What Is The Bull Case For US Stocks Going Forward?
A few editions past, we mentioned almost in passing that US stocks and risk assets could be supported by a slow-yet-steady news flow of improving inflation data.
The idea is that a bounce in risk assets could be sustained for some time if we get a period of positive information about US inflation. We felt it was worthwhile exploring because, as we outlined in some detail, these "bear market bounces" can be quite significant - even during prolonged market downturns.
In fact, they can be so significant that they can tempt many investors to believing that the good times have returned.
As a reminder, here are the bear market rallies in the Nasdaq downturn back in 2000-02:
Especially early on, you might easily have thought that the upwards trend was reasserting itself after a sudden pullback.
The lesson is: picking bottoms is difficult!
Today we explore this theme partially to detail what is possible and to reiterate our earlier warning - be careful of buying a bounce and expecting a renewed upwards trend.
This is especially the case if most of the bounce has occurred and is, regardless, rising on low volumes, deteriorating liquidity conditions and more hope than reality.
However, there is another reason to engage in this exercise: we could be wrong.
And thus there is a real case to be made for exploring what being wrong might look like.
The bull case for US equities might be summarized as:
Provided peak inflation has, in fact, already passed we could be set up for a period of (gradually) lower inflation data that allows the US Federal Reserve to assess that they are gaining control over the situation.
This, in turn, would allow the US central bank to change their guidance about the rate path going forwards thereby causing shift in the number of interest rate hikes that are expected or "priced in" and relieving some of the strain on credit and financial conditions.
Historically, a "pause" (the central bankers' preferred term) in a hiking cycle is typically worth a further 10-20% bounce in the stock market. We are not predicting that one will occur but even the possibility rising in probability would be a meaningful change from current expectations.
Easier financial conditions and credit would create - especially over the short term - a pretty virtuous and self reinforcing cycle:
Less inflation -> will mean fewer hikes -> which will mean more growth and lower costs for debtors everywhere - which could lead to higher equity markets and so on.
That could be pretty good!
There are other possible positives as well. Such as, perhaps, just perhaps, Xi Jinping and China will begin to see the folly of their ways when it comes to "Dynamic Zero Covid" or some sort of lasting ceasefire or even peace agreement in Ukraine.
Shanghai has finally re-opened relatively completely and we can only hope that the CCP and its leadership will begin to take a different tack. This isn't looking very likely but, as with the conflict in Ukraine, one can always hope!
A recovery of global planting conditions and expected agriculture yields would also be a tremendous help.
Any or all of these developments would also diminish the exaggerated but possible risk of a recession and allow consumers a breather while protecting corporate margins.
What to watch for this to occur, one way or another?
Simple answer: the US Dollar.
The US Dollar has been on a tear this year. Now, that is good for US tourists abroad and anyone who is borrowing in dollars and spending in another currency but, in general, a very expensive dollar puts a lot of strain on the international financial system and, therefore, the global economy.
Why?
Well, a more expensive dollar makes it very hard for anyone who has borrowed in dollars (or must buy commodities or components priced in dollars). Their debts or costs just keep marching higher.
Over time, a rising dollar, like a rising tide in a coastal community, creates hidden strains and stresses that can suddenly not be so hidden.
It can cause bankruptcies, ruins business models and challenges consumption patterns (and creates poverty) the world over.
One small but timely example of the above. A strong US dollar can crimp the foreign sales of large US corporations. Microsoft investors found this out to their surprise and displeasure this week when the software and cloud computing giant unexpectedly cut its guidance on sales and earnings because of strong gains in the greenback.
In conclusion, the relative price of the US Dollar matters. And not just for the price of a margarita or fish 'n chips abroad.
And here is the chart for the US dollar index at present:
As you can see, the last few relatively calm weeks have come with an easing of the dollar's climb. This is sort of the inverse of US financial conditions we have spoken about before.
Watch this space as a simple and single indicator that will encapsulate a lot of the tensions that are ongoing in the US economy.
The US is diverging from the rest of the world. As the employment report made clear on Friday, despite the boo birds yelling recession ever louder, the economy continues to grow strongly and is sucking more and more people into the labor market.
That is great! It is also good for inflation. More people coming into the labor market will mean that wage pressure will remain muted which will also help in the battle against inflation.
Less positively, less wage inflation won't help workers handle the higher costs. When we are so critical of inflation and why it is so terrible, this is why!
It isn't all good news however. Elsewhere there are some sectors of the economy that remain very challenging!
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