To The Moon

What is the outlook for US stock in the next month?

So far in June, various economic activity index have generally weakened, while some indicators predicting inflation have not risen significantly.

The market's trend this month can be summarized as an "inflation top + recession trading pattern" or a "double downward inflation and economic trading pattern".

In this context, the rally in stock markets and the downward movement of the dollar index are proceeding in parallel (Figure 1).

In particular, Treasury yields in the G7 countries have also continued to move downward, with the yield curve extremely flat or even inverted (Figure 2).

Figure 1: Since July, US stocks have rallied; the U.S. dollar index has retraced.(orange: dollar index; blue: SPX futures)

US Treasury yield curve spread- especially 10 y minus 2y yield spread is a useful indicator for economic recession.

Figure 2: The inversion of 10y and 2y Treasury yield increases

However, in addition to inflation expectations and economic indicators, we would like to point out three more important factors in the current "inflation and economic downside trading pattern":

1. Policy time window.

That is, the current market is based on the July FOMC meeting is expected to have stabilized in mid-July, and the Fed will not meet again until September this year to discuss interest rates.

2. Excessive pessimistic valuation of companies

Important companies' pessimistic performance expectations have been fully priced in the second quarter.

Figure 3: Relationship between Nasdaq and FOMC and tech giants' earnings reports as of July 21

3. The short/long position ratio.

As seen in Figure 4, the VIX 2/8-month futures spread in June was near a relative high and formed a double top with the previous high; at this point, the spread has returned to a reasonably low range.

The green circle at the top of Figure 4 reflects the higher pricing of near-term risk in the U.S. equity market, commonly known as market panic. Since the beginning of June, panic has been near the average level during the epidemic market and near the highs of the first quarter of 2018.

Figure 4: S&P 500 volatility futures VIX 2/8-month spread

The market's extreme pricing of near-month risk then limits the shorting of the market.

As seen in Figure 5, the short/long ratio for U.S. equity options has reached highs at the end of June at the height of the '08 financial crisis and 20-year pandemic.

The market's ratio of bearish to long positions was already overcrowded to historical extremes before the current round of trading took place.

Figure 5: $S&P 500(.SPX)$ VIX to options bull/bear ratio (coordinates are reversed, which can be interpreted as a ratio of short/long positions)

Figure 6: SPX futures: similar oversold situation

Source: https://www.cmegroup.com/tools-information/quikstrike/commitment-of-traders.html

However, the current market also has very strong short-term and long-term constraints.

Short-term constraints.

• The resilience of the U.S. economy and residential sector at the bottom (Figure 7, see Figure 14 for a more specific discussion)
• The Fed's tolerance for excessive flattening of the U.S. bond curve (Figure 8)
• Inversion of the U.S. bond yield curve
• Recession & Inflation cooling

Long-term factors

• demographic factors

If the U.S. labor market does not continue to soften as smoothly as the Fed or the market would like and the data does not go as expected in the future, it could mean that the medium- to long-term structural factors of inflation will evolve into a short-term reality.

Figure 7: Citigroup Economic Surprise Index vs. 10y Treasury yield

Figure 8: Spread of 10y Treasury yield and Fed Funds Rate

Let's talk specifically about the above factors.

1. Resilience of the U.S. economy and residential sector

Despite the recent rate hikes, bank lending remains strong. Loan growth has accelerated to record highs, if you don't count the spillover spike during the 20-year epidemic (Figure 9).

This suggests that rising borrowing costs are not deterring borrowers.

Given the strong borrowing capacity of U.S. households given their rising wages (Figure 11) and current record net wealth (Figure 12), loan growth is likely to continue.

As interest rate hikes widen spreads and encourage lending, the U.S. banking system, whacked by the '08 financial crisis, may instead achieve pro-cyclical credit creation in this higher interest rate environment.

The continued surge in bank lending at higher rates is noteworthy because banks are making and creating money "out of thin air" when they lend. This flow of new money through the economy could keep prices rising.

Figure 9: U.S. Bank Lending Continues to Grow

Figure 10: U.S. Housing Market in Supply Crunch

2. U.S. Labor Market

Wage growth in the U.S. is currently very strong and is likely to continue amidst significant labor shortages in a wide range of industries. The current overall U.S. wage growth rate of 5% is a record high and appears to be accelerating (Figure 11).

Of interest is the fact that low-income workers are experiencing the highest income growth (Figure 11), and they are also spending a relatively higher share of their income.

All major labor market indicators point to a continued strong labor force, ranging from decades of low unemployment to a record 2 job openings per unemployed worker.

Part of the labor shortage may be due to a shrinking labor force, in which case the shortage would be structural and become less sensitive to higher rates of wage growth. This suggests that the Fed needs to adopt a more restrictive policy to moderate wage growth.

Figure 11: Wage growth rates of U.S. workers by class.

3. The stock of wealth of U.S. households

Earlier this year, the net worth of U.S. households had risen to a record $150 trillion (Figure 12), largely due to asset inflation, which, even after the recent decline, remains significantly higher than it was before the epidemic. Even the price of B-T-C after the crash is twice the pre-epidemic level (Dogecoin is also 30 times more expensive).

On the debt side, many households have boosted their net worth by refinancing their debt and locking in historically low interest rates early. The Fed's tightening stance has lowered asset prices, but as stated earlier, the market is pricing in a return to lower interest rates in the future. The high level of wealth of U.S. households will make higher inflation not as unaffordable, reducing the likelihood of a return to 2% inflation as soon as possible.

