MAGGIE LAKE: Hi, everyone. Welcome to the Daily Briefing. It's Monday, May 16th, 2022. I'm Maggie Lake, and here with me today is Eric Johnston, head of Equity Derivatives and Cross Asset for Cantor Fitzgerald. Hi, Eric.
ERIC JOHNSTON: How are you, Maggie?
MAGGIE LAKE: I'm doing well. Thanks for being with us.
ERIC JOHNSTON: Thanks for having me. I'm very excited.
MAGGIE LAKE: Yeah, it's such a good time. Welcome to Real Vision, there's a ton of stuff going on to talk about, didn't really look like it on the surface today. It was a weird churning day, we saw equities in the US tried to rally. But once again, weakness into the close. It looks like the Dow, as we're settling here, looks like the Dow was going to try to hang on to some gains just barely.
But we did see the S&P down a little more than a third and the NASDAQ down another 1.2%, really closing on the lows of the session. We had oil, gold up, the 10Y yielding 2.8% When you see this kind of day, especially coming off the huge volatility we've seen lately, what do you make of this market action?
ERIC JOHNSTON: Overall, I would say that the conviction that's in the market is extraordinarily low, I'm not sure that I've ever seen it lower in my career, and you combine that with liquidity right now is extraordinarily poor. And that's beyond equities. That's really across all asset classes, including the rates market where you're seeing a lot of volatility.
You also have this dynamic in the market where dealers are short gamma, which is-- and we think it's a pretty significant amount, probably in the $10 billion to $15 billion range, which essentially means that as the market rallies, they're going to be buying, and as the market sells off, they're going to need to sell. And that's exacerbating all the moves.
What was interesting about today's action is that it looks like the stagflation trade was being put on today. You saw oil was strong. Within equities, you had energy and materials performing well, in concert with consumer staples, healthcare, utilities, so essentially, buying defensives, buying those sectors that do well with inflation, and then everything else, whether it be cyclicals or growth names coming under pressure. But really, it's interesting, by the day and really by the minute, the narrative and the trading changes so quickly, and it's because conviction right now is so extraordinarily low.
MAGGIE LAKE: Yeah, I'm glad you said that, because it does feel that way. And it explains why we're seeing these what feels like outsized moves if the market conditions are as you described. Because sometimes when you see that, you think, oh, everybody thinks a certain way. That's not the case at all. It just sounds like it's the dynamic of the market. Do you feel like that stagflation play is the right one to be in right now? Does that seem like the right thing given the economic outlook we're seeing?
ERIC JOHNSTON: I think, generally, yes, however, I think the inflation outlook is actually going in the right direction. There are a number of signs out there that tell me that the direction of inflation is going to be heading south for the next four or five, six months. And it's happening for a few different reasons.
The first one is, if you look at wage growth, if you look at the last payroll report, if you look at the three-month annualized number for hourly earnings, they've been accelerating at about 3.5% on an annualized basis. And if you rewind six months, that number was about 6.5%. That's getting incrementally better.
If you look at what is going on with net worth, last year, in 2020-2021, we had some of the largest net worth increases that we've seen in a very long time between housing, bonds, and stocks all going in the same direction. That's now reversing course. And that's also going to have a helpful effect on inflation.
And then of course, you have the base effect, where you look at last year, inflation really started to surge back in April, so the compares every month get harder and harder. Yes, I think generally we're in that paradigm of I do think growth is going to continue to slow, inflation is going to be there.
But I think very importantly, as we speak, the inflation picture is getting better and you're actually seeing that in inflation breakevens where if you look at five-year inflation breakevens they peaked around 3.75% about three or four months ago. They're now around 3%. It's a pretty sharp move lower in breakevens. The rates market is clearly seeing this. And I think that's going to be an important positive narrative in the coming weeks and months.
MAGGIE LAKE: I'm interested because I think that we do seem to be getting some consensus around the idea that we may have seen peak inflation. But the concern is, how elevated does it stay? And then what does that mean for the Fed? Let's get some questions right in. I love it, send them on in and we'll try to weave them into the conversation.
Paul in The Exchange asking, do you believe the Fed's future rate increases will happen? Or are they going to put the brakes on before they go through all the projected increases? If inflation stays elevated, doesn't that box them in? Even if it's peak, if it's still really high, don't they have to stay the course? How do you see that playing out?
ERIC JOHNSTON: I think for the next two meetings, 50 bps and 50 bps I think is in the cards no matter what happens, but I think that right now, we are at peak hawkishness. And when you look at what's priced in the rates market, it has the Fed funds rate going to about 3% by May of 2023, May of next year. And I actually think that's a little bit too aggressive.
I think actually, one of the best trades out there right now is being long Fed fund futures. Because I think that ultimately, what we're going to see over the next six months is that inflation is going to come down, growth is going to weaken, I think equities will be over the next six to seven months going to be under further pressure.
