The midsummer hypothesis that indicated, as a probable alternative, a sideways trading phase for the indices to correct from technical oversold levels as a result of the first marked selloff that began at the end of 2021, seems confirmed.
This rebound certainly exceeded expectations, in the sense that the expected range, between 3700 and 4100 on the US S&P 500 index, was surpassed to the upside, fading out at the 4300 level, thanks to short-covering related to massive short positions accumulated in recent months. However, this is a usual dynamic for a bearish phase, which statistically is divided into three phases, the first drawdown, quantifiable at the level of indices in 20/25% from the previous high, followed by a technical bounce quantifiable in 10/12% , to conclude with the last part of the decline of a further 10/15% from the previous minimum.
In terms of the S&P 500 index, starting from the high in 2021 near 4900; it dropped in June to 3650 to then recover back up to 4300, while the index is currently in the middle of the range indicated previously, 3700 / 4100, with a short-term target being re-visiting the June low. Therefore, the model would predict that the bear market phase should end upon reaching the 3200 level, but the past few weeks have included new elements in the fundamental framework that could constructively modify the prospective dynamics of the indices. First of all, the FED via recent statements by its governors has confirmed the flexible approach to the issue of monetary policy indicating the possibility of a return to quantitative stimuli in the event of a sharp deterioration in the financial markets, the ECB has revised in a less rigid way its credit tightening program, the cost of a WTI barrel of crude oil has returned to its January level before the Russian invasion and strong currency flows into the dollar are shrinking. In particular, the central banks that in June formalized a program of marked increases in the cost of money and significant reductions in their balance sheets, in order to cope with the inflationary upsurge in energy and food costs, perhaps are realizing that inflation instead is the logical consequence of a decade of surreptitious liquidity creation which between 2009 and 2020 did not translate into an inflation problem as the structural deflation linked to the globalization process of the world economy amply offset the negative effects on the rate of increase.
As a consequence of the pandemic, in fact from 2020, a process of deglobalization has instead begun, in the sense that international companies are markedly reducing dependence on foreign suppliers, thus renouncing the advantages in terms of costs of production factors, in order not to suffer bottlenecks in the supply chain which occurred after the shutdown due to COVID. So inflation could remain high for another 12/18 months, making it likely that the cost of money will be higher than the market expects, but on the other hand, central banks could change their minds about the extent of the reduction in their balance sheets. This hypothesis, if confirmed, would have very significant effects on the extent of the recession expected in the two quarters bookending yearend, in the sense that the one trillion dollars that the Fed has removed from its balance sheet is equivalent in impact to economy of an increase of 4% of the rate on the reserve funds itself, which when added to the current cost of money in the US, begets almost a 7% theoretical rate. To summarize, at best, if the incoming recession proves to be modest and will not have a significant impact on jobs, given the pre-existing shortage of human resources caused by the shutdown of the 20/21 two-year period, the technical support level of 3650 could represent the double bottom of the current bearish phase, otherwise a breach of that level would open the way to 3200.
The preferred stock markets are the US and Japan, while it seems that the People’s Bank of China is changing its mind on the indefinite defense of the yuan exchange rate making the Chinese stock market compelling, as it has corrected due to the restrictive monetary policy implemented to date. On the currency front, it is advisable to continue to underweight the euro against the dollar and the franc, while as for fixed income the uncertainty caused by the combination of inflationary and recessive expectations prevails, suggesting short maturities in euro and Cd’s in dollars.
Nicola Bravetti Data Source: Bloomberg
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