January Strategy: Volatility, QT, Earnings and Soft Landing Potential

Andrew Wilkinson, IBKR’s director of investor education, discusses potential market drivers for early 2023 with his colleagues Steve Sosnick, chief strategist, and Jose Torres, senior economist.

Note: Any performance figures mentioned in this podcast are as of the date of recording (January 10, 2023).

Summary – IBKR Podcasts Ep. 55

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

Hi everybody, welcome to today’s IBKR podcast. I’m joined today by chief strategist here at Interactive Brokers Steve Sosnick. How are you, Steve?

Steve Sosnick

I’m great, happy New Year, Andrew.

Andrew Wilkinson

And staying back at you. We also have in the same room today. Jose Torres, IBKR’s senior economist welcome Jose.

Jose Torres

Thank you very much. Happy New year. It’s great to be here in Greenwich with my colleagues.

Andrew Wilkinson

Positive start to the year in terms of stocks, bond yields have come down a little bit. Should investors expect smooth sailing this year? What do you think?

Steve Sosnick

Nope. (laughter) Sorry, onto the next question. I I think it’s you know my my theme for last year still applies at least to early 2023. And that is as long as the Fed is restrictive — and restrictive does not necessarily mean actively raising rates.  It can mean maintaining a higher level of rates while continuing to do quantitative tightening, which, by the way, is kind of a sideshow at this point.  I think we’ll talk about it later. As long as the Fed is not pumping money into the system, that tends to increase volatility. And I think we will get continued volatility as the year goes on.  So, smooth sailing is a lot to hope for right now.

Andrew Wilkinson

At at this point, I I definitely agree with that. But Jose, let’s let’s throw it to you. We we’ve seen some encouraging data on the inflationary front recently. Is a soft landing possible? Is it probable? What do you think?

Jose Torres

Definitely possible, but it is unlikely.  What makes it possible is the fact that there’s been a high amount of cash buffers in the economy, both with corporates and with households. But when you’ve had this level of inflation that we’ve seen this cycle, historically it does take a recession to bring down that high level of inflation. When we look at what the Fed has done, it’s already been impacting the interest rate sensitive sectors pretty dramatically. Real estate and manufacturing. The consumer is doing all right, due to all the excess savings, and the labor market is beginning to weaken beneath the surface. First it was the tech companies that now it’s the banks, right? So, when you look at real estate and manufacturing together, that’s about 30% of the economy. You look at the high-income jobs in the tech companies and the banks, maybe add another 5%? That’s 35% of the economy that’s weakening dramatically. How could that not spread to the other areas of the economy? We’re already seeing that ISM services came in way below expectations in contraction territory alongside the PMI for manufacturing, and I think we’re going to see a lot more weakness ahead consistent with what the tech companies and the banks are seeing because they’re laying people off.

Andrew Wilkinson

Steve, talk to me about investors and complacency.  The VIX seems to be subdued, certainly relative to some of the spikes we saw last year. What what, what what, what’s happening there?

Steve Sosnick

Well, remember relative to the spikes of last year, sure, we’re subdued. But that was, you know that was a a major bear market move. We’re we’re actually somewhat elevated compared to historical levels of VIX. We we we got we went from an extraordinarily low level of VIX, you know where we were flirting with the low teens, or even flirting with single digits when we went back, if you remember, before the “Volmageddon” of 2018.  But the historical average is mid to high teens. So there is a fair amount of volatility priced in, but that goes back to what we were talking about earlier about the the the idea that volatility could persist. Remember, the VIX is not a fear gauge.  It plays one on TV, but it is that’s not how it’s constructed. It’s it’s constructed as the market’s best estimate of volatility over the coming 30 days. And that’s saying that on average, we’re going to we’re looking at a reasonable possibility of 1% intraday daily moves over the next 30 days, and that’s that’s not outrageous by any standard.

Andrew Wilkinson

Yeah, and as as we said earlier, that the the market’s off to kind of a steady start so that that fits in with that at this point.

Steve Sosnick

Well steady steady yes, if you look cumulatively, but we we basically entered, then we plunged, then we then we zoomed and now. We’ve come back a little bit, you know. So, we’re punctuated by you know really we’re punctuated by one massive up day. And we can get into the the the brief causes where you know a lot of it was led by the stocks that were getting tax loss selling into the end of the year and just, you know, we were oversold and due for a bounce and you know we got it and now we’re working through that over the past couple of days.

Andrew Wilkinson

Well now Jose, let me turn back to you and we’re going to talk about the labor market. You mentioned a moment ago about the ISM and early signs of contraction there, but on the labor front we’re still getting 200,000 jobs plus per month. How does that affect the economic outlook? And what about those calling for recession?

