Markets Update - November '23

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IN THIS PUBLICATION:

• We’ve moved from an oversold market to an overbought one in just two weeks.

• US Financial conditions eased by 23 basis points in a single day, one of the largest moves since 1990 outside of recession periods.

• NATO members ex-US have been underspending on defense for the better part of the last forty years (totaling a cumulative shortfall of $1.4-$2 trillion in defense investment). This can’t go on.

The Big Melt-Up

Last month, as markets continued to trade in risk-off mode, we made the argument in favor of being bullish through year-end:

• “The key question we’re asking ourselves right now is: with the bear narrative (higher rates, higher energy prices, higher US Dollar) so well understood, does the market believe enough of these risks are priced in, and instead of a move lower, we bounce back from here?”

• “The recent correction might just bring investors the entry points they were waiting for to close off a strong year of performance.”

We then explored the possibility of a bear case and a bull rebound in even more depth in our last research piece. We highlighted that:

• Positioning was light and conditional bond and equity demand from traders would have been very significant if the market started to turn, setting up a perfect backdrop for a melt-up.

• Seasonality was delayed by a week, but not cancelled.

• Corporate buybacks were about to come back to the market as earnings season came to an end, setting up a good amount of corporate demand through the first week of December.

Fast forward one month, and markets did rebound, hard, without signs of slowing down.

• The S&P 500 recently had an 8-day winning streak, interrupted by Powell on the 9th day (which would have made it the longest winning streak in almost 20 years).

• The NASDAQ 100 has also bounced back hard. NVIDIA, Meta, Amazon, and Microsoft all recently moved towards fresh one-year highs.

• Both indexes have continued to rally hard this week after the lower-than-expected CPI print allowed market participants to start pricing Fed cuts by June 2024. The CPI print also led to a sharp move lower in the US Dollar, which helped support gold and Emerging Market segments of the market.

• The post-CPI print rally was so significant that US Financial conditions eased by 23 basis points in a single day, the 30th biggest one-day easing event since 1990 (this is actually remarkable because most events of this magnitude usually happen around outlier periods such as 2008/2009 and COVID).

The one-liner is that we’ve moved from oversold to overbought in two weeks. The caveat is that we can stay in overbought territory for a while (see summer of this year).

The question is, where do we go from here?

Our base case is that the drivers of this rebound will continue to move markets higher through year-end:

• The bid coming from corporate buybacks will continue to be here through December.

• Seasonality works through year-end as well. In fact, over the last 50 years in which the S&P 500 was up more than 5% by this time of the year (has happened 30 times), returns for the remainder of the year were positive 27 times (90% of the time).

• Market breadth is improving, meaning that the overall performance is becoming less dependent on the Magnificent 7 – this reduces concentration risk and should make the market less volatile.

• Interesting fact highlighted by Charlie Bilello: “If the S&P 500 fails to hit a new all-time high in the next month and a half this would be the first year since 2012 without at least 1 all-time high.”

The risks to this view are pretty obvious:

• An increase in the geopolitical risk premium that is hard to quantify (but that Scott will shed light on in our next research piece next week). This is a very dynamic situation that can change pretty rapidly, and any meaningful events should be reflected in higher prices of both oil and gold.

• A surge in the US Dollar (which tightens financial conditions) – this is something that Michael Nicoletos has covered extensively and it’s the reason why we’re hosting a podcast with him in early December (will be released here).

• Barring the above, all other risks are mostly related to 2024 (recession, US bond issuance failing to find a bid, credit events) and whilst they are indeed important, we think they should inform our asset allocation for 2024 and not for the last month of the year.

• One way to play the rest of the year is through options given that volatility is reasonably cheap and you get to participate on the upside. As per the Barclays derivatives team: "With VIX having staged one of the largest drops in history, we recommend renting rather than buying further upside, and screen for stock replacement via cheap calls.”

