MIDDAY MACRO - 3/4/2022
Color on Markets, Economy, Policy, and Geopolitics
MIDDAY MACRO - DAILY COLOR – 3/4/2022
OVERNIGHT - MORNING RECAP / MARKET WRAP
Price Action and Headlines:
Equities are lower, with European markets closing down around -4%, while the S&P is still holding in its weekly range as headlines continue to drive sentiment and improving domestic data means little
Treasuries are higher, with a flight to safety increasing overnight on news that a nuclear plant in Ukraine was under attack, while better jobs data did not reverse that trend
WTI is higher, as expectations for Russian oil sanctions continue despite European officials and the Biden Administration not being supportive. The weekend may bring an Iranian deal, but much is still unclear
Narrative Analysis:
Markets are waking up to the fact that the conflict may be much more severe and longer-lasting than initially expected, causing a massive red day in European risk assets while America is being viewed as somewhat more insulated from the energy and food shortages likely to come. A very strong jobs report failed to materially reverse the risk-off mood that increased following heavy fighting around a Ukrainian nuclear power plant. Oil is well bid despite the fact that an Iranian deal could be reached soon as the fate of millions of barrels a day of Russian oil supply is highly uncertain. The dollar is significantly outperforming due to the flight to safety while the Euro is being dumped, falling below 1.10 for the first time since the pandemic hit. The bottom line is this is an extremely volatile and uncertain time with little clarity on how things normalize.
The S&P is outperforming the Nasdaq and Russell with Low Volatility, Hogh Dividend Yields, and Value factors, and Utilities, Energy, and Real Estate sectors are all outperforming.
S&P optionality strike levels have the Zero-Gamma Level lower to 4437 while the Call Wall fell to 4450. Even though markets remain very headline-driven and in a volatile setup, implied volatility has remained somewhat contained but is rising. The term structure remains in a backwardation suggesting short-dated puts remain in high demand. Zooming out, the large negative gamma and high implied volatility means the downside remains vulnerable to sharp “steps” lower.
S&P technical levels have support at 4260-80, then 4200, and resistance is at 4350, then 4385. S&P is back at the bottom of its weekly range with 4hr RSI now oversold. The 4260-80 area continues to be key support as it is the neckline that needs to be held as there is little support below.
Treasuries are higher, as this risk-off tone has the entire curve well bid. The 10yr yield is now at 1.70%, falling 13.7bps, while the 5s30s curve is steeper by 5bps to 53.5bps.
Deeper Dive:
Things are not good. There is no clear path to de-escalation in Ukraine, increasing the risks of a direct NATO and Russian Federation conflict. Although Europeans insist that energy sanctions are not coming, we believe that as the conflict intensifies and more casualties occur, they will capitulate. Hence any risk rallies should be viewed with caution given the likelihood oil will continue to stay elevated if not rise meaningfully further, increasing inflationary pressures and taxing consumption. Eventually, the persistence of these energy cost increases coupled with food price increases will lead to the global economy entering a recession.
Markets have begun to increasingly reflect a higher probability that a global recession is coming due to a growing realization that the Ukrainian war will be much longer-lasting and more impactful than initially thought. The U.S. is better insulated from both energy and food increases than Europe, Japan, and most emerging market nations, but market-implied fear/stress indicators are increasingly rising here.
The 2yr and 3yr swap spreads continue to widen, showing increasing sensitivity to volatility, geopolitics, and market uncertainty over inter-bank credit.
The Libor/OIS and Ted spreads are widening while flows into money market funds are elevated.
Front-end T-bills have backed off negative yields but are only at single digits now.
Equity volatility continues to climb higher with the VIX in the mid-30s.
Bond markets across product lines are highly illiquid, and differentiations in pricing are being exacerbated based on convexity, liquidity, credit, and structure.
*Counter-party risk is rising as exposure to Russia will cause still unknown losses throughout the international financial system
*Eurostoxx VIX is significantly more elevated than the S&P VIX but coupled with other measures U.S. markets are increasingly reflecting growing fear levels
The current mix of export controls and sanctions led by the U.S. and Europe are designed to impose a high economic cost on the Russian people and promote regime change. The bottom line is that a permanent member of the UN Security Council and number two global commodity producer is effectively an international pariah state. This will not change until Putin, and his cronies are ousted. Until then, Putin will continue the war until he achieves regime change in Ukraine, showing minimal concern for the economic and human costs to his nation.
