: neutral
  • Discretionary: heavily underweight
  • Utilities: overweight
  • Industrials: neutral
  • Telecommunications: underweight
  • Health Care: neutral
  • Information Technology: heavily underweight
  • Energy: heavily overweight
  • Iron ore & Base Metals: underweight
  • Critical Materials (e.g. Lithium and Rare Earth Elements): heavily overweight
  • Gold: overweight

ASX signals a bear market

The ASX 200 broke support at 7200, signaling a primary down-trend. The declining Trend Index has warned of fading buying pressure for several months. Expect retracement to test the new 7200 resistance level but respect is likely and would confirm the primary down-trend.

ASX 200
The largest sector, Financials, similarly broke support at 6250 and we expect retracement to test the new resistance level.

ASX 200 Financials
The ASX 300 Metals & Mining Index encountered resistance at 6000 but remains in an up-trend. Another test of 4750 is likely.

ASX 300 Metals & Mining
The All Ordinaries Gold Index retreated this week, under the weight of a broad equities sell-off, but a rising Trend Index continues to flag buying pressure.

All Ordinaries Gold Index
Gold priced in Australian Dollars continues to trend upwards, the recent shallow trough having respected support at 2500. Target for the advance is 2800.

Gold in Australian Dollars
Conclusion

The ASX 200 breach of support at 7200 warns of a bear market; retracement that respects the new 7200 resistance level would confirm. Financials also warn of a bear market, while the Metals & Mining sector is likely to test support at 4750. The All Ordinaries Gold Index is retreating to test support at 6000 but this should present a buy opportunity as the Australian Dollar price of Gold continues in an up-trend.