Wall Street surged on hopes of China stimulus and Fed pause

On Monday, Wall Street Futures recovered from the Israel-Hamas panic low on hopes of a Fed pause in November and the end of the tightening cycle amid intensifying ME geopolitical tensions. Also, less hawkish talks by Fed’s Logan, Jefferson, and Mester helped. Also gold got an additional boost, while USD stumbled. Oil was hovering around $86, at the same opening levels as the U.S. may not be interested in blaming Iran directly.  

Also, Iran's Supreme Leader Khamenei denied claims that Iran was behind Hamas attacks. The US Defence Department Spokesman Kirby: The US and Israel have not seen any firm evidence of Iran involvement in the Hamas attack. The U.S. said: “Iran likely knew that Hamas was planning operations against Israel, but without the precise timing or scope of what occurred”.

Saudi Arabia also insisted regional peace/de-escalation: “We are working to prevent wider regional escalation”. Iran also tweeted: “The issue of Palestine holds great significance in the Muslim world. We are actively engaging in discussions with parliamentary leaders from Muslim countries to extend support to Palestine.”

Iran likely knew that Hamas was planning operations against Israel, but without the precise timing or scope of what occurred.

On early Tuesday European session, Wall Street (U.S.) and European stock/indices Futures got a further boost on hopes of an imminent Chinese stimulus:

·         China mulls new stimulus and higher deficit to achieve growth target

·         China to ease loan requirements for car purchases

·         China considers stimulus, higher deficit spending to counter property bust

·         China to boost financial assistance to expand consumption

On Tuesday, US listed shares of Chinese firms also jumped on report China considering new stimulus to meet annual growth target.

Wall Street got some boost as IMF upgraded U.S. real GDP growth for 2023:

·         IMF raises US growth forecast to 2.1% in 2023 and 1.5% in 2024, citing stronger business investment and growing consumption

·         But IMF also lowers 2024 global GDP growth outlook to 2.9% from 3%, while IMF raises 2024 global CPI forecast to 5.8% from 5.2% in July

·         IMF warned of inflation’s tenacity and weaker global growth in 2024; i.e. IMF sees a global stagflation like scenario

·         IMF forecasted +0.7% growth in Euro area in 2023 and 1.2% in 2024, down from July forecasts of 0.9% and 1.5%

·         IMF cuts growth forecast for China to 5% in 2023 and 4.2% in 2024, vs July estimates of 5.2%, 4.5% respectively

·         IMF forecasts UK growth of 0.5% in 2023 and 0.6% in 2024 vs July forecasts of 0.4% and 1%

·         IMF forecasts Japan growth of 2.0% in 2023 vs 1.4% estimate in July, leaves 2024 forecast unchanged at 1.0%

IMF Chief Economist Gourinchas noted:

·         China needs forceful action by its authorities

·         It's too early to say if price moves will be sustained

·         We've already seen oil price rise somewhat

·         Multilateral cooperation can help reverse headwinds for global economy

·         Nations should aim to avoid geo-economic fragmentation

·         IMF sees fairly sharp slowdown for the UK. We see UK growth remaining fairly weak

·         We're watching impact of Mideast carefully. It's too early to assess the Mideast conflict impact

·         Inflation remains uncomfortably high, and bringing near-term expectations down is crucial

·         The world economy is limping along, not sprinting

·         US bond selloff may reflect extra quantities on market

·         IMF's Adrian: Italy-Germany bond yield spreads remain well contained

IMF noted: Resilient Global Economy Is Limping Along, with Growing Divergences

“The global economy continues to recover slowly from the blows of the pandemic, Russia’s invasion of Ukraine, and the cost-of-living crisis. In retrospect, the resilience has been remarkable. Despite the disruption in energy and food markets caused by the war, and the unprecedented tightening of global monetary conditions to combat decades-high inflation, the global economy has slowed, but not stalled. Yet growth remains slow and uneven, with growing global divergences. The global economy is limping along, not sprinting.

