2022 was a tough year for Investors.
Rising inflation globally, subsequent Central Bank Monetary Policy tightening (despite protestations in Q1 that inflation was “transitory”!), Energy price rises, war in Ukraine, supply chain issues post Covid and the resulting tightening liquidity conditions of all of that are but a few of the Macroeconomic factors that kept us on our toes. And that’s before we delve into the Fraud/Drama of the Crypto class, if you dabble there as part of your portfolio.
But 2023 will be better right? Right?
Well, as always in Financial Markets we don’t deal in absolutes and as I’ve said via other medium you should be hugely wary of anyone trying to sell certainty to you. We look at the probability, what is more likely, and (in my view at least) the higher probability remains that 2023 sees at least initially a continuation of 2022, from a Risk On perspective.
There are, of course, nuances to that view as a full year outlook. I have milestones I’m watching for through Q1 that could present an opportunity for a rally into H1 end, potentially early Q3, so I’ll base decisions off these from a Risk perspective as we progress. I’m currently around 80% in cash across my portfolio and I don’t expect to be allocating long term positions in Q1, personally, at the moment.
Lets have a look at some of those considerations.
I also want to keep in mind the article I wrote previously around the US Presidential 4 year cycle and what my interpretation of historic data suggests about positive return from Q4 (2022) through H1 2023, as the two could well intertwine for a period depending on how events play out.
Growth, Inflation & Liquidity: The Drivers of Markets
Growth and Inflation are considered by many to be the two most impactful variables where Market behaviour is concerned. These directly impact upon prevailing Liquidity conditions and we know (from even recently observed history) that Market expansion and contraction is intrinsically linked to Liquidity.
I saw some work recently by the excellent Darius Dale of 42 Macro (seriously, check him out if you don’t know the name) around his bespoke Net Liquidity model and I really like the way he frames his analysis around what that Net Liquidity Model and caste forward projections tell us.
We obviously draw some of our own assumptions around Liquidity from Central Bank Monetary Policy, in the sense that rising rate environments from a common sense perspective have an adverse affect on Liquidity. For example, Long dated bonds held as collateral on balance sheets lose market value against cash. Basically, credit becomes more expensive.
To see that assumption play out in a model such as this gives confidence in that thesis and allows us to frame a go forward position based on our expectation (or rather the projection) of interest rate rises into 2023.
As we can see from the 42 Macro model, Liquidity conditions have been worsening since the Hawkish FED Pivot in 2021, through all of 2022. So our high level assumption above that we can infer weakening liquidity conditions from tightening monetary policy appears, to an extent at least, tested and resolved in this data.
We can also see in this same chart how Net Liquidity tracks with the S&P500 price (the red line, ES contract).
Click all Images to Enlarge
Another interesting chart from 42Macro (from July 22) shows just how much Liquidity has driven asset markets over the last decade. In fact, it is their thesis, one that is pretty difficult to argue with looking at the data presented, that Net Liquidity has been the “primary driver of asset markets for a decade-plus.”
Link to 42 Macro Twitter Thread.
The conclusion from this section/data: Increasing liquidity drives market expansion, decreasing liquidity drives market contraction and the primary drivers of liquidity, in general terms, are growth and inflation (through monetary policy).
A Macro bottom needs a Macro change in Liquidity, which needs a change in Hawkish stance from the FED.
Fed Funds Rate: Pivot Imminent?
There’s a lot of talk of an imminent FED Pivot, but how much of that is based on reason and how much is wishful thinking? Well, in order to discuss that further we have to set the terms for “a Pivot” so we know we’re comparing apples to apples.
The classic definition and as such the one that I prefer is “a change in monetary policy from loosening to tightening (Hawkish) or tightening to loosening (Dovish)”. This definition, to me at least, would not include a slowing of rate rises (in the current scenario) and even a pause when rates reach FED target could be considered tenuous as an actual Pivot, but I’d be willing to look at that at least as a “soft” Pivot of sorts.
