Breakout week for equities, flattish rates and bonds. Nasdaq and Nikkei 225 leading the charge, but notable performances by the S&P 500 and the Euro Stoxx 50 as well. Some volatility in the US because of the debt ceiling hangover. The Fed should be done after June. Continue to be positive on equities (but watch out for stops!) and neutral on bonds.

Major market events 22nd May – 26th May 2023

Highlights for the week

Mon: EU Consumer Confidence.

Tue: DE Manufacturing PMI, UK Manufacturing PMI, US Manufacturing PMI, US Services PMI. Wed: UK CPI, DE Ifo Business Climate Index.

Thu: DE GDP, US GDP, US Initial Jobless Claims.

Fri: UK Retail Sales, US Core Durable Goods Orders,

Performance Review

• A breakout week for equities on the back of the positive earnings reports. Technology is still leading the market, led by MAGMA (Microsoft, Apple, Google, Meta, and Amazon), Reports for 1Q23 were very positive, with 78% of S&P 500 companies reporting a positive earnings surprise, and 76% of S&P 500 companies reporting a positive revenue surprise.
• The Nikkei 225 managed to reach levels not seen in 33 years, since the real estate boom in the 90s. It continues to benefit from a very benign monetary policy and its 1Q23 GDP surprised on the upside, with a 0.4% increase relative to a forecast of 0.1% and no growth in the previous period. It was followed closely by the Nasdaq, whose 2023 run seems to be unstoppable.
• Finally, there was a breakout by the S&P 500, topping its previous Feb 2 peak (4,179.76), which becomes the next support. If the index does not break that level this week, then it could be predictive of another leg up for equities. Watch the debt ceiling discussion and NVIDIA’s Earnings Wednesday after close as possible confirmation of the bullish trend. For the Nasdaq 100, the sky seems the limit, as it’s 1000 points clear of its previous top on Feb 2 (12,803.14), but the S&P 500 hasn’t managed to do that yet (4,179.76). There are positive developments in Europe too, despite the rates overhang persisting, as the Euro Stoxx 50 is approaching its previous peak set in July 2007 (4524.45) and a breakout above that level might signal another leg up for equities.
• The never-ending discussion on rates continues; after the Fed did hike by 25 bps in May as expected, questions abound on whether this is going to be the last increase and the top in rates. Nick Timiraos (Chief Economic Correspondent of the WSJ) wrote that a possible hike in June is a close call; the market is currently pricing a 20% probability of another hike before the break. There is growing consensus that the current level of rates is at a restrictive level for the economy, and therefore Governor Powell could continue to keep it at the same level for the rest of the year to further tame inflation. After having gone past the rates tantrum, the baton passes on to the economy, which so far has performed admirably, despite the tough environment. In 2H23 it is expected that the economy will meet a more benign rate environment. The decline in earnings in 1Q23, -2.5%, was way ahead of expectations of -7%: this could be their trough. It is important to see if bottom-up forecasts for both 2023 and 2024 continue to be cut or, at some point, manage to find their feet.
• 1Q23 earnings reports are drawing to an end, with 95% of S&P 500 companies having reported, although they will continue this week with some notable companies reporting, with NVIDIA on Wednesday being the most important by far.

Checking up on the economy: the good

The ‘good’ points to more sustained growth and no recession, albeit at the cost of higher rates (the ‘higher for longer’ moniker that is soon becoming a mantra), even though expectations for rate cuts are mounting. There does seem to be a change in the narrative though, at least according to what is being priced by the market, with rates becoming less of a concern and the economy’s performance becoming more of a concern. An early look into 2H23 orders point to a continued strong performance by US Corporates; Walmart was the last company to impress, reporting revenues and earnings which were both ahead of expectations. It is significant to see that, on a micro level, the expectations of an upcoming recession have decreased materially since 2Q22, with presently about 20% of the S&P 500 mentioning it on Earnings Calls

Source: FactSet

As mentioned, in 2H23 companies should face a more benign rate environment, The chart below shows that the market does expect the Fed to be on hold after June. Pricing even incorporates a number of cuts to be done in 2023 which in my opinion are too early to call, but certainly reaching the top in rates should be a relief for both US corporates and the market.

Source: The Daily Shot

Strictly connected to rates there is inflation. A collapse of the spread between PPI and CPI (currently negative) should bring lower inflationary pressures, which would reinforce expectations for a Fed pause in 2H23.