Global activity bottomed out at the end of last year while inflation—both headline and underlying (core)—is gradually being brought under control. But a full recovery toward pre-pandemic trends appears increasingly out of reach, especially in emerging market and developing economies.

According to our latest projections, global growth will slow from 3.5 percent in 2022 to 3 percent this year and 2.9 percent next year, a 0.1 percentage point downgrade for 2024 from our July projections. This remains well below the historical average.

Headline inflation continues to decelerate, from 9.2 percent in 2022, on a year-over-year basis, to 5.9 percent this year and 4.8 percent in 2024. Core inflation, excluding food and energy prices, is also projected to decline, albeit more gradually than headline inflation, to 4.5 percent in 2024.

As a result, projections are increasingly consistent with a “soft landing” scenario, bringing inflation down without a major downturn in activity, especially in the United States, where the forecast increase in unemployment is very modest, from 3.6 to 3.9 percent by 2025.

But important divergences are appearing. The slowdown is more pronounced in advanced economies than in emerging market and developing ones. Within advanced economies, the US surprised on the upside, with resilient consumption and investment, while euro area activity was revised downward. Many emerging market economies proved quite resilient and surprised on the upside, with the notable exception of China, facing growing headwinds from its real estate crisis and weakening confidence.

Three global forces are at play. First, the recovery in services is almost complete. Over the past year, strong demand for services supported service-oriented economies—including important tourism destinations such as France and Spain—relative to manufacturing powerhouses such as China and Germany. High demand for labor-intensive services also translated into tighter labor markets, and higher and more persistent services inflation. But services activity is now weakening alongside a persistent manufacturing slowdown, suggesting services inflation will decrease in 2024 and labor markets and activity will soften.

Second, part of the slowdown is the result of the tighter monetary policy necessary to bring inflation down. This is starting to bite, but the transmission is uneven across countries. Tighter credit conditions are weighing on housing markets, investment, and activity, more so in countries with a higher share of adjustable-rate mortgages or where households are less willing, or able, to dip into their savings. Firm bankruptcies have increased in the US and the euro area, although from historically low levels. Countries are also at different points in their hiking cycles: advanced economies (except Japan) are near the peak, while some emerging market economies, such as Brazil and Chile, have already started easing.

Third, inflation and activity are shaped by the incidence of last year’s commodity price shock. Economies heavily dependent on Russian energy imports experienced a steeper increase in energy prices and a sharper slowdown. Some of our recent work shows that the pass-through from higher energy prices played a large role in driving core inflation upward in the euro area, unlike in the United States, where core inflation pressures reflect instead a tight labor market.

Despite signs of softening, labor markets in advanced economies remain buoyant, with historically low unemployment rates helping to support activity. So far, there is scant evidence of a “wage-price spiral,” and real wages remain below pre-pandemic levels. Further, many countries experienced a sharp—and welcome—compression in the wage distribution. Some of this compression reflects the higher amenity value of flexible and remote work schedules for high earners, reducing wage pressures for that group.

Risks

While some of the extreme risks—such as severe banking instability—have moderated since April, the balance remains tilted to the downside.

First, the real estate crisis could deepen further in China, an important risk for the global economy. The policy challenge is complex. Restoring confidence requires promptly restructuring struggling property developers, preserving financial stability, and addressing the strains in local public finance. If real estate prices decline too rapidly, the balance sheets of banks and households will worsen, with the potential for serious financial amplification. If real estate prices are artificially propped up, balance sheets will be protected for a while, but this may crowd out other investment opportunities, reduce new construction activity, and have an adverse impact on local government revenues through reduced land sales.

Either way, China’s economy needs to pivot away from a credit driven real estate model of growth. Second, commodity prices could become more volatile under renewed geopolitical tensions and disruptions linked to climate change. Since June, oil prices have increased by about 25 percent, on the back of extended supply cuts from OPEC+ (the Organization of the Petroleum Exporting Countries plus selected non-members) countries. Food prices remain elevated and could be disrupted further by an escalation of the war in Ukraine, causing important hardship for many low-income countries. This, of course, represents a serious risk to the disinflation strategy. Geo-economic fragmentation has also led to a sharp increase in the dispersion in commodity prices across regions, including critical minerals. As Chapter 3 of this report analyzes, this could pose serious macroeconomic risks going forward, including to the climate transition.