Now that we have that out of the way, what data do we have with regards:
- The overall FED Target
- The potential rate path for 2023
Overall FED Target
The chart to the right is from the latest FOMC meeting, held in December 2022 and it shows what FOMC members currently think is the appropriate level for monetary policy (specifically FFR) for 2023 through 2025, with a longer run target as well.
The first thing to note from this is the longer run target, which consensus has at around 2.5%. Given the length of time the FED instituted ZIRP (Zero Interest Rate Policy) post the GFC in 2008, we have an entire generation who think ZIRP is normal. It is not and it never has been. With the long run projection the FED is telling us explicitly that we should not expect a return to that sort of “ultra loose” policy.
This is, in my opinion, entirely sensible. Mainly because ZIRP for so long was entirely not, but lets not get into that!
The second and more pertinent takeaway from this chart is the FOMC position, at present, for 2023. A target FFR of 5.0% – 5.25% marginally leads from 5.25% – 5.5%, with a couple of members each favouring 1 rung lower and higher. From this, we can project that the most likely peak for 2023 is 5.25% – 5.5%. We are currently at 4.25%-4.5%, meaning a delta of 0.75% – 1.0%.
We also know that in December 2022 the FED slowed the rate rises. We previously had 4 x 75bps, followed by 50bps in December. It would be hugely unlikely then that they would raise in February 23 by more than December, having started to slow. And as we now know the target is 75bps away from current, that means the FED cant hit the lower end of their target with any less than 2 further rises, February and March.
Or, in short, probabilities tell us then that there’s unlikely to be a pivot, soft or hard, in Q1. The earliest this could come is the first Q2 meeting in May.
Potential Rate Path for 2023
The FED Watch tool over at CME provides us with lots of data with regards Fed Funds Rate and one of the more useful tables is shown to the left. The question posed here is “What is the likelihood that the Fed will change the Federal target rate at upcoming FOMC meetings, according to interest rate traders?”.
The blue cells show the most probable path for rates based on market opinion at the moment. We can read this, essentially, as what the market is pricing in. There are a few interesting takeaways from this data.
The first, in correlation with the thesis of the previous section, is that a (soft) pivot is unlikely till May’s meeting at the earliest. Two further 25bps increases in Feb and March with a pause anticipated in May is what current sentiment appears to be.
I think we have to be realistic that this isn’t strong correlating evidence of a May pivot, it’s more likely that many traders are doing the same analysis that we did above and Occam’s Razor suggests that particular outcome as the one with the fewest assumptions required. But it does at least show that Market Participants have similar view.
The second interesting thing from this chart is that Traders, or if we wrap them up as an embodiment of “The Market”, seem to think in greater numbers that the FED are bluffing than telling the truth about their headline target rates. There is, in all fairness, a decent percentage looking for 5.25% from May onwards, but the majority seem to favour 5.0 as a ceiling.
I think we really need to take note of this as if we assume that this data represents what the majority of the market think and thus has priced in, then a FED follow through on their stated target to 5.25%, or even 5.5% which was only marginally behind as we saw in the FOMC data above, would cause a reaction in Markets. I think we should be cognisant of that heading out of Q1 and into Q2. The 6 weeks between the March and May meeting, if we’re sat below stated target with this CME data still calling for a top in FFR then we could see a rally into the May meeting with FED follow through rejecting that downwards.
One to watch, but not the main focus of this section of the article. The primary focus here, trying to tie this all together, is that Liquidity conditions don’t appear on track to improve through Q1, into Q2 and as such we should expect to see a continuation of the downside we saw in 2022 while Net Liquidity finds a low.
What about the US Equities 4 Year Cycle?
