Surveillance: Market Pause with Sheets (Podcast)

piece together all of what Morgan Stanley is doing. Andrew, I'm going to suggest in August, your head is spinning. We've got to get from August to September. What are we gonna look like in September? Well, thanks Tom so so much. I do think markets are in this interesting pause, this interesting quiet before you. A lot of incredibly important events that are all arriving in September October. Right, we have an important FED meeting in September where we think

the Fed's gonna hike another fifty basis points. We have inflation that's going to be coming down, but we think it's gonna be coming down slower than probably the FED would like. And then you also have a very important earning season where we think the numbers are going to get reduced further into third quarter earnings. So I think at the moment, you know, the market has been getting some relief from the fact that inflation has been a little bit better. Sentiment was was very barish. You've had

some better than expected economic data. But I don't think these issues have been resolved. And we still think that the Fed has more to go and then also will ease policy less next year as they want to stay serious about inflation and two at times, and I'll say this for you, I think even the team of unfatty being characterized described as perma bess, you won't spring. In fact, you were out front saying, let's buy this market, let's go, let's go, let's go. Can you tell me the difference

between now and them? Because if there were a lot of people that conditioned by that experience andry, they just remember people tanning them, don't buy this, don't buy this. And then we got down the road off the lows and they realized that ms the rally andrew what's the difference between now and them? What are the signals that would triggered then that you said by that aren't being triggered now, yeah, thanks, thanks Jonathans. So I think there

are a number of early big differences. I think in early after after that market decline, you had a lot of very early cycle signals. You had very depressed economic data, very depressed sentiment. Importantly, very easy monetary policy with very low inflation. Remember we had that kind of infamous negative number of traded for a barrel of oil, and you had very low valuations are much much lower valuations, all those things coming together, a lot of things that you

usually get kind of around around a recession. Now, I think as we kind of fast forward to today, I mean, valuations aren't necessarily expensive on all asset classes, but they're they're nowhere near as cheap as they were in early But I think more importantly that the Monterey policy backdrop

is night and day. It's it's gone from kind of whatever whatever it takes response to an unprecedented pandemic to you know, one of the fastest paces of rate hikes that we've seen in the last thirty years in attempting to get in front of some of the highest rates of inflation we've seen in the last forty years. So I think it's that that resolve from central banks, especially the FED, that we think continues. That's one of the big differences. So, Andrew, all of that makes logical sense.

And yet we've seen the return of the meme stocks in recent weeks, speculative behavior that we all thought was going to be long gone in an era in which central banks are tightening policy. What kind of signal does that send to you? And how hard do you think the Federal Reserve is going to have to push back against that kind of behavior. Yeah, thanks, Kelly, And so

this is a great question. I mean, anytime you're on the more cautious end of the spectrum and you're incorrect about that, I think, as as we've been over the last couple of weeks, you do need to think hard about that thesis and if you're missing something, And I think if it was a rally that was being led by by new leadership, cyclical leadership, a sign that you know, we've had the worst of the slowdown behind us and things are going to ret re accelerate, I think I

think that would actually be a very encouraging sign. I mean, I think that would be the sign that this really is a mid cycle slowdown or or we've already had the sell off off of recession. But I think the the re emergence of some of the biggest beneficiaries of of low rates, zero rates, quantitative easing in one that that doesn't feel like kind of a new cycle starting. That feels a little bit more like shorts being squeezed, investors being fearful of missing out, a sentiment maybe not

being as depressed as we otherwise might like to think. So, you know, I also think from a FED perspective, the FED has to think about financial conditions, and it's goal is to tighten financial conditions. And so again, you know, as we've seen stocks bounce back, and as we've seen some the most speculative areas of the market bounce back, that's that's going against one of the things that FED is trying to accomplish. So, Andrew, when do we get the wake up cold? What's the wake up co look like?

What do you anticipating? Is it one speech from Chairman Pound next week at Jackson Home, Wyoming? Is the data? What is it? Yeah? So I think it's a it's a number of things I think we need to look out for. And again, I do think this upcoming window for markets is pretty important. I think if you know if worse things are going to happen, or if trouble is going to emerge, it's it's going to happen in the next the next two months, or it's not going to happen. So I think that trouble would come from

inflation not coming down as fast as expected. So the upcoming CPI, especially core CPI, core PCE not declining UM as much as the Fed would like. I think that would push the Fed and push the market to to remove their rate cut expectations from next year. And we like pushing against those rate cut expectations next year. We also like being along the dollar for those reasons. And