Figure 12: Net Wealth Stock of the U.S. Residential Sector

4. Demographics in the medium to long term

The aging of the population will be inflationary as the supply of labor to retire decreases but consumption increases, which is a medium- to long-term structural factor in the current round.

The integration of China and Eastern Europe into global trade over the past three decades has equated to a significant spike in global labor supply, which has continued to depress inflation.

However, this effect is being reversed by the reduction in the labor force as a percentage of the population due to longer life expectancy and low birth rates around the world, compounded by a wave of counter-globalization. This can already be seen in the United States, where the primary working-age population, which has been growing steadily for decades, has now stalled (see Figure 13).

Figure 13: Projected Age Composition of the U.S. Population, by Year

While labor supply is declining due to an aging population, labor demand is not necessarily declining. And retirees will continue to consume (the silver-haired economy has become the current sunrise industry), and while retirees may buy fewer cars and properties, research shows that their overall consumption actually increases due to increased medical and health care spending.

The baby boomers back then were actually very wealthy, a generation that had fully enjoyed the economic dividends of the past few decades, and had not only accumulated thick wealth resources (relative to this younger generation), but they also received government transfers.

Therefore, even if they do not have labor income, they still have enough money (relative to the current generation of young people) to spend.

When the continued demand for labor hits a decline in labor supply, wages increase and it is difficult to keep inflation down.

In the long run, it appears that a decline in labor supply will limit the effectiveness of policies that respond to high inflation or recession.

Raising interest rates to curb aggregate demand would have less of a negative impact on employment, but curbing inflation would require more aggressive monetary tightening.

A decline in labor supply would also weaken the correlation between recession and labor market slack. A recession could simply be a reduction in the labor force due to an increase in the number of retirements. With such demographics, the past standard of rate cuts would be meaningless because the economy would remain at full employment. In fact, interest rates would have to be structurally higher to counter the inflationary impact of a continued shrinking labor force.

5. Policy

Another major factor is the expected guidance from the top of the U.S. regarding the U.S. recession.

In general, both Biden and Yellen tend to define the economic downturn as a "necessary price" and a "temporary pullback" to control inflation and bring the post-epidemic U.S. economy back from overheating to a more balanced track.

In response to this guidance and "denial" of public expectations, it is difficult to say that it will not lead to any statistical technical adjustments or other temporarily unpredictable data "modifications".

In fact, various U.S. economic indicators are now at the low end of the range in non-crisis mode and have become limiting factors for lower medium- to long-term U.S. bond yields or short-term constraints on recessionary trading.

Figure 15 shows that the Citigroup Economic Surprise Index is already at historical lows, making it difficult to trade the U.S. economy further down without a large and unexpected exogenous shock (e.g., the '08 financial crisis, the 20-year pandemic)

Figure 15: Citigroup Economic Surprise Index vs. base period-adjusted US bond 10Y yield

As shown in Figure 16, new orders in the ISM U.S. Manufacturing Purchasing Managers' Index have also slipped to the low end of the range during the non-massive crisis. If there are no major new surprises, will there be a revision in expectations for a "recession"? Very likely.

Figure 16: U.S. Manufacturing PMI

6. The Federal Reserve

If the stock market returns to the "bull market" and the bond market continues to perform the "recession and 2023 rate cut" trading pattern, it will be very unfavorable to the recovery of real interest rates and the tightening of financial conditions.

The Fed's grip on inflation control lies in real interest rates and financial conditions, and if financial conditions are allowed to return to a loose state prematurely, it is difficult to say whether the tightening of anti-inflationary efforts since this year will be a lost cause.

We quote here a quote from former New York Fed President William Dudley in an interview after the July FOMC meeting to support this idea.

l Interest rates could eventually reach 4%. As Powell made clear in his conference, the risk of doing too little is much greater than the risk of doing too much. So the Fed may be doing a little too much because they have to make sure they succeed in bringing inflation back down to 2%. Powell said the Fed has raised rates to the neutral range, which I'm skeptical about given the level of uncertainty.

l I think it's important to recognize that the Fed wants financial conditions to tighten because they want economic growth to slow so that the labor market is slack and the upside of the market is very limited. I think financial conditions have tightened quite a bit in the last six months, but if the market expects the stock market to rise another 5-10% from now on, I think that undermines what the Fed is trying to achieve.

Conclusion

The subsequent constraints of the current "dual downward inflation and growth trading pattern" are as follows.

• The range characteristics of the economic data
• The resilience of the household sector
• The tolerance of the Fed's policy
• Policy guidance in the short term
• Geopolitic risk
• Structural changes in inflation and job markets represented by population in the medium to long term

For near-term trading,

we can't say that the constraints in this article will immediately kill the current market.

So when will the current market trend to turn or pullback occur?

First, the starting point of the current market is the extreme tightness of positions in the market.

Then the end point may also be a situation where certain large trading species achieve position equilibrium.

Second, the short-term constraints mentioned in our paper are corroborated by definitive data. Readers should pay attention not only to whether the constraints are "confirmed", but also to the strength of the empirical data to determine the allocation of positions.

When the time is ripe to open a reverse trade, you can try to build a trading strategy that goes long on long-term inflation.

Similarly, if U.S. financial conditions tighten again, real interest rates rise again, you can also review the first half of this year's trading experience.