Source: Real Investment Advice

After the slide in 2022, the S&P 500 has been performing admirably. A period of 7 months without a new yearly low is usually a bullish signal for the market. The recent breakout certainly helps to that end; now we must watch if it will hold, though!

Source: Carson Investment Research, FactSet

Checking up on the economy: the bad

Let’s start with this chart with a very useful reminder: earnings do not survive recessions. So we absolutely must avoid one if we are to thrive. Goldman Sachs has estimated that earnings fall, on average, by 13%; and has estimated a fall of 10% should we get a recession in 2023. Consensus is at $220; Goldman Sachs leads with $224, followed by J.P. Morgan with $205, Bank of America with $ 200, and finally Morgan Stanley with $ 195. Applying the -10% to the consensus estimates would get us in the proximity of Morgan Stanley’s scenario.

Source: Goldman Sachs Global Investment Research

Goldman Sachs is also forecasting a reduction of record profit margins in 2023, being more cautious than consensus. Clearly, that would be a negative for US corporates that have to contend with slowing earnings. A reduction in profit margin would make earnings growth more complicated.

Source: Goldman Sachs Global Investment Research

Checking up on the economy: the ugly

Valuation certainly isn’t cheap. It is even less so considering such appealing yields, particularly on the short end. This has led some to speculate that the current P/E is unsustainable. The current forward P/E of 18.3 is higher than the 10-Year average of 17.3. Hence earnings are of paramount importance. It is true that the market is expensive, but it much depends on the outlook for earnings in 2H23. If the economy can continue to perform, it would seem feasible to see the market trading around such multiples, perhaps with a slight compression due to the better results reported.

Source: Goldman Sachs Global Investment Research

This is really ugly – Deutsch Bank’s recession probability model is forecasting 100% recession. Were that to happen, we would almost certainly face a reduction in earnings and a compression of the multiple. creating a double whammy against the stock market. I suspect that one of the factors influencing the Deutsche Bank model is the US LEI, which is currently flashing a recession over the next 12 months. Let’s hope that the US Economy will continue to go steady as she goes …

Source: Deutsche Bank

Source: The Conference Board

Sentiment and what the market is telling us

The Fear and Greed Index is still in Greed territory, ending the week with a reading of 67, down from a previous reading of 58. It seems to move in synch with the market’s recent upward moves.

Source: CNN Business

The lagging AAII Sentiment Survey, as usual, paints a different picture: the bears seem in charge (and they certainly weren’t last week), followed closely by those with a neutral position. A lot of new buyers, perhaps?

Source: AAII Sentiment Survey

What are the Flows telling us?

Tech is trumping everything – and here’s to back-to-back inflows in the sector. This could point to a momentum strategy – playing the winners. So far in 2023, this is a strategy that has met with considerable success, due to the stellar performance of MAGMA stocks. Long may it continue.

Source: BofA Global Investment Strategy, EPFR

It is also noteworthy to consider the allocations to debt and equities done by Bank of America’s private clients. Debt seems low at 22%, while equities seem high at 60%. While it is true that the 60/40 portfolio is back in vogue after a disastrous 2022, this does show a certain confidence in the market.

Source: BofA Global Investment Strategy

Source: BofA Global Investment Strategy

Earnings Review

Source: FactSet

The forward 12-month P/E ratio for the S&P 500 is 18.3x, up from last week’s reading of 18.0x, which is below the 5-year average at 18.6x but above the 10-year average at 17.3x. The present, bottom-up level ($221.09) is beginning to slip from Goldman Sachs’ top-down $224 forecast, but it did manage to reverse its course after 1Q23. As we have been going down steadily for a while, I just wonder if at some point down the year the US Corporates will find in them what it takes to reverse this trend, as forecasted to happen in the back half of the year.

For 1Q23 the blended EPS decline for the S&P500 on aggregate is -2.2%. If correct, it will mark the second consecutive quarter in which there has been an earnings contraction. The upward revision to 2Q23 earnings growth (-6.4%), has been surprisingly negative if compared to 31 Mar’s -4.7%, but it is still very early days. Despite the concern about a possible recession next year, analysts still forecast a positive growth in earnings for the overall market in CY 2023 of 1.0% year on year, vs 1.1% on Mar 31, while revenue is forecasted to grow by 2.4% vs 2.1% on Mar 31.

Source: FactSet

With estimates now measured against the forecasts as of Mar 31st, there