Third, while both underlying and headline inflation has decreased, they remain uncomfortably high. Near-term inflation expectations have risen markedly above target, although they now appear to be turning a corner. As Chapter 2 of this report details, bringing these near-term inflation expectations back down is critical to winning the battle against inflation. With tight labor markets, ample excess savings in some countries, and adverse energy price developments, inflation could become more entrenched, requiring even more forceful action from central banks.

Fourth, fiscal buffers have eroded in many countries, with elevated debt levels, rising funding costs, slowing growth, and an increasing mismatch between the growing demands on the state and available fiscal resources. This leaves many countries more vulnerable to crises and demands a renewed focus on managing fiscal risks.

Finally, despite the tightening of monetary policy, financial conditions have eased in many countries. The danger is of a sharp repricing of risk, especially for emerging markets, that would appreciate further the US dollar, trigger capital outflows, and increase borrowing costs and debt distress.

Policies

Under our baseline scenario, inflation continues to recede as central banks maintain a tight stance. With many countries near the peak of their tightening cycles, little additional tightening is warranted. However, easing prematurely would squander the gains achieved in the past 18 months. Once the disinflation process is firmly on its way and near-term inflation expectations are decreasing, adjusting the policy rate downward will allow the monetary policy stance, that is, the real interest rate, to remain unchanged until inflation targets are in sight.

Fiscal policy needs to support the monetary strategy and help the disinflation process. In 2022, fiscal and monetary policies were pulling in the same direction, as many of the pandemic emergency fiscal measures were unwound. In 2023, the degree of alignment has decreased. Most worrying is the case of the United States, where the fiscal stance has deteriorated substantially. Fiscal policy in the US should not be pro-cyclical, even less so at this stage of the inflation cycle. More broadly, fiscal policy everywhere should focus on rebuilding fiscal buffers that have been severely eroded by the pandemic and the energy crisis, for instance, by removing energy subsidies.

We should also return our focus to the medium term. Here the picture is becoming darker. Medium term growth prospects are weak, especially for emerging market and developing economies. The implications are profound: a much slower convergence toward the living standards of advanced economies, reduced fiscal space, increased debt vulnerabilities and exposure to shocks, and diminished opportunities to overcome the scarring from the pandemic and the war.

With lower growth, higher interest rates, and reduced fiscal space, structural reforms become key. Higher long-term growth can be achieved through a careful sequence of structural reforms, especially those focused on governance, business regulations, and the external sector. These “first-generation” reforms help unlock growth and make subsequent reforms— whether to credit markets, or for the green transition—much more effective.

Multilateral cooperation can help ensure that all countries achieve better growth outcomes. First, countries should avoid implementing policies that contravene World Trade Organization rules and distort international trade. Second, countries should safeguard the flow of critical minerals needed for the climate transition, as well as that of agricultural commodities. Such “green corridors” would help reduce volatility and accelerate the green transition.

Finally, all countries should aim to limit geo-economic fragmentation that prevents joint progress toward common goals and instead work toward restoring trust in rules-based multilateral frameworks that enhance transparency and policy certainty and help foster a shared global prosperity. A robust global financial safety net with a well-resourced IMF at its center is essential.”

Overall, except U.S. and India, IMF painted a subdued economic growth and elevated core inflation; i.e. something like stagflation. IMF also urged U.S. / G7 countries to shun cold/trade war mentality with China and to promote multilateral trade and defragmentation.