Jose Torres

Well, the labor market right now is significantly out of balance.  There’s about 1.7 job openings for every unemployed person. There there is a labor shortage out there. Companies are laying people off and from an inflationary perspective in the 1970s and 80s we actually had dips in economic activity while we’re still adding jobs.  And I think right now what’s going on with corporates is that they’d rather take the hit to margins. Margins are elevated from a historical perspective. They’d rather take the hit to margins now and be positioned to capture market share and grow in the next cycle rather than trimming too much at this point and then playing catch up later. And I think that’s part of the reason why companies are still hiring in aggregate. Albeit we are seeing pockets of weakness, like I said earlier, in tech and then financials.

Andrew Wilkinson

Kind of kind of comes back to Steve’s original point, though about the Fed having to really be diligent and and monitor this very closely if we’re growing.  So Steve, let me ask you:  what about the impact the quantitative tightening on the market.  Will we see that anytime soon?

Steve Sosnick

We’re starting to see it. I just think people don’t realize. It I mean you know the the Fed balance sheet has been steadily declining and and and the pace has picked up in the decline. And so we’re about 10% off the highs if you look at the size of the Fed balance sheet – a bit more than that maybe. But but the pace is going in the more the the direction is, is is market unfriendly. And as you know, I don’t want to overuse Warren Buffett’s tide going out analogy, but basically that is the monetary tide going out. We rose we rose much higher on an incoming tide.  There was money and it was sloshing around. Now we still have a lot of money sloshing around. There’s still $2 trillion in money showing up in overnight repos at the Fed, which is basically the banks and the and the you know the banks that can access the Fed window saying, “OK, we have way too much money on our hands. You know we got nothing better to do than than give it to the Fed at 4.3%,” which is which is a quite nice rate. So you can, on the plus side, you could say that’s cash that needs to be deployed, but if the Fed is withdrawing liquidity, the odds are that just sort of tends to dry up and and becomes yet another concern about fighting the Fed.

Andrew Wilkinson

So, Jose, let me bring that back to you. Can you translate that into the impact of quantitative tightening on the economy?

Jose Torres

Absolutely. So last year we’ve had about $500 billion come off of the feds balance sheet. This year we’re expecting about $1.1 trillion, so it’s a significant amount of cash being being withdrawn from the system. We’re seeing the impacts beginning to arise at banks, and they’re starting to tighten lending. They’re not lending as much on auto loans, They’re tightening on credit cards. They’re tightening on mortgages, especially true, also with middle and large size companies. Financing is drying up, so. As we can, as the Fed continues to tighten monetary and withdraw that cash from the system, the pie is literally getting smaller and I think that ultimately it points to reduced demand and slower economic performance, like what the banks and the tech companies are seeing. And they’re laying people off because they’re seeing weakening demand in the near to medium-term future.

Andrew Wilkinson

And Steve, let’s let’s wrap up with you. What are, what are some of the developments you might be looking out for in terms of earning season which begins this week?

Steve Sosnick

There there’s a couple of thingw  you know. First of all, I. I’ve I’ve said various times that I wish we could rearrange earnings season. I don’t like the fact that we lead with the banks because they’re they’re way too idiosyncratic and so the one thing the one take away there would be: Wat does you know what did the bank chair chairmen say at their conference call? What does Jamie Dimon, Brian Moynihan, etcetera etcetera have to say about their corporate clients and their and their consumer lending and and activity? But in terms of, you know, does bank you know what does Goldman Sachs trading results tell you about the the overall state of the earnings season?  Zero.  But so then, so once you get past the banks, I think we want to see first of all are expectations too low?  The last couple of earnings seasons we’ve we’ve had them set too low and we’ve seen rallies,  But there’ll be a lot of interesting guidance because the argument among a lot of people is that valuations are too high based on 2023 earnings.  What do we start to what do we start to see here? And that’s a big, that’s a huge what I’m going to call bid, bid-ask, spread.  So you know, I think expectations are that that these companies can can beat their posted numbers. But then what are they going to say in terms of guidance and how will they react? How will that impact valuations on on the medium to longer term? So, there’s a lot of moving parts this earnings season. I wish I can tell you I had some true clarity as to what would be the outcome going forward, but it’s it’s really tricky right now because there are so many moving parts as we get as we get into the season.

Jose Torres

If I may add, I don’t believe that earnings estimates at this juncture are pricing in a mild recession.  At the same time, rates are really high relative to near term history. The market has had a tough time dealing with the 10-year above 3% in recent history.  So you have a situation where I don’t think earnings expectations are going to hold up, and I also think relative to rates. The market is pricey, so similar to what Steve said earlier about smooth sailing, I don’t think we’re going to have much of it this year.

Andrew Wilkinson

Well, I’d just like to thank both of my guests for such a miserable discussion to begin the year. (laughter) And don’t forget, folks look out for more at ibkrpodcasts.com and wherever you download your podcasts. Thanks guys, thank you.

Steve Sosnick

Thank you.

Jose Torres

My pleasure, thank you.

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https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/services/december/

https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/pmi/december/

https://www.federalreserve.gov/data/sloos/sloos-202210.htm