*Putin is very aware of the danger his regime is in as the economy implodes and reports show he is becoming more isolated, increasing the risk of further miscalculation and escalation
When we put it all together, there is no clear diplomatic off-ramp channel for the conflict, with an escalation and prolonged period of fighting now being the likeliest outcome. Given the already negative moves in markets and increased volatility, something will break somewhere, expediating the negative feedback loop already occurring. As a result, we see the current range-bound equity market as likely unsustainable. The consolidation occurring over the last week will likely lead to a strong break lower with technicals indicating not much support and optionality becoming increasingly negative for the S&P as it approaches 4000 and moves below.
*If the S&P neckline breaks and is not quickly recaptured, technicals indicate a move lower to below 4000, with the 3700-3600 area being the ultimate end zone
As a result, we are closing a number of our longs. It's just not a constructive macro backdrop, and our view is now that the effects/outcome of/for the war have become materially worse for global growth and risk assets. We are closing our $IWM, $ROBO, $EEMA, and $PKW longs. We are willing to give our lithium mining and battery long expressed through $LIT a little longer as well as our REIT ETF expressed through $VNQ given they should both outperform in this environment, although outperforming could still mean significant losses so we will respect the not too far off stops. The bottom line is that the knife keeps falling. We don’t see a meaningful catalyst for it to stop falling and are happy to be in cash and miss an initial bounce if things meaningfully change.
*Due to our oversized position in cash and past gains from oil, the portfolio is only down -2.1%. However, the opportunity cost is much higher as we failed to capture the rally in commodities and Treasuries.
Econ Data:
Non-Farm Payrolls increased by 678K jobs in February, the most in seven months and above market forecasts of 400K. Job growth was widespread, led by leisure and hospitality (179K), namely food services and drinking places (124K) and accommodation (28K), followed by professional and business services (95K). The reported jobs created in January and December were also revised higher. The unemployment rate fell to 3.8% from 3.9%, while the labor force participation rate edged up to 62.3% from 62.2%, showing impressive gains in the household survey. Average hourly wages were unchanged, missing the expectation of a 0.5% increase and moving higher by 5.1% on an annual basis, while the average weekly hours rose slightly to 34.7.
Why it Matters: February’s report leaves employment 2.1 million jobs below its pre-pandemic level, and many economists believe the job market could recover all the pandemic losses this year. The weak growth in average hourly earnings was due to the very strong number of jobs created and increased hours worked, continuing the strong growth in aggregate income. It also shows that shortages may be easing with the continued improvement in the labor force participation means an additional 300 thousand people joined the labor force in February. The increase in manufacturing jobs reinforces this view, and what we have seen elsewhere in ISM PMIs and regional Fed surveys, which also show the problem of “skilled-labor” shortages has been improving. This reduces the risk of a more entrenched wage spiral inflationary cycle occurring. It also means profitability is likely to meaningfully improve moving forward as firms have learned to do more with less (reducing labor’s bargaining power) and heavily invested in both digital and physical capital expenditures to improve future productivity.
*A broadly strong payrolls print coupled with positive developments in the household survey will give allow the Fed to say mission accomplished with their “maximum employment” goals
*Positive signs for the reopening with front-line workers returning post-Omicron, however, healthcare and childcare still remain well below pre-pandemic levels
The ISM Services PMI fell for a third month to 56.5 in February from 59.9 in January, below market forecasts of 61. The reading pointed to the slowest growth in the services sector in a year. A slowdown was seen in Business Activity (55.1 vs. 59.9), New Orders (56.1 vs. 61.7), and Supplier Deliveries (66.2 vs. 65.7) while Employment contracted (48.5 vs. 52.3) and Prices rose slightly (83.1 vs. 82.3). On the positive side, the Backlog of Orders (64.2 vs. 57.4) and New Export Orders (53 vs. 45.9) saw impressive increases while inventories continued to grow.
