LD Capital: Weekly Report 25/09: Misjudging the FOMC, Major Institutional Withdrawal, Will the U.S. Government Shut Down Over the Weekend?
Market Overview
Equities and Bonds Market
Amidst the Federal Reserve’s aggressive stance, soaring treasury yields, and the looming threat of a government shutdown, the U.S. stock market’s future looks dim as these risks have heightened investor panic.
The S&P 500 Index (SPX) fell 2.9% last week. Despite the dip, it’s still up by 12.8% this year. To negate all its gains for 2023, there’s still a significant way to go. The Nasdaq 100 Index fell by nearly 3.5%, with the Russell 2000 performing worse, declining almost 4%.
The industries that faced the most considerable drop include non-essential consumer goods and real estate. Healthcare and utilities experienced smaller declines.
Cyclical stocks continued to underperform compared to defensive stocks:
Both the S&P 500 and the Nasdaq 100 have dropped over 6% from their highs at the end of July. This past week was particularly unsettling for investors, marking the worst week since the Silicon Valley Bank’s collapse on March 10. This downfall mainly stems from the Federal Reserve’s anticipated prolonged higher interest rate, which triggered a sell-off in U.S. stocks and bonds.
According to EPFR data, investors are selling off global stocks at this year’s fastest pace. As of last Wednesday, there was a net stock sale of $16.9 billion, while investors purchased $2.5 billion in bonds, marking the 26th consecutive week of inflows.
The European stock market has seen funds outflow for 28 consecutive weeks, with investors losing $3.1 billion just in the last week.
With soaring oil prices, energy stocks have witnessed the most significant single-week capital inflow since March, totaling $600 million.
Investors also withdrew $300 million from gold and $43 billion from money market funds. So far this year, investors have poured $1 trillion cash into money market funds.
Concurrently, they have allocated $147 billion to U.S. Treasuries.
The U.S. 10-year Treasury yields move inversely to their price, approaching a 16-year high. High treasury yields offer investors a very attractive return. Such investments, viewed as almost risk-free, weaken the appeal of stocks. The spread between 2-year and 10-year treasuries has shown some relief, hitting its lowest since May last week, mainly due to longer-term yields rising more significantly.
The hawkish stance of the Federal Reserve was the primary driver in the markets last week. Other market risks include high oil prices, the resumption of student loan payments in October, a surge in workers’ strikes, and the potential government shutdown if the budget isn’t approved by September 30.
Seasonal factors also present headwinds. According to Bank of America statistics, as of September 18, the S&P 500 typically falls 1.66% during the first ten days of the month when its performance is below the monthly average. This trend continues this year. Seasonal patterns suggest that the stock market will face a significant dip in early October. However, this could present opportunities for buyers to capitalize on lower prices. Historical data over the past 70 years reveals that of the ten times the SPX fell at least 1% in August and September, nine of those times it finished higher in October.
If the S&P 500 Index falls to 4200 points (a roughly 3% decline from the current level), this would bring its P/E ratio to 17.5, consistent with the 10-year average, which may lure buyers.
Technically, the SPX broke below the 100-day moving average at 4380 points last Thursday and breached the 23.6% Fibonacci retracement level. However, it’s still above the 200-day moving average, currently at 4191 points. The position of the 200-day moving average aligns perfectly with the 38.2% retracement of the rebound since the end of last year, making the 4200-point mark a potentially strong technical support level. Given the absence of economic red flags, a sustained steep drop seems unlikely, with short-term consolidation being more plausible.
The substantial market dip after this FOMC decision aligns with historical patterns. Out of the past 14 meetings, the market dropped an average of 1% on the following day in ten of those instances. The subsequent week usually saw fluctuations, with the market struggling to fully recover the initial losses.
Historically, when the SPX experiences a dip exceeding 5%, it averages an 8–10% decline from its peak over four weeks. The current dip’s duration (38 days) has surpassed this historical average, though the decline magnitude hasn’t yet reached it.
· The downturn in small-cap stocks might be signaling anticipated growth slowdowns.
The Russell 2000 small-cap index has dropped over 11% since its July 31 closing high, roughly twice the decline seen in the S&P 500 over the same period. The S&P 500 industrials peaked on August 1 and has since fallen about 8%. Small-cap and industrial stocks typically plummet when the economy is headed for a recession.