then it's the earnings out. I mean this has been something that might calla Mike Wilson in the US or my Colleaguraham sector in Europe have been very focused on. Is is a view that the earnings expectations they think are too high. Now the third quarter is often a relatively weak quarter seasonally for earnings. That's often when companies come out and take guidance down. We'll see if that happens again. But our expectation or are concern is that the risk of that is is still elevated, and we'd

like to get through that third quarter earning season. First, What do you owned the front half of this year? That's for sure. The second half is up for Graps Andrew shake Samo can stand the andre also as a waite. What's important is to watch flows and when it's August and it's slow, flows really matter. Uh uh. Emily Garfao over at our asset division, reporting today on a massive switch and flows that we've seen in the equity income and this is all wrapped around quality. The search for

quality is seen and flows. Kelsey Barrow on the bond side, fixed income portfolio manager, JP Morgan Management, Emily Grafo was looking at the equity market, what do you see in flows in bounds? And you and Bob Michael look at the screen, what do flows look like? Yeah, so we've seen some pretty large moves within the fixed income market

over the last few months. So if you think about what the market was pricing in terms of recession probabilities implied within triple B spreads or the equity market, it was as high as around eighty percent in mid June. Now that's down to about so we've seen a very large retracement in in high yield spreads down to the mid to low four hundreds. And what we feel in terms of that movement is we understand why there's been

a repricing. There is an increased probability of a soft landing that at this point, this level of spread is really no longer protecting you from the still material risk of hard landing, UM if inflation remains stickier, which is our base case. Okay, Cassie, So what is that lefth the treasury market and how that's priced right now? You

more comfortable with that? Chris haf You Wells Fargo wrote this in the last twenty four hours, the eight pril's five basis point in version seems to have got more attention than the almost fifty basis point in version we had last week. Why do you think that is? Well, we've been positioned for curve flatteners. Uh. I know, I was last here on July six. We were calling for higher front end yields on a flatter curve. The twos tends curve is now thirty basis points flatter um, and

we think that that makes sense. The Fed has done two supersized rate hikes now what we're looking at. So the market is pricing in uh, the FED funds rate getting to around three and a half percent by the end of the year. That's basically in line with the FED. The real divergence comes in where the market is pricing rate cuts and the Fed is expecting to continue to hike, And I think the minutes gave us some insight into that.

I noticed one of the things that that stood out to me was the fact that there are a number of people on the committee that expect that once they get the policy rate to rest directive, they're actually gonna need to keep it there for a period of time. And we are lean on that side expecting that the Fed is going to need to keep policy rates higher because although we got one decent inflation report, we're still

seeing a lot of wage pressure. And one of the data points that that we thought really was under underappreciated last week was unit labor costs productivity adjusted wages, which is also still very strong relative to previous cycles. Then cassy previous hiking cycles. How much longer do you think they're going to keep it at that terminal? Right? That peak? Right?

The Fed in this hiking cycle relative to psychos gone by. Yeah, So we looked back at the last four or five six hiking cycles, all kind of the modern hiking cycles that you'd think of, and a couple of things stood out to us. One, the Fed never stops hiking rates when the real Fed funds rate is still negative. So, just to put it out there, the real Fed funds rate is still minus six percent if you deflated by headline CPI. So they still have a lot more to go.

But in terms of how long they're going to keep policy and restrictive, on average, we see that the Fed keeps rates uh at that terminal rate for about seven to twelve months, so about a year. Uh. And we think given the magnitude of the inflation problem, given the fact that the unemployment rate actually continues to take down despite you know, we'll watch initial claims later this morning, uh, and so we expect them to to be more in

line with the historical average of the last four tightening cycles. Well, while we're looking back at history, let's talk about the seventies as well, because I noticed some research out of Berkeley's on credit earlier this week, essentially saying, when you look at this inflation and growth environment and it's most akin to nineteen seventy to ninety to nine eighty, both periods which were not good for credit, and they say

this time isn't going to be different, will it. We are a little bit more cautious on specifically high yield give the retracement we've seen there, there are probably some things that are are going to uh, you know, put some resistance below four hundred on high yield spreads. One,

we do expect that issuance is going to start picking up. Also, if you you know, break it down between the categories, uh, within the high yield, one of the areas where you're going to really need to see a lot of retracement to get spreads materially tighter would be triple c's And these lower quality companies are starting to feel the pinch

of higher prices, higher interest rates UM. And so you know where we're more focused is in short dated investment grade credits or higher quality as well as short dated securitized credit. These have better break evens, they have better all in yields UM. We can feel more comfortable with the credit quality. And if you look at how they performed in this rally. They've they've kind of lagged relative to the US high yield market where what high yield spreads need to get to in order for it to