Two key, non-consensus, ideas that are worth flagging:

• JPMorgan strategist Marko Kolanovic suggests that investors sell risk on assets into this rally given how it has been mostly driven by short covering and momentum strategies. He is taking profits on his long-term bond gains and using that to buy commodities on the back of recent weakness and geopolitical risks.

• From Bobby Vedral: “Given their importance for daily cross-market moves, here again my view on US yields: (1) “normal” US 10y yields should be at 5% = 2% growth + 2% inflation + 1% term premium. (2) Inflation will be sticky due to new realities, such as demographics/labour-shortage, cost of climate transition and geopolitical friction. (3) The term premium reflects the need to attract marginal buyers to a deluge of new debt issued by a US government that is running a budget deficit of 7% in peacetime while the economy is growing 5%. (4) Meanwhile, the largest foreign buyer of US debt, the Bank of Japan, just de facto ended its yield control policy, which ceteris paribus means less buying of Treasuries in the future. (5) The recent drop in bond yields and sharp rally in equity markets leads to easier financial conditions, which the Fed will be forced to counteract with words and deeds. Bottom line: long-term US yields are staying in the 5%-postcode for longer.  Get used to that.”

Both would imply higher commodity prices (think energy and gold) and likely lower “long duration” assets (bonds and tech). So far though, the break below the 50-day moving average is clear.

Aerospace & Defense Outperforms

This year has been all about rewarding what in 2022 did poorly.

Whilst the “long duration” assets rebound has grabbed all the headlines, be reminded that from a sector point of view, since the Middle East conflict began, Aerospace and Defense companies have outperformed tech.

A&D has significantly underperformed both tech and the broader market since 2020, and the reasons are pretty obvious (higher input cost inflation, labor shortage, and supply chain constraints).

But the bigger point to be made is that NATO members ex-US have been underspending on defense for the better part of the last forty years (totaling a shortfall of $1.4-$2 trillion in contributions to defense spending according to Michael Cembalest at JP Morgan).

If you’ve read Scott’s latest Editorial on the geopolitical risks of the European natural gas and LNG supply chain, you’ll know that in order to ensure energy security, this underspending cannot continue. We quote:

• “There are several, non-obvious, geopolitical risks that will continue to influence the European, and by extension, global natural gas and LNG markets well into 2024.

• The first is the Armenia-Azerbaijan war, which might directly impact future European gas imports from the region.

• The second is the Israel-Hamas war, which directly impacts Egypt’s ability to export LNG to Europe.

• The third relates to Europe’s ability to protect its network of gas pipelines in the North and Baltic Seas from Russian and Chinese attacks.”

There are some long-term narratives that will be with us for a long while. Increased defense spending is definitely one of them.

Emerging Markets in 2024

If rates have indeed topped, then it would be fair to become a tad more bullish on Emerging Markets. Within EM, one country worth looking at is probably Brazil. It’s located far away from conflict areas, it’s resource-rich, has been running reasonable monetary policy (they started raising rates way before Developed Markets central banks), and demographics are in their favor.

As Otavio Costa puts it: “Why would anyone invest in US stocks at 50 to 100 times earnings when you can acquire shares of a well-established Brazilian company trading at just 5 times its annual profits with strong ties to commodity prices? Today's skepticism towards Brazil reminds me of the early 2000s when its respective equity market experienced a remarkable surge of 16-fold.”

Samantha LaDuc’s Outlook for 2024

Roger sat down with Samantha LaDuc (she’s known for “market timing”) last week to discuss her 2024 outlook. Some quotes:

• "The risk parity portfolio died with Covid."

• "I don’t see bonds being bought."

• "We have to have some macro event that causes flows to trip negative, until then, VIX is sold and not bought."

Samantha also sees a lower US Dollar in 2024, and eloquently explains the risks to US Treasuries associated with the BoJ’s monetary policy (the caveat is that she tells us not to panic until there’s a reason to).

Their discussion helps frame the macro backdrop for 2024 from a market perspective rather than an economic one. Worth your time.

Thanks for reading through! Obviously, none of this is investment advice.