Downside Surprise
Stocks in the US closed higher on Monday, recovering from last week’s steep losses as investors took advantage of lower prices and anticipated a potential interest rate cut from the Federal Reserve.
The S&P 500 climbed 1.1%, snapping a five-day losing streak after suffering its worst week since early 2023.
Sectors such as consumer discretionary, industrials and financial stocks led the recovery, as well as tech shares which were among the hardest hit during last week’s selloff.
Traders shifted their focus to upcoming inflation data, which will provide crucial clues on the Fed's policy decision later this month.
Investors are debating whether the central bank will cut rates by 25 or 50 basis points, following last week's mixed jobs report.
Friday's jobs report came with downward revisions, yet again.
As we discussed late last month, over the past three years the Biden Bureau of Labour Statistics (BLS) has consistently reported jobs data in a way that has led to very consequential misreads on the health of the economy by policymakers.
In 2021, the initial monthly reports from the BLS UNDER reported job creation by 1.9 million jobs for the full year. The BLS ultimately revised UP eleven of the twelve months.
The economy was a lot hotter than the Fed thought. Inflation ran wild, and the Fed was behind the curve.
In 2023, the initial monthly reports from the BLS OVER reported job creation by what was initially thought to be 360k jobs. Not only did they end up revising DOWN ten of the twelve months of payroll numbers, but they also followed with a huge one-off downward adjustment to the job picture for much of that period (818k fewer jobs than initially reported for twelve months through March 2024).
That brings us to Friday. August job creation came in 20k fewer than expected, and came with news of 86k fewer jobs (as revised down) from the previous two month reports.
So, the unreliable BLS reporting on jobs first led the Fed to hold policy too easy for too long, fuelling historic inflation. Now, the risk is growing that the unreliable BLS reporting (in the opposite direction) may have led the Fed to hold policy too tight, for too long.
On that note, remember the Fed Chair himself has told us numerous times over the past year, that if they wait for inflation to get to two percent before they start cutting, "it would be too late."
Too late means overshooting to the downside. And overshooting to the downside means putting deflation risk back on the table.
With that, we get CPI on Wednesday. It's expected to come in at 2.6% (the headline number). What if we get a downside surprise on inflation?
Clearly that would have been celebrated a few months ago. But now, given the deterioration in the jobs picture, a downside surprise in the inflation data would further signal that the Fed is behind the curve — they've miscalculated.
What are some clues on Wednesday's report?
If we look to China and the input prices on many of the products we buy, the recent producer prices report shows input prices have fallen now for nine of the past ten months, and year-over-year prices have been in deflationary territory for 23 consecutive months.
As for direct inputs into U.S. CPI, the biggest contributor to the sharp fall in U.S. inflation from 9% to under 3% has been energy prices. So, if we look at the price records from the EIA for August (Energy Information Administration), oil was down 6%, retail gas prices were down 12%, and natural gas was down 23% (all for the same period a year ago).
GRYNING | Signals - Performance of the ensemble and benchmarks
The equity of the equally-weighted strategy ensemble fell 1.9% this week versus a drop of 4.2% for the S&P 500 index. More information on the strategies can be found in the link below:
Comments:
The dollar-neutral Dow-30 long-short strategy performed as expected, delivering the much-desired convexity last week with a gain of 0.8%. A higher return would be even more beneficial to the ensemble, but given the volatility and chop in the markets, the performance of the dollar-neutral long/short was satisfactory.
Consider this trivial example: if there are five strategies and each one falls 4% during a week, the average fall is naturally 4%. However, if there is an additional strategy that delivers a gain of 2%, then the ensemble falls 3%. During previous bear markets and large corrections, the long-short strategy offered weekly gains as high as 4%. Usually, during rapid crashes, short stocks make more than what long stocks lose.
The problem with using long-short as a convexity hedge is that during strong bull markets, and especially right after strong rebounds, the short stocks lose much more than what the long stocks gain, and the strategy becomes a drag on performance. However, this is an inevitable price to pay for having a hedge.
Due to the small convexity that the long-short strategy provided, the ensemble experienced a 1.9% loss last week, compared to a 4.2% loss for the S&P 500 index. In fact, the ensemble is targeting a beta of about 0.5, and the performance was slightly better than expected.