look attractive. Well, back in June we got around six hundred, and at that point we thought that we were at least starting to price in UH and get compensated for those risks of harder landing for an increase in defaults. Now, I don't want to ignore the fact that on a high level, credit fundamentals are still extremely strong. UH. We're starting from a very good point for both investment grade

and high old companies, high cash balances. They've termed out their debt, their leverages is on track and looks good um relative to pre COVID, But we do have to realize that where we are in the cycle, things are going to deteriorate from here. Margins seem to hold up actually better in this last earnings report, but we do see that that that's not something that's going to be

sustainable as inflation pressures remain. You can see just awesome as always and wonderful to cashop again here in New York, Cassey better with that of JP morgan Esset Management. My recollection. John Is Francisco Blanche has loved to charge on over a hundred dollars of barrel on Brent. When he said it, it was a shock. He's had a global Commodities and

derivative research at Bank of American joins us today. Francisco, I want to touch on one paragraph in your new report which was shocking, and Kayley wants to pick up on the news of the day. You tore about tore apart our key distal it which is a forty seven thousand gallons on a Boeing seven seventies seven that all of us need, that we all take for granted when we fly around domestically and internationally. You say, watch jet fuel.

Why well, look Tom, and I think we have We still have China, and lookdown we have large sports of Asia also in partial lookdown when it comes to international travel and um, and I think that's gonna open up in the next sixth both months we are down on Jeff field Man globally from pre of the levels, um, we could see a pickup of half a million barrels day, maybe more just on that front alone. And again this has been the leading fuel in the last twelve months.

I expected to be the leading fuel the next twelve months. How will they come over to Brent Cruz price. Can you extrapolate over from the new Pacific RIM demand over to over a hundred dollars of barrel brand? I'm definitely constructive on brand right here. We've we've pulled back after the seasonal driving peak in America. But I think coming

into the winter, you're gonna have jet fuel demand. You're going to have demand from Europe because of the record high natural press you have there um and and also remember um we still have a very tight global refining system for for variety of reasons. So all of that I think is gonna drag us back higher. I've got fourteen themes. I have to go to the social reality that Europe faces. This is not about math, It's not

about spreads, crack spreads and the rest of it. It's about multiple multip post standard deviation moves that become social policy. Tell us how your world can help Europe and this crushing social policy of where prices are electricity in France as an example, Well, Europe faces an obviously a very

complicated situation. If you look at European natural gas um right, I mean comes from Russia used to come from Russia, and you've lost right around um, you've lost right around ten percent of the entire energy supply of Europe with Russia curtailing that gas um other things man equal, that

would that would mean a ten percent GDP contraction. And what's happening right now Essentially Europe is trying to price itself back into the global economy, so to speak, by attracting liquid gas from Japan from China bringing it to the European continent. But also importantly we're seeing the shutdown of zinc smelters, aluminum smelters, um steel plants, and fertilizer capacity,

so that that's all important. Again. So essentially all European energy prices are rising above global prices, but importantly a lot of the domestic produced energy intensive commodities like steel and what have you are also being displaced out um. And and that's the way Europe is going to avoid a very very steep recession and probably end up with just the mile That's that's essentially approach we're going through. Well, Francisco.

What I find so ironic about frances Nuclear was supposed to help them out and yet because of the climate issues in the river temperatures, it also is inhibiting their ability to use that power, which brings me to clean energy. There is now moves in the US after the signing of the Inflation Reduction Act. In that effort, there's also metrics within that, like a methane tax for example, for US producers. How is that ultimately going to affect supply

of fossil fuels? Well? Um one of the hardest parts, right that we often forget is that the COVID collapse in demand also brought about a collapse in investment. Um so, was not just the demand shock, was also a supply shock. We had negative oil prices. We had um we had natural gas in Europe TTF at one dollar per m b tu, which is the same gas US trading at eighty bucks and m btu right, almost like like a cryptocurrency if you like, and not precisely Bitcoin, one of

the more extreme ones. And this is a real commodity that actually people use every day. So um so, I think, I think false health fuels have have a tough future ahead of them because nobody wants to sign long term call leases, right um and and and no financial institution or no major France institution wants to be financing thermal coal either. Uh, it's hard to get financing for conventional oil and gas or or or just shell gas. So I think I think the issue is is going to

be in the medium term. We are trying to move very fast into into a greener economy because we have this pressure is coming from climate and we've seen them. Right. Part of the problem you talked for nukes. Part of the issue in the with the French nukes is that we don't have enough water on European rivers, which is a function of glaciers melting fast. Right, So we're starting to get all the compounded effects of climate change across