Why it Matters: The service side of the economy slowed in February; however, it wasn’t all bad. The Backlog of Orders and New Export Orders increased significantly, buffering the slowdown in New Order and Production activity. Regarding supply-side impairments, there was a slight improvement given employment situation looks to be improving, while there was no material worsening in Price increases or Supplier Deliveries. However, Anthony Nieves, Chair of the ISM, commented that “respondents continue to be impacted by supply chain disruptions, capacity constraints, inflation, logistical challenges, and labor shortages. These conditions have affected the ability of panelists’ businesses to meet demand, leading to cooling in business activity and economic growth.” Comments from respondents confirmed this with both expectations for demand to remain strong while supply chain challenges persisted
*Overall ISM PMI composite in February was driven lower by the Service side as Business Activity, New Orders and Employment fell
*Inflationary pressures increased slightly while Demand measures were more mixed
New orders for manufactured goods rose 1.4% in January, quickening from a revised 0.7% increase in December and above market expectations of 0.7%. Orders rose faster in industries producing both durables (1.6% vs. 1.2% in December) and nondurable goods (1.2% vs. 0.1%). Among durable goods, the main upward pressure came from transportation equipment (3.4% vs. 1.7%), mainly driven by orders for nondefense aircraft and parts followed by machinery (2.6% vs. 1.3%). Meanwhile, factory orders excluding transportation equipment rose 1.0%, faster than an upwardly revised 0.5% gain in December.
Why it Matters: Manufacturing sectors continue to significantly increase activity as the restocking of durables and overall economic backdrop have yet to weaken materially. The gains were widespread, with both transportation and machinery leading the way. The backlog of orders also grew, as unfilled orders increased 2.5%, after rising 0.6% in December.
*The growth in goods since the pandemic has been notable given that production levels have generally been capped by material and labor shortages
Policy Talk:
Chairman Powell delivered prepared remarks and answered questions twice this week as part of his Semiannual Monetary Policy Report to Congress. His prepared remarks highlighted that “supply disruptions have been larger and longer-lasting than anticipated, exacerbated by waves of the virus, and price increases are now spreading to a broader range of goods and services.” He stated the committee continues to “expect inflation to decline over the course of the year as supply constraints ease and demand moderates.” Powell said he is supportive of only a 25bp rate hike but noted the Fed would move cautiously given events in Ukraine. If inflation does not fall as expected, he is open to raising rates by 50 bps at one or more future meetings. However, he reiterated the Fed would remain data-dependent and not lay out the plan in its entirety. He suggested the plan for the balance sheet would not be completed by the March FOMC meeting but hinted that it would encompass a three-year time frame, the Fed would likely have to sell MBS securities in 2023 and 2024 and not just rely on runoff which works better with Treasuries.
Why it Matters: Powell stayed on message and continued to highlight the persistence of inflation as being surprising but that it would fall throughout the year. He also navigated the general partisan issues during the Q&A without revealing too much new information. He did surprisingly all but commit to raising rates by 25bps at the March FOMC meeting, something the Fed Chairman historically doesn’t do, clearly eager to calm markets given the increased geopolitical uncertainty. We continue to think the Fed will be generally more patient than sell-side research is expecting as inflation slows and growth likely misses forecasts. At the same time, geopolitical-driven market volatility will tighten financial conditions more significantly than expected, encouraging a more patient approach.
*Markets are now pricing in five 25bp rate hikes this year as Ukraine is causing expectations to fall
Executive Vice President Lorie Logan of the NY Fed Markets Group spoke at NYU regarding her thoughts on the pandemic response and the future of the Fed’s balance sheet. She highlighted that the FOMC’s toolkit for addressing both severe market functioning disruptions and economic downturns is comprehensive and effective. Moving forward, the Committee has already indicated there will need to be a significant reduction in the balance sheet. The current composition of the BS has a lower weighted average maturity of Treasury holdings, and there will be large shifts in principal payments, ranging from $40 to $150 billion. However, December’s FOMC meeting noted the committee’s intent is to shrink the BS in a predictable manner. Logan went on to acknowledge that the Fed will continue to operate in an “ample reserve” regime, but the demand for reserves is still uncertain and will vary over time. She has confidence that the new Standing Repo Facility provides a backstop to market functionality if reserve availability becomes stressed. She finished by noting that the Fed has “some experience in shrinking its balance sheet, but the process is relatively novel.” The last time the Fed raised the target range of the ZLB was in 2015, and Logan believed they successfully managed the fed funds rate. However, the current environment is different, with higher levels of liquidity, and hence the ON RRP facility will play a more important role as banks shedding reserves would likely lead to increased money market use.