Traditionally, these companies are the first to bottom out before a broader market rebound. They’re closely tied to the domestic economy and usually lack the diversification of their larger counterparts, making them riskier bets during times of economic uncertainty.
While U.S. small-caps and industrials are on a downturn — typically a recession signal — some investors currently see these trends as mere noise, especially after a year where the stock market outperformed expectations.
Bloomberg survey data indicates that the market expects only a 1.1% decline in corporate profits for the third quarter, followed by positive earnings next year.
· Beating Wall Street’s Expectations
Last week, the S&P 500 Index closed at 4321 points, surpassing Wall Street’s average forecast of 4366 points for 2023. Analysts were mostly bearish in the first half of the year, but due to consistently outperforming data, they’ve been actively upgrading U.S. stock year-end forecasts in the past two months. Moreover, investors prioritize the revival of corporate earnings over interest rates. Not only has this been one of the primary drivers for the U.S. stock market’s past surges, but it is also a key factor for future potential rises.
· China’s Stock Market Strikes Back
Following the announcements by the US and China on the 22nd to establish bilateral economic and financial working groups, and the similarity in their wording, there are positive indications in US-China relations. As a result, stocks in mainland China, Hong Kong, and US-listed Chinese concept stocks have surged.
The statement mentioned that under the guidance of US Treasury Secretary Janet Yellen and Chinese Vice Premier He Lifeng, the US and China have respectively set up economic and financial working groups. These groups will provide ongoing structured channels for frank and substantive discussions on economic and financial policy issues, and exchange information on macroeconomic and financial developments.
The establishment of these two groups also marks the resumption of regular economic dialogues between the two countries for the first time since the Trump administration abandoned structured engagements in 2018.
A key point of interest for possible positive developments is whether the Chinese President will attend the Asia-Pacific leaders’ summit (APEC) in San Francisco in November. Given the current tensions and the location of the APEC meeting in San Francisco, this could be seen as a home turf diplomacy for the US. If China’s top leader were to attend, it might give an impression to some as a sign of deference. However, China clearly does not want to convey the impression of leaning unilaterally towards the US. The relationship is seen as equal.
· Have Stocks and Bonds Decoupled?
There’s an extremely negative correlation between stocks and bonds (i.e., when interest rates rise, the stock market falls). This correlation has reached historic lows, suggesting a possible reversal is due.
Forex Market
The US dollar has risen for the tenth consecutive week, with the DXY up 0.3% to 105.6. Although this only takes it back to levels seen last November, it’s the longest upward streak in nearly a decade.
After the Bank of Japan maintained its ultra-loose monetary policy, the yen fell, with USDJPY reaching a near 11-month high of 148.46. The Bank of Japan also pledged not to hesitate to ramp up stimulus if needed, which provides reasons to continue shorting the yen. However, as the exchange rate approaches 150, there’s speculation that the Japanese government might intervene to support the yen. Japan’s Finance Minister Suzuki Toshimitsu mentioned on Friday that he wouldn’t rule out any options, warning that a selloff of the yen could hurt the trade-dependent economy. (But we believe that currency devaluation is also importing inflation into Japan, something the BOJ longs for.)
In the UK, an unexpected slowdown in the rate of price growth led the Bank of England to halt rate hikes, causing GBPUSD to refresh a six-month low of 1.22305 last week.
The Canadian dollar strengthened against the US dollar last week, due to rising oil prices and expectations of further rate hikes by the Bank of Canada. Data showed that Canada’s annual inflation rate for August jumped to 4.0% from 3.3% in July, driven by rising gasoline prices.
Despite intervention by the People’s Bank of China, the yuan weakened slightly last week, moving from 7.27 to 7.29 and even breaking the 7.3 mark on Thursday. It’s conceivable that without intervention, USDCNY might be even higher. However, a positive sign was the sharp rise in the Chinese stock market on Friday, with the CNY rebounding on optimistic sentiment.