On Tuesday, Fed’s Bostic said:

·         The US economy is solid and strong

·         We are in the process of finding a new equilibrium on rates

·         If things come in differently from my outlook we might have to increase rates, but that's not my current outlook

·         We don't need to increase rates any more

·         The economy is clearly slowing, lot of impact are yet to come

·         I think our policy rate is sufficiently restrictive to get inflation to 2%

·         We are in a good place for policy to get us to 2% inflation

·         I don't have a recession in my dot plot

·         There's certainly more for us to do

·         There is still a long way to go to get to inflation target

·         Inflation has improved considerably

·         The Fed needs to be nimble and ready to adapt to risks

·         Impact of the war in Israel on the economy is uncertain

On late Tuesday, Fed’s Kashkari said:

·         I'm optimistic we can shrink the Fed's balance sheet back to the pre-crisis trend line

·         The possible yield surge reflects rising US debt issuance

·         The recent rise in 10-year yield is perplexing

·         Inflation is headed down

·         If the ME conflict in Israel gets big enough, it could have implications for the US economy

·         My geopolitical events have an uncertain implications for the economy

·         The level of excess consumer savings is still a question mark

·         We have more work to do on making banks resilient

Market wrap:

On Tuesday, U.S. stock market was boosted by hopes of Chinese stimulus, Fed pause/pivot, less hawkish Fed talks and U.S. reluctance to blame Iran directly for the Israel-Hamas conflict, avoiding a major escalation of ME geo-political tensions. But Wall Street Futures were also affected late Tuesday as there was some of escalation of ME tensions (after reported rocket/missile shelling on Israel by Hezbollah and Syria). Also, Fed’s Kashkari sounded more hawkish than expected.

On late Tuesday, blue chip Dow Future stumbled from around 34089 to around 33905 and closed around 33905; gained around +0.4%; tech heavy NQ-100 surged +0.58%, while broader SPX-500 added+0.52%. Wall Street was boosted by utilities, consumer discretionary, materials, consumer staples, financials, industrials, healthcare, real estate, communication services and techs, while dragged by energy to some extent (lower oil).Dow was boosted by Boeing, 3M, Home Depot, Walmart, Intel and Caterpillar, while dragged by Merck, travelers, Microsoft, UnitedHealth, Apple, Salesforce, Amgen and  Chevron.

Conclusion:

The Fed is now preparing the market for higher for longer policy and another hike in November- then a possible end of the tightening cycle by Dec’23. Overall, the U.S. labor market and core inflation trajectory are still hot enough for another Fed hike. Fed never surprised the market with its rate action and by mid-October (after core inflation and labor/wage data for September), it will be clear whether the Fed will go for another +25 bps hike in Nov’23 before going for a final pause in Dec’23. Fed may not be in a hurry to cut rates before Sep’24.

As per Taylor’s rule, for the US:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.50.00-2.00) =0+2+3.50=5.50%

Here:

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation (CPI+PCE) =5.50% (for 2022); H1CY23 average core inflation around +5.40% (~5.50%)

As there is no significant easing of core inflation, especially core service inflation, the Fed may go for another +25 bps hike in Nov’23 and possibly the end of a tightening cycle. But, if core CPI inflation indeed eased further to below +4.0% by Oct’23, then the Fed may refrain from any further rate hike in 2023 and may also indicate some rate cuts in Q2CY24 in the Dec’23 SEP (ahead of the US Presidential Election in Nov’24) to keep real repo rate around +1.00% levels (restrictive zone).

Looking ahead, oil prices may stay elevated in the coming months between $75-95 instead of the earlier $65-75 despite US efforts to bring more supply from, Mexico, Brazil, Iran, Iraq, and Venezuela. OPEC/Saudi Arabia will not ‘cooperate’ with the U.S. for ‘breach of trust’ in refilling SPR (as agreed ‘verbally’). Elevated oil prices around $90 will continue to boost energy/transportation/logistics costs and core inflation. Saudi Arabia/most OPEC producers and even Russia are now seeking $85 oil prices on a sustainable basis to fund budget deficits, EV transition, and also the cost of the Ukraine war.

China may also deploy more targeted stimulus to bring out the economy from the deflationary spiral in the coming days, which may also support elevated oil prices. But at the same time, China is now also producing higher oil by almost 5 mbpd against its demand of around 15 mbpd. China is also taking various steps to increase domestic production of oil rather than being too dependent on Russia, Iran, Saudi Arabia, and even the U.S.