the energy supply system. UM and and and I think, um, I think it's obviously very important to move quick to green fuels, but at the same time we have this gap. And unfortunately, remember prices are just the balancing item for supply and demanding commodity markets, and we continue to expect very high volatility um continued inflation and of course a lot of basis risks in terms of differentials, time spreads, and cross commodities across the complex. So I I just

don't think. I think commodity markets are going to give us a solution, but it's all gonna be extreme pricing for a while and we remain constructive on the complex. Francisco, I've got thirty seconds left. Can you tell me what you think Eupe looks like this winter? We're going do a four day work week. What's going to happen with

the effort to curve consumption? Um? Well, Europe is going to is going to to curve consumption by by definition, it's as I mentioned at the very beginning, it's happening already, um with with curt elements to to uh of energy supplight to industry, but also curt elements of uh um temperatures at home during the summer and during the winter as well. Right, so we're going to see UM forced

reductions potentially potentially rolling brownouts in some parts of Europe. Right, I mean, this is what what what it looks like. And it's almost, you know, it's almost like like the developed markets are becoming emerging markets and and in in a in a in a weird kind of way. So Francisco, Bank America Global Research, Francisco, awesome. As always, I'm gonna go right to it. You know what I care about, Dan ives, which is the chips that are in all

these miracle toys we use. The the new Apple phone in September, we'll have the A sixteen chip, which is five nanometer technology. Blah blah blah. Is that enough to get Kaylee Lines to buy a new phone? I think it's Kellie and about forty million others because I think, what were you're really gonna see here? This is a catalyst that speaks of the pen up demand that we see across the installing She woundered forty million of a billion iPhones worldwide have not upgrading three and a half years.

And I think this is still significantly underestimated by the street. Dan. I take huge issues, as I know you do, with the way the media tosses out O MG, why would anybody buy a nine hundred dollar toy? What percentage of us are buying this on a monthly plan? And has that worked out for Apple and frankly for the cell phone providers? Well, it has that's about from from a monthly perspective, and you put that together, it's ultimately, especially when we were going to be a hundred increase on

the iPhone pro pro mact. It's become more than jestable. Remember you haven't had a price increase and call it four or five years. I think you're starting to keep consumers now more and more look at a thousand hour iPhones has really pay the price of what they expect to be. When it comes to Apple, what about in China. I understand that the U S consumer is in a pretty healthy position, but we've actually seen Apple doing discounting in China on higher end models. That's a pretty important

market for them. What is your read on how that's going. Yeah, it's a great question. I think in China, re estimate about of the Chinese consumers in terms of iPhones are in the window of an upgrade opportunity and actually more and more pushing towards the higher a sp throw pro mac. That's very important is this all plays out, because that's

the hearts and lungs of the Apple bull story. And I can tell you this week our checks in Asia basically showing firm demand in terms of coming out of the gates drive on four teams, which looks like the lawn state you know called first week after Labor Day. Yeah, September seven, is coming up quick. Dan. Of course for me, I have a ton of Apple products. It's more about the ecosystem because my phone connects to my watch, I get eye messages on my Mac laptop. I have the

AirPods that hook up steamlessly to my phone. I mean it's the whole thing. When people upgrade an iPhone, what about the rest of it? Both services, that's really been the key to the valuation rereading that we've seen. I mean, that's going to be ninety billion of annual revenue going into next year, and and and that's why they have a golden and all baseps on mapp. Then I want to get through this quickly just because of time. The one percent text on share by backs, is that going

to ruin your world? The Danais world. I view it as noise is not going to change. Okay, I want you to frame for all the gloomsters out there and Apple. Now you're by on Apple three years out? Where is this a hundred and seventy dollar stock? Well, peters will continue to eat an Apple. I view this is and it exceeds three trillion mark app to twenties are base case,

to forties are bull kids. And this just continues to be what I view in the middle inning of just an unpressed made upgrade cycle despite the dark storm cloud, Dan, I thank you so much. Thank you for your work at Wedbush supposed to have been extraordinary on this hugely popular part of the market. This is the Bloomberg Surveillance Podcast.

Thanks for listening. Join us live weekdays from seven to ten am Eastern on Bloomberg Radio and on Bloomberg Television each day from six to nine am for insight from the best in economics, finance, investment, and international relations. And subscribe to the Surveillance podcast on Apple podcast, SoundCloud, Bloomberg dot com, and of course on the terminal. I'm Tom Keene and this is Bloomberg