Commodities and Cryptocurrencies
Although Russia announced a temporary ban on gasoline and diesel exports, tightening an already tense global fuel market, hawkish signals from the Federal Reserve temporarily cooled the rise in oil prices. After reaching its highest level this year, the price of crude oil experienced its first weekly decline in a month, though the decrease was marginal. In general, the spot market still shows signs of tightness, with US inventories declining again (only rising 3 times in the past 12 weeks). Gold also faced a jolt from the Fed but showed resilience overall, ending the week nearly flat.
Cryptocurrencies experienced significant fluctuations last week, rising initially and then plummeting over the weekend. BTC fell 0.9% in 7 days, Ethereum dropped 2.4%, and BTC dominance slightly rose from 48.9% to 49.1%.
Ethereum declined by 5% over the past month, while BTC remained almost unchanged. The former’s underperformance may be associated with a re-entry into an inflationary state. Network fees on the ETH network plummeted over 9% to $22.1 million last week, the lowest in 9 months. Data from Ultrasound.money reveals that the supply of ETH has been increasing, as the number of tokens burned (or destroyed) for transaction validation is less than the number of new tokens created. Some analysts believe that the widespread use of Layer2 solutions has reduced congestion on the ETH mainnet. Matrixport reiterated a bleak outlook for cryptocurrencies other than BTC in its Friday analysis, citing “shockingly low earnings” and “lack of market focus” on the upcoming protocol update. The company predicted earlier this month that if this trend continues, ETH could drop to $1,000.
In the past 30 days, the top 100 tokens by market cap experienced:
Although XRP and Grayscale triumphed over the SEC, and some fund companies have filed new Bitcoin and Ethereum spot ETF documents, investors have withdrawn nearly $500 million from publicly traded cryptocurrency products in the past nine weeks. According to CoinShares’ weekly report, the total outflow from publicly listed cryptocurrency products last week was $54 million, marking the fifth consecutive week of sales.
Matt Maley, Chief Market Strategist at Miller Tabak + Co., stated in a report, “Many investors are concerned that the crypto market has had some good news in recent months, which hasn’t really helped Bitcoin and other currencies rise… When institutional investors look for asset classes to help them perform in the last three to four months of the year, they won’t consider cryptocurrencies
Headline News Events
[Federal Reserve’s Bowman Hints at Multiple Rate Hikes, Daly Says Not Ready to Declare Inflation Victory]
Federal Reserve Governor Michelle Bowman stated that she’s in favor of another interest rate hike, and possibly more than one, indicating that she’s likely to take a more aggressive approach to tackling inflation compared to her Federal Reserve colleagues.
Bowman said on Friday, “I still anticipate that further rate hikes might be necessary to bring inflation back to 2% on time,” using the term “hikes” to describe her interest rate expectations.
She expressed, “I believe there’s a continuous risk that energy prices may further increase, reversing the inflation progress made in recent months.”
Bowman also noted that monetary policy seems to have a lesser impact on lending than expected.
She elaborated, “Even though bank lending standards have tightened, we haven’t seen significant credit contractions that would cause a significant economic slowdown.”
Bowman’s comments suggest that she might be forecasting the highest rates for 2024, when one official predicted the federal funds rate would be between 6% and 6.25%.
San Francisco Fed President Daly mentioned on Friday that she’s not ready to declare a victory against inflation. She stated that unless there’s more confidence in inflation returning to price stability, “we won’t be content with our target.”
[Morgan Stanley: Fed Has Completed Rate Hikes]
Morgan Stanley’s Chief U.S. Economist, Ellen Zentner, stated that cooling inflation should keep the central bank on hold until they’re ready to cut rates next year. In the short term, the Republican party might cause a government shutdown, reinforcing the Fed’s reason to maintain its stance in the November meeting. She explained that a government shutdown would prevent policymakers from accessing all the necessary economic data to make decisions.
For the Fed to continue raising rates in November and December, two conditions must be met.
The first condition is that the Fed is content with more labor market slack and a slowing employment growth. The Fed has already mentioned this in their statement. The three-month moving average for employment growth is around 150,000. If this number starts to accelerate again, the slowing trend in job growth might appear unsustainable.
The second condition is that core services inflation (excluding durable consumer goods prices, which are continually deflationary and only account for 25% of the core inflation bucket) also accelerates. Service sector inflation is the critical aspect here. For core services inflation to pick up again, it would need a significant rise of approximately 0.6 percentage points, which seems challenging.
