Institutional investors take cover. The IA narrative seems to be slowing down, liquidity is tightening, Russia was a worry all weekend and the regional banks are not out of the woods yet. Today, let’s take advantage of the general calm in the markets to recap the various events.
The FED changes its tune
Ten days ago, the famous FOMC took place, an event at which the FED talks about monetary policy. It chose not to raise rates, as you probably know.
Ahead of this FOMC, we had discussed the probabilities regarding the July hike. At the time of publication (June 8), the probability of a July rate hike was estimated at 50.7%.
The probabilities have now shifted, with market participants estimating a 77% probability that the FED will raise rates in July.
The historical chart can be seen below.
The FED has been particularly hawkish at its recent meetings. Thanks to Alexandre Baradez (whom I invite you to visit at follow on Twitter), we have a glimpse of the FED’s latest speeches.
The FED wants to continue its fight against inflationbut will it really do so? We saw in a previous article that it will probably have to make concessions, for two reasons:
- If the currency loses value, the debt is lighter If you have a fixed debt with a nominal amount to repay, inflation reduces the real value of that debt over time. Therefore, the real burden of debt repayment is reduced.
- Returning to the two-percent target would be too economically costly : If the FED really wants to get inflation back to 2%, the cost to the economy will be too great, as wewe saw at the beginning of the year.
The cost of bringing inflation down to the two-percent target would be an unemployment rate of 6.4%. If this were to happen, it would be in the run-up to the US presidential elections. Bad press for Joe Biden, who intends to to run again.
I think the FED will keep rates high, until :
- Unemployment rises drastically Historically, the FED has pivoted when unemployment becomes too high.
Or
- A « Credit event » is coming Credit events are much harder to predict. The regional banks are extremely exposed to commercial real estate, which is currently in a delicate position. But there can be many other causes of a credit event.
The problem here is that market participants have predicted a faster rate cut than Goldman Sachs expects. When the market realizes that the FED is not going to cut rates right away, this will probably weigh on the price of risky assets.
Institutional investors take cover
There are several reasons why stakeholders are currently seeking to hedge their bets:
the asymmetry between put options and call options
Put options are used to protect against falling prices, while call options are used to profit from rising prices. When the asymmetry is unbalanced in favor of call options, this indicates that investors are primarily interested in potential gains on the upside, and are less concerned about a downside.
Rotation
The « Index Return of Cyclicals vs. Defensives ex. Commodities » compares the returns of an index representing cyclical vs. defensive stocks, excluding commodity-related stocks.
Cyclical stocks are generally those whose performance is closely linked to economic health and growth, such as the industrial, technology and automotive sectors.
Defensive stocks, on the other hand, are considered more stable and less sensitive to economic cycles, such as utilities, consumer staples, healthcare, etc.
The US Current Activity Indicator measures the level of current economic activity in the United States. This indicator is based on various economic data: industrial production, retail sales, employment, consumer spending, etc.
The « Indexed Return of Cyclicals vs. Defensives ex. commodities » chart has been climbing since the beginning of 2023, indicating that market participants are gaining exposure to cyclical stocks.
These charts have always been highly correlated: when the economy is doing well (current activity indicator), they take exposure to cyclical stocks, which are the ones that will perform best; when the economy is in trouble, they retreat to defensive stocks.
Why such decorrelation?
In my opinion, it’s a combination of several factors. On the one hand, exacerbated pessimism at the end of 2022, beginning of 2023, meant that a lot of people were shorting the market.
Secondly, an AI narrative and the strength of stocks linked to this impressive narrative.
Thirdly, FOMO, which is exacerbated by closing short positions.
Below we see the median SPX performance from peak to trough, in total AND after a drop in amplitude.
On average, SPX declines following a drop in amplitude have been more violent, particularly over a 6-12 month time horizon. Which seems logical: risk is concentrated on a handful of stocks, in this case AI-related stocks.
Liquidity is king
« Raising the debt ceiling prevents the USA from going bankrupt, but it also implies that the USA will have to issue new bonds to replenish a « security » base on the US Treasury account. To buy these bonds, commercial banks will withdraw liquidity placed with the FED’s reserves, and if yields rise anyway, this will exacerbate US citizens’ interest in money market funds, further weakening the banks. »
How will the debt ceiling deal bring about the next banking crisis?
After the BTFP (Bank Funding Term Program), having been created by the FED in response to the failure of several banks, market depth has clearly increased, as we can see from the following chart representing the depth of the SPX orderbook.
It has begun to contract in recent weeks, as the US central bank issues bonds to replenish the US Treasury account.
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A very different feeling
Several surveys indicate that investors have recently become much more optimistic. Let’s take a look in order:
The American Association of Individual Investors survey is based on the responses of a sample of individual investors to a weekly survey. Respondents are asked to give their opinion on the markets, either Bullish, Bearish or Neutral.
U.S. individual investors haven’t been this optimistic since the end of 2021.
Second survey, from the National Association of Active Investment Managers. These are no longer individual investors, but asset managers.
This survey asks association members to provide information on their positions and feelings.
The latter have not been so optimistic since the end of 2021. This very pronounced acceleration over the last few weeks leads me to believe that this is a case of FOMO (Fear of Missing Out).
And this is reflected in investor positioning. Below is a chart showing the net exposure of non-bank investors to US index futures, expressed in billions of dollars.
Non-bank investors may include fund managers, institutional investors, pension funds, hedge funds and other non-bank financial market participants.
For the first time in 2023, market exposure is net long.
So are systematic investors, those using algorithms. They have not been so exposed to US indices since August 2022.
Who does what?
Bank of America’s institutional clients sell tech, buying the communications sector and selling tech. Institutional clients » include pension funds, insurance companies, foundations, universities and sovereign wealth funds…
And they’re also starting to avoid buying large caps at these price levels.
The problem here is, as we’ve seen many times before, it’s the large-cap tech stocks that have largely driven the indices in 2023.
Hedge funds continue to buy technology stocks, and sell energy and healthcare. They therefore continue to position themselves in cyclical stocks.
Goldman has decided to underweight the USA in favor of Europe.
Here we see two lines, blue for Europe and black for North America. Goldman has underweighted the USA and overweighted Europe relative to the MSCI ACWI index.
The MSCI ACWI (All Country World Index) is an index used to represent the performance of the global stock market.
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