I wanted to cover this quickly as it provides a bit of a nuanced view of the potential equity curve from Q4 last year through H1 2023. For those who didn’t read that previous article I’ll briefly explain the premise in a sentence:
“In 91% of the last 23 US Equities Presidential 4 Year Cycles the time period starting Q4 year 2 (last year) and running through H1 Year 3 (2023) has returned positive results on the S&P500 and Dow, the last negative return being in 1938.”
https://wosscapital.com/the-4-year-bitcoin-cycle-the-greatest-myth-there-ever-was/
The October opening price on SPX was $3609.78 and we currently sit at $3800 and some change.
Why is this relevant to the outlook for 2023? Well, 91% is pretty high from a probability perspective. The offside Risk is non zero, obviously, but at 91% over a large sample of both cycles (23) and years (100) it is fairly compelling. As we come to the end of the Liquidity Cycle downturn, correlating with the last of the rate rises in potentially March/May 2023, it is conceivable that this level, $3600, is the H1 2023 floor for the S&P.
That is to say, for Q3 to H1 to return a positive outcome for the 22nd time in 24 cycles, that is the level that cant be breached prior to end June 23 and with the Liquidity squeeze starting to slow as rates head towards their final FED destination, this is looking, potentially, like it may well play out.
H1 Summary
In summary for H1 then, what I’m looking for is:
Continuation of 2022 conditions in Q1 as Liquidity Cycle contraction completes. FFR hikes in Feb and March most likely towards FED stated 5.25%-5.5% target, with any pause in rate rises hugely unlikely in Q1. No rush to allocate long term positions, but potential for mid term play into summer rally depending on employment data (see explanation later).
Q2 likely the earliest we see soft Pivot (hike pauses) but again hugely unlikely to see any contraction in rates (hard Pivot) as it makes no logical sense to run up to target and reverse instantly. The FED know that policy change takes 6-12 months, conservatively, to filter into the economy.
But what about post H1 – Recession looming
Firstly, I want to say that the overall outlook for the year will depend very much on when the Liquidity Cycle contraction ends and when the official US recession starts after this, mainly because the period in between, if we see one, could be reasonably expected to provide some relief to the markets post monetary policy tightening.
If we see that period of stability and a bounce, the recession impact will be from a higher cost basis. If the two run closer together and we’re pricing in a recession from a lower cost basis as a result (without the relief bounce) then that’s where you get to lower bottom prices across Risk On (sub 3200 SPX, sub 12k BTC etc.).
In terms of a recession itself, despite many calls to the contrary the US hasn’t officially entered a recession as yet, mainly due to Energy Prices propping up overall economic figures. But the FED seem to know that one is coming and have implicitly stated as much in their latest FOMC minutes.
This table is again from the December 2022 FOMC minutes and I want to draw your attention to the metric I’ve highlighted, which is the FED’s projection for headline Unemployment in 2023, 4.6%.
The current rate of Unemployment is 3.7%, meaning a delta of 0.9%: The FED expect the rate to increase by this much in 2023, or 13 months from November where the current data ends. Unemployment has NEVER, in history, risen by 0.9% over a 13 month maximum period (November 22 – December 23) outside of an official recession, as the lower chart form the St Louis Fed shows us.
By adding these projections to their minutes, the FED seem to be telling investors to expect a recession to start in 2023 and that late 2023, Q4, is the most likely timeframe based on Growth, Employment and CPI projections.
Conclusion
Is 2023 shaping up to be better than 2022? Honestly, not really, at the moment it feels like we’re in for more of the same, with potentially a relief rally from Spring into Summer should the US economy continue to show strength into rising rates, before recession hits later in the year.
Obviously this is an interpretation of different data points and based entirely on probabilities. As I said at the outset, this isn’t a prediction it’s an interpretation on which to make plans.
My plans: I’m certainly not in any hurry to buy Risk Assets in Q1 and I’ll take my Q2 steer from the FED. I may allocate a little for a mid year relief rally with the intention of de-risking prior to Q4, if conditions are right in April/May, but between now and then short term swing and intraday trading wins out over macro positioning.