The Federal Reserve projects that the real interest rate will further rise from around 1.9% at the end of this year to 2.5% next year. “If you input this into any macro model, it becomes clear that the Fed doesn’t truly hope for a soft landing.” It’s speculated that there might soon be disagreements within the Fed.
[Ackman Reiterates Short on Bonds, Predicts 30Y at 5.5%]
Bill Ackman continues to short bonds and expects long-term rates to rise further due to increasing government debt, rising energy prices, and the escalating cost of transitioning to green power.
The founder of Pershing Square Capital Management, Ackman, commented, “The long-term inflation rate, combined with the real interest rate and a term premium, indicates that 5.5% is the appropriate yield for 30-year treasuries.”
The current yield for 30-year treasuries stands at 4.58%, marking its highest level since 2011 last week. In early August, he publicly stated his position in shorting the 30-year treasuries, which at the time had a yield of approximately 4.1%. Based on futures prices, it was 122 on August 1st and 117 on September 22nd.
Ackman added that due to the economy performing better than expected, infrastructure spending supporting economic growth, and debt supply, expectations for an economic recession have extended beyond 2024. It’s unlikely that the inflation rate will retreat as the Federal Reserve Chair hopes.
“No matter how many times Chairman Powell reiterates his goals, long-term inflation will not return to 2%,” Ackman expressed. “After the financial crisis, this number was arbitrarily set at 2% in a world quite different from the one we live in today.”
[Thai Prime Minister Predicts Tesla, Google, Microsoft to Invest $50 Billion]
Thai Prime Minister Srettha Thavisin stated on Sunday that Thailand anticipates receiving investments from Tesla (TSLA.O), Google (GOOGL.O), and Microsoft (MSFT.O) totaling at least $50 billion.
He said, “Tesla will explore electric vehicle manufacturing facilities, and Microsoft and Google are looking into data centers.” However, he did not clarify whether the anticipated $50 billion is a joint investment or if each company would invest individually. He had meetings with executives from these companies earlier last week.
[U.S. Says It Can’t Exclude China from Critical Mineral Supply Chain]
U.S. Deputy Secretary of State responsible for economic growth and the environment, Jose Fernandez, stated on Friday that even though the U.S. seeks to diversify the sources of raw materials for various products, ranging from electric car batteries to solar panels, they cannot exclude China from the crucial mineral supply chain.
He emphasized China’s pivotal role in raw mineral processing, indicating that it will continue to be an essential partner for the U.S., especially as these minerals are vital components for electric car batteries. The broader adoption of electric vehicles is a central principle in the government’s climate change efforts.
Why is the battle over “critical minerals” heating up?
Although many critical minerals are abundant globally, extracting and refining them into usable forms can be expensive, technically challenging, energy-intensive, and highly polluting. China dominates many of these products’ entire value chains, accounting for more than half of the world’s battery metal production (including lithium, cobalt, and manganese) and nearly 100% of rare earth production.
Currently, about 50 metal elements and minerals meet the “critical” criteria set by the U.S. and EU. They play a role in building infrastructure required to reduce carbon emissions from climate change, and some are also used in semiconductors for civilian and military communications.
• Lithium, graphite, cobalt, nickel, and manganese — primarily for electric vehicle batteries
• Silicon and tin — electric cars, smart grids, meters, and other electronic products
• Rare earth — turbines magnets, electric vehicles
• Copper — grids, wind farms, electric vehicles
• Gallium and germanium — solar panels, electric cars, wireless base stations, defense radars, weapon targeting systems, lasers
Position and Capital
Last week, the positions of subjective investors remained almost unchanged (maintaining a historical percentile of 53), while the positions for systematic strategies saw a significant decline (from percentile 72 to 59).
Overall, the position in U.S. stocks slightly decreased from 61 to 59, moving into the neutral range.
Last week, equity funds experienced a massive net outflow of $169 billion, which nearly offset the highest inflow over the past 18 months from the previous week. The U.S. had the largest single-week net outflow of the year at -$179 billion. Europe’s net outflows surged to a 6-week high of $31 billion, marking the 28th consecutive week of net outflows. Emerging markets, however, reversed to a net inflow of $26 billion after two weeks of net outflows, and both Latin America and Japan’s stock markets also saw net inflows. Data from the Japanese Ministry of Finance indicates that foreign investors sold off approximately 1.58 trillion yen (roughly $107 billion) of Japanese stocks last week, nearly double the amount from the prior week, marking the highest since March 2019.
Bond funds this week had a net inflow of $25 billion, slowing down from the previous two weeks. Emerging market bonds experienced outflows of -$14 billion. Money market funds saw a slight net outflow of -$43 billion this week, after strong inflows in the previous two weeks. The U.S. led the outflow with -$72 billion, and Japan also had a slight outflow of -$2 billion.
By sector, technology ($13 billion) continued its inflow, and energy ($8 billion) also saw significant inflows. The financial sector saw an accelerated outflow of $14 billion, marking the 8th consecutive week of outflows. Both the healthcare ($5 billion) and real estate ($4 billion) sectors experienced outflows, with other sectors seeing minor capital movement.
When looking at position levels by sector, only technology (z-score 0.30, 67th percentile) remained slightly over-allocated, but still close to the neutral level. Essential consumer goods (z-score 0.15, 61st percentile) have been reduced to neutral, similar to non-essential consumer goods (z-score 0.01, 66th percentile). Industrial products (z-score -0.08, 57th percentile) and energy (z-score -0.08, 62nd percentile) are slightly below neutral. Information technology (z-score -0.33, 48th percentile), healthcare (z-score -0.44, 35th percentile), and raw materials (z-score -0.47, 36th percentile) remain significantly under-allocated. Real estate (z-score -0.67, 16th percentile), finance (z-score -0.75, 16th percentile), and utilities (z-score -0.76, 16th percentile) are even more underrepresented.
In the futures market, S&P net long positions slightly decreased, while Nasdaq net longs jumped to their highest level since May.
This has elevated the overall position level of the U.S. futures market to its highest since early last year. However, this is mainly because the data was only collected up to Tuesday and doesn’t include post-FOMC data. This suggests that speculators were betting on market increases before the meeting, but they were mistaken. This number is expected to drop significantly in the next update.
Market Sentiment
Last week, the AAII investor survey bullish ratio dropped to 31.3%, the lowest since June 1, with bearish and neutral views both hovering around 34%.
The CNN Fear & Greed Index dropped to its lowest level since March at 35.9.
Goldman Sachs’ institutional sentiment indicator plummeted from an overbought level of 1.2 to a neutral 0.2, echoing similar metrics from Deutsche Bank indicating significant institutional selling.
Bank of America Merrill Lynch’s bull-bear indicator declined last week from 3.6 to 3.4.
The Week Ahead
We are currently in the week between the FOMC meeting and the next non-farm payroll report.
Data to watch includes the U.S. August core PCE price index — the Federal Reserve’s favorite inflation indicator, the U.S. August durable goods orders, U.S. Q2 GDP final figures, China’s September PMI data, China’s August year-on-year profits for large-scale industrial enterprises, and the Eurozone’s CPI inflation data.
Central bank activities include Federal Reserve Chairman Jerome Powell attending a meeting and answering questions, and the Bank of Japan releasing the minutes of its July monetary policy meeting.
On the government front, the focus is on a potential U.S. government shutdown. Nearly 4 million (including 2 million military personnel) federal employees will feel its immediate impact. Essential staff will continue working, while others will be furloughed until the shutdown ends, with no pay during the deadlock.
Members of the American Federation of Government Employees have an average annual income between $55,000 to $65,000, while temporary workers average $45,000. This could place these individuals under financial strain.
Additionally, if the government shuts down, the U.S. Bureau of Labor Statistics announced it would halt data releases, including key inflation and unemployment figures. The absence of crucial government data would make it challenging for investors and the Federal Reserve to interpret the U.S. economy.
Goldman Sachs estimates that a one-week government shutdown would reduce economic growth by 0.2%, but growth would rebound once the government reopens.
Hardline Republicans have stated that any stopgap spending bill is a non-starter for them. They are pushing for a shutdown until Congress negotiates all 12 appropriations bills that fund the government, an ambitious task that historically would optimistically be resolved by December.
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