Why it Matters: Logan said the FOMC is prepared to adjust its approach to reducing the size of the balance sheet, should economic and financial developments warrant, but an initial plan is starting to be formulated. However, she highlighted ongoing work to understand vulnerabilities in the treasury market better, and additional reforms are likely warranted. Interestingly she commented that there would need to be “meaningful adjustments to private-sector balance sheets” given the need to absorb the net increase in Treasury and MBS issuance and lower levels of liquidity. She warned this could take time, and the Market Group desk will be monitoring this closely. In the end, this is the biggest question facing the street, who takes on this supply in what will likely be a rising rate environment? Will there need to be changes to the Supplementary Leverage Ratio or other regulations to incentivize demand from the banking sector if others don’t step up? In the end, the BS runoff plans will be more dependent on the answer to this than any longer-term BS* targets.
*Stepping back to the big picture, there will be a lot of supply coming in the coming years, and it is unclear who the end buyers will be.
*Banks are already heavy holders of Treasuries, and it is unclear how much more appetite they will have given the pick up in more traditional business uses of their balance sheets
TECHNICALS / CHARTS
Four Key Macro House Charts:
Growth/Value Ratio: Value is higher on the day and the week as the Ukraine war has growth expectations falling. Large-Cap Value is the best performing size/factor on the day.
Chinese Iron Ore Future Price: Iron Ore futures are higher on the day and week as Russian sanctions and boycotts have metals generally higher across the board
5yr-30yr Treasury Spread: The curve is steeper on the day and week, with Fed tightening expectations continuing to fall and Treasuries well supported in the belly
EUR/JPY FX Cross: The Yen is higher on the day and the week, as the full effects of the Ukrainian war are starting to hit European markets fully
Other Charts:
The dollar is becoming significantly overvalued due to the flight to safety bid it has been enjoying
The rental vacancy rate just hit 5.6%, the lowest level in nearly 40 years, indicating that rent will pressure shelter/OER inflation until this trend reverses.
Inventory levels for commodities are generally very low
Oil's ability to go much higher is capped by the increasing tax it will have on global consumption, increasing the likelihood of a recession.
Powell attributed a $10 increase in oil to a rise in inflation by 0.2% but highlighted the length of the rise was more important
ARTICLES BY MACRO THEMES
MEDIUM-TERM THEMES:
Real Supply-Side Improvements:
Grand Plan: Lowering Prices and Leveling the Playing Field in Ocean Shipping – White House
The Biden Administration released an Ocean Shipper Fact Sheet accusing the industry of price gauging and abusing their monopolistic position. Besides unfairly raising prices, the shipping “alliances” can cancel or change bookings and impose additional fees without notice, according to the Fact Sheet. The carriers have also continued to pursue practices that directly contribute to port congestion, such as imposing “box rules” that require truckers to use only certain trailers to haul their containers.
Why it Matters:
At the end of the letter/Fact Sheet, the President calls for Congress to pass robust reforms to the ocean shipping industry, including reforms that address the current antitrust immunity for ocean shipping alliances found in the Ocean Shipping Act. The administration is also ordering the Department of Justice and the Federal Maritime Commission to enforce any violations of the Shipping Act and related laws.
China Macroprudential and Political Loosening:
Heavy Cost: China Declared Its Russia Friendship Had ‘No Limits.’ It’s Having Second Thoughts. – WSJ
Russia’s subsequent invasion of its neighbor is forcing Beijing into adjusting its foreign policy in a way that risks damaging relations with the U.S.-led West and undoing years of efforts to paint itself as a responsible world leader. It was Beijing that suggested including that the two countries’ friendship has “no limits,” according to the officials and advisers. The intention was less a declaration China would stand by Russia in case of war than a strong message to the U.S. about the resolve the two have in confronting what they see as increased American threats, the people said.
Why it Matters:
What Beijing will do next depends on how hard the U.S. will push sanctions on Russia, say the foreign-policy advisers. Mr. Xi also likely will continue to maintain his partnership with Mr. Putin, as Beijing sees little chance of improvement in its U.S. ties and needs to keep Russia around as its most important strategic collaborator even if it isn’t an outright ally. But that will require China to continue to straddle an increasingly difficult diplomatic position.
LONGER-TERM THEMES:
National Security Assets in a Multipolar World:
Help?: The U.S. Expects Chinese Tech Firms to Help Choke Off Russia Supply – Bloomberg
Washington is expected to lean on major Chinese companies from Semiconductor Manufacturing International Corp. to Lenovo Group Ltd. to join U.S.-led sanctions against Russia, aiming to cripple the country’s ability to buy key technologies and components. Any items produced with specific U.S. inputs, including American software and designs, are subject to the ban, even if they are made overseas.