The U.S., as a producer, is also benefitting from elevated oil prices. The U.S. is also a beneficiary of the Russia-Ukraine war and other geo-political tensions involving North Korea, China, and Iran. The U.S. defense/military industry is now booming. Also, the lingering Cold War mentality with China is resulting in supply chain disruptions and elevated inflations. The global economy continues to face the daunting challenges of macro-headwinds- elevated inflation, high levels of debt, tight and volatile financial conditions, continuing geopolitical tensions, fragmentations, and extreme weather conditions.

Going by the present trend/run rate, the U.S. core CPI may fall to +3.8% by Dec’23 and +3.4% by Feb’24, which may keep the Fed to hold on rates at +5.7% till at least Aug’24 before going for any rate cuts -25 bps or even -50 bps each in Sep’24 and Dec’24 (one rate cut every QTR end from H2CY24). Fed would like to boost Wall Street as well as Main Street before Nov’24 U.S. Presidential election. Fed has to ensure a soft landing; i.e. price stability along with financial/Wall Street stability and Main Street stability.

Looking ahead, the Fed may try to balance the financial/Wall Street stability and price stability by expressing intentions to cut from June’24 (H2CY24) to ensure a soft landing while bringing down inflation. Also, the Fed has to ensure lower borrowing costs for the U.S. Government (Treasury) endless deficit spending and mammoth public debt of almost $32T. The U.S. is now paying around 9.5% of its revenue as interest on public debt against China/EU’s 5.5%. This is a red flag, and thus Fed has to operate in a balancing way while going for calibrated hiking to bring inflation down to target, avoiding an all-out recession; i.e. to ensure both price stability and soft-landing.

Overall, it seems that the White House would be quite happy if the Fed could bring back core inflation towards 2% on a durable basis, while keeping the unemployment rate below 4% ahead of Nov’24, the U.S. Presidential election. The Fed is itself eager to cut its losses by cutting rates. The U.S. 2Y bond yield is now hovering around +5.15% and may soon scale 5.25-5.50% in hopes of another +25 bps Fed rate hike for a terminal repo rate of +5.75% by Nov’23. Even after the expected pause after Nov’23, the Fed may keep open for further hikes by projecting at least another 25/50 bps hike in H1CY24 (one rate hike at Q1 and Q2) if core inflation does not fall as expected as a result of the still hot labor market and other demand-related factors.

Bottom line: All focus would be now on US Core CPI data Thursday; as of now the implied probability of another +25 bps hike on 1st November is only around 11%; if Fed does not try to improve it to at least 80% by 16th October (start of blackout period), then Fed may pause in November with a hawkish stance- keeping option of the last hike in December; i.e. Powell/Fed may prefer a hawkish hold stance if core CPI eases further in September

Technical trading levels: DJ-30, NQ-100 Future, Gold and oil

Whatever may be the narrative, technically Dow Future (33950) now has to sustain above 33900 levels for a further rally to 34000/34150-34250 and 34300/34555-34600/34825-35070/200-415/850 levels; otherwise, sustaining below 33800, may again fall to 33650/33450-33200-32950 and further to 31700-31500 levels in the coming days.

Similarly, NQ-100 Future (15400) now has to sustain over 15500 levels for a further rally to 15750/900-16000/655 in the coming days; otherwise, sustaining below 15450-400, may again fall to 15000-14700, and further to 14500-14300/175-100/13890 and 13650-13125 levels.

Gold (XAU/USD: 1863) now has to sustain above 1875 for any further rally to 1885/1900 and 1910/1920-1926/1937 and 1952/1970 levels; otherwise, sustaining below 1870-1865, may again fall to 1825/1810-1798*/1770 level in the coming days.

Technically, whatever may be the narrative, oil (86.40) now has to sustain over the 88.00-89.00 area for a further recovery towards 90.50/91.50 and 94.00/96.00-102.00/115.00-120; otherwise sustaining below 87.50, it may correct again towards 82.50-81.40-81.00/80.00-78.75/77.50 and 75.00-70.00/67.00 area in the coming days.