What I could see happening is the Fed goes 50 and 50. And then at that point, what they could say is that they want to see how the economy takes the rate hikes that they've put in. At that point, they may start to drag their feet, maybe they go down to 25 bps, or maybe even towards the end of the year, potentially take a pause.
And their excuse can be, we're seeing inflation go in the right direction, financial conditions have already gone tighter than we think. And most importantly, there's a lag effect to rate hikes, and that allows us to pause and see how the data goes from here.
MAGGIE LAKE: Interesting, because that's, I think, what the Fed is hoping. It's a version of a soft landing, like, listen, we start, we get this thing under control, and then we can be more data dependent and see how it goes and ease back in time to prevent something happening. I think the worry out there is that it's super hard to do that and the Fed may not have the tools.
Jim Bianco recently caught up with Danielle DiMartino Booth, the CEO of Quill Intelligence, big Fed watcher, former Fed person. And she's much more worried and pessimistic about the Fed's ability to navigate this. Let's have a listen to a clip from that.
JIM BIANCO: But Powell told the American public last week, he has the resolve, and he has the tools. Do they?
DANIELLE DIMARTINO BOOTH: Right now, because there are so many exogenous forces on inflation, and food's hot. Right now, because there's so many outside forces, they only have so many tools to address inflation. If they want to address housing inflation, which is the largest line item on any given household's budget, they can break the back of housing, which brings us back to resolve.
And it wasn't the 75 basis points that got me as much as when he started falling back into his old pattern of repeating, if financial conditions warrant, if financial conditions warrant. And that's code for as long as the stock market hangs in there, then we'll have all kinds of resolution. And that was what was initially interpreted with the 3.5% move. That was however many standard deviations away from the norm.
The backlash the next day was, this is no Paul Volcker. This is not somebody who has the resolve to do what needs to be done to eventually-- runaway prices that the Fed can control, i.e., housing, that is not in the public interest, which is in the Federal Reserve's very top paragraph of their main website.
As his first paragraph of the statement said that he was going to make the hard moves on behalf of the American people because the Fed is mandated to make policy in the public interest. He apparently is in it, but with housing costs eating people alive, you've got to break it, or then you just stick it to the people.
MAGGIE LAKE: And that full interview is available to all members on our website. Eric, I think John from the RV site, has an interesting question that I think plugs into what Danielle was talking about there. He says, Eric, the buy the dip mentality still persists. For example, once Jerome Powell hinted that there could be a hard landing, high growth equities rallied on Friday. How long does the equity market have to stay down before the negative wealth effect forces the Fed's hand? I think these are all ways of saying Is there a Fed put still?
ERIC JOHNSTON: The answer, the short answer is no, or it's much further below than where we are now. And we're clearly in a very different environment than we've seen the last 12 years because not only, over the last 12 years, not only have we had the monetary point, but we've also had fiscal where any downturn has been bailed out by fiscal stimulus.
And that's also not going to be happening, because in all likelihood, the Republicans will take at least one house in November and that's going to really limit the amount of fiscal spending for the next two years. And then, as far as the Fed goes, I think that what's different during this hike cycle versus prior cycles is the balance sheet. And I think almost the balance sheet reduction is probably even more powerful, and more influential on inflation than rates are.
If you look at a couple of examples recently, where equity markets have been weak, and you've seen companies, whether it's Amazon or Carvana, or Uber, Facebook, other companies announced that they're going to be cutting jobs. And in many cases, these job cuts are being forced by what they're seeing from the equity markets.
When their stock's under pressure, they need to either raise cash or improve their margins. And that's causing them to announce cuts. It does become very self-fulfilling. And I think that the reduction in the balance sheet is going to be one of the major headwinds for equity markets. And I think that to my point earlier that they might pause, that pause would be for rate hikes, but the balance sheet reduction would be continuing.
MAGGIE LAKE: Yeah. Great point. Great point, Eric. We're really not hearing about that as much as one would think given that it signals this really different regime. We've been so fixated on the language on the rate hikes. A lot of investors in parts of the market have. I want to ask you a quick question about equities and then I want to talk a little bit more about that balance sheet.
It sounds like you think equities have a lot further to go to the downside. What time horizon are you looking at? And what kind of weakness are you expecting? Is it in those beaten-up names? Or do we see different sectors, that rotation where defensives hold up a bit better or value holds up a bit better, and it continues to hit the NASDAQ and tech? How do you see this playing out?
ERIC JOHNSTON: My view over the course of the next 3, 6, 9 months to a year is that we're negative. And I think we're going to much lower prices which I can get into. But within that, I do think we are going to have a tactical rally. If you look back in the year, the bear markets of the year 2000, 2001, 2002. You look back to 2007 and 2008. These were years where the S&P went down 60% and 70%, respectively.
But within those selloffs that occurred over depending on which one, a year and a half to two and a half years, there were plenty of rallies within that, and many that were two, three months long in duration as the market was in this bear trend. I think we're in a very similar situation now. The dynamics around the background of what's causing this is very different than both of those situations, but the point of having I think we are in in a one-, two-year bear market.
But within that, there are going to be times where we're going to get these tactical rallies. And I think that we're in one of those right now. As I mentioned earlier, my background is I've been a trader my entire career. And I combined deep fundamental analysis around the macro and the micro with the trading perspective, trading dynamics that I see.
Right now, I think we're set up for a fairly big bounce based on where our positioning is right now, based on the inflation dynamics that I was mentioning earlier, and some other dynamics, but that's within this bear thesis that I have, where the balance sheet is certainly part of it. Where we ultimately go over the next year, I think that the S&P can go to a mid-3000s, which would give us calls about 15 percentage from here further downside. But that's going to take to take time, it's not going to be a straight line.
MAGGIE LAKE: Right. Ralph asking, what causes that tactical rally? Is there a catalyst? Or is it just that we see a drift up here barring any terrible headlines? How do you think about timing around that?
ERIC JOHNSTON: Sure. I think it's going to happen in the near term. I think it's going to happen in the next few weeks. If you look at the trading dynamics right now, and the positioning, positioning amongst the institutional community is extremely light. Hedge funds net exposure is at its actually below where it was in March of 2020. It's very close to a five-year low.
If you look at systematic funds, CTAs, vol control, and others, their exposure is also very close to a five-year low. And then macro funds are predominantly short equities. When you combine those dynamics, with the fact that buybacks right now are in full force, we think they're probably buying about $4 billion to $5 billion of stock per day, and liquidity is quite poor. We think that that lines up right now for the potential to get a sharp rally.
In terms of what the catalysts are, I would say a couple things. Number one is I do think that the inflation outlook over the next couple months is going to improve. People are going to get that we really have hit peak, and that that's going to be moving lower. I also think that the recession fears, although I do think that growth is going to weaken, if you look at where jobless claims are right now, they're very close to historic lows.
The labor market is, as we all know, is very, very strong. It's in the process of it will weaken, and it will reduce some of the excess demand for roles. But that employment strength is really going to prevent this economy from really rolling over hard because debt levels, both on the corporate side and individual side are very light relative to history. It doesn't lend itself to a hard recession at this moment.
That could happen in 2023, and I think we will be in a recession 2023. But for right now, that's not on the horizon. And I would add one more thing, which is that earnings have held up so far very well. I do have a view that earnings will eventually roll over because margins right now are at levels that are not sustainable. But for right now, earnings season just finished and estimates actually went up. I think it lines up pretty well right now for a rally.
MAGGIE LAKE: If that's the growth forecast, what does that mean for bonds? Michael's asking, where do you think 2Y and 10Y are in three months?
ERIC JOHNSTON: Yeah, so I think bonds are a buy. And I think Fed fund future rates are a buy. I think the outlook for the next couple months, it's going to be slower growth is going to continue to be the narrative, lower inflation. And then one of the dynamics I think is really important is that if you look at the individual investors' allocation to bonds and allocation to equities, this is a really important factor.
Right now, allocation to bonds is at a historic low or at least recent historic low. And then equity allocations are pretty close to an all-time high. One of the dynamics I think plays out over the course of the next year is that the individual investor rotates out of equities and goes into bonds. The whole argument for the past decade has been the TINA argument. And that is starting to starting to fade where you're getting into municipal bond yields, investment grade credit yields, preferreds.
They're actually very attractive, but it takes time for the individual investor to react to these moves that we're seeing in rates and particular with all the volatility that's out there. I think as things calmed down over time, you are going to see this big migration out of equities and into different fixed income assets.
MAGGIE LAKE: That's so interesting. Because at the same time, we've been hearing a narrative that listen, the 60/40 model is dead. It's not coming back. Generationally, do you think there's been any change that tilts the weight toward equities for preference for equities?
ERIC JOHNSTON: I don't. Certainly, this has been the worst bond market performance almost in history. I believe it has been in history. So clearly, looking back, you would say it's quite dead. But I think looking forward, I do think that it can work and there can be more of a hedge going forward, where they could act as a buffer where if our equities thesis plays out, that bonds will react favorably to it.
MAGGIE LAKE: I want to circle back to the idea of the balance sheet. The Fed announced that, of course, they're putting out this idea that it's going to happen in this orderly fashion. But against the backdrop of what we've seen huge moves in the 2Y, we've seen across global markets, the Japanese yen, massive moves. We've seen these outsized moves in volatility and what had previously been really stable safe investments. Are you worried about the financial system's ability to deal with quantitative tightening?