Why it Matters:
China is Russia’s biggest supplier of electronics, accounting for a third of its semiconductor imports and more than half of its computers and smartphones. China is opposed to the current level of sanctions, but the U.S. expects its companies to uphold the new rules due to their reliance on U.S. designs and technology. Beijing has made self-sufficiency in the semiconductor sector as well as other critical technologies and commodities a longer-term ambition Xi is calling “Dual-Circulation.” His goal is to have a self-sufficient supply/demand domestic economy that is buffered from any potential western aggressions.
Electrification and Digitalization Policy:
Private/Public: As Tanks Rolled Into Ukraine, So Did Malware. Then Microsoft Entered the War. – NYT
Before Russian tanks began rolling into Ukraine, alarms went off inside Microsoft’s Threat Intelligence Center, warning of a never-before-seen piece of “wiper” malware that appeared aimed at Ukrainian government ministries and financial institutions. The threat center, north of Seattle, had been on high alert, and it quickly picked apart the malware, named it “FoxBlade” and notified Ukraine’s top cyber defense authority. Within three hours, Microsoft’s virus detection systems had been updated to block the code.
Why it Matters:
After years of discussions in Washington and tech circles about the need for public-private partnerships to combat destructive cyberattacks, the war in Ukraine is stress-testing the system. Company executives, some newly armed with security clearances, are joining secure calls to hear an array of briefings organized by the National Security Agency and United States Cyber Command, along with British authorities, among others. But much of the actionable intelligence is being found by companies like Microsoft and Google, who can see what is flowing across their vast networks.
Holes: U.S., Japan, and EU rush to close a crypto loophole in Russia sanctions - NikkeiAsia
The Japan Virtual and Crypto Assets Exchange Association (JVCEA), the industry's self-policing organization in the country, began discussing new rules Thursday, including a ban on transactions involving Russia that are mediated by exchanges. European Union finance ministers agreed Tuesday to "further investigate actions to avoid any circumvention of the sanctions, especially by the use of crypto assets." The U.S. is also looking at a number of ways to block activity in crypto from Russia or other OFAC sanctioned countries.
Why it Matters:
About 17.3 million residents of Russia own cryptocurrency, nearly 12% of the population, according to crypto payments company TripleA. Many blockchain developers hold crypto assets, and some wealthy Russians have used them as a channel to move money offshore. The ability to regulate the crypto landscape will only grow in importance due to the current war in Ukraine. So far, the crypto industry has pushed back, but more is coming.
Commodity Super Cycle Green.0:
Rethink: Eye-Watering Energy Prices Spark a Nuclear Power Rethink – Bloomberg
Finland and the Philippines are the latest to show their support for nuclear, after Germany, South Korea, and others softened opposition to the sector. German officials and energy companies are considering delaying a plan that would phase out nuclear power and close the country’s last plants by the end of the year. South Korean President Moon Jae-in recently asked officials to move on the start-up of long-delayed reactors, indicating a shift in policy on atomic power.
Why it Matters:
Anything and everything that can produce energy is being looked at now as global oil, coal, and gas prices skyrocket amid uncertainty over Russian supplies. Nuclear power had lost favor in many countries after a number of high-profile safety incidents, and new construction projects in Europe and the U.S. were plagued by delays and cost overruns. The tide has shifted in recent months thanks to a global energy supply crunch that lifted coal and gas prices to record levels. That momentum has been supercharged in recent days by Russia’s invasion of Ukraine.
Loading Up: EU aims to double the amount of gas in storage by next winter – FT
The EU intends to more than double the amount of gas in storage before next winter by providing subsidies to reduce its reliance on Russian supplies. A European Commission draft proposal will set a target for 80% of storage capacity to be filled by September 30, up from 29% now. It is also likely the energy commissioner will set mandatory storage levels each year.
Why it Matters:
Politicians have accused Russia of reducing gas supply deliberately to drive up prices, with an increase of 170% over 2021. Gas reserves would allow countries to make up the shortfall. Russia accounts for 39% of EU gas supplies, and the bloc has so far ignored calls for an embargo after the invasion of Ukraine. Brussels also wants a faster deployment of renewable energy. It urges quicker planning processes and greater investment. Countries have bumper receipts from selling carbon permits under the Emissions Trading Scheme.
Current Macro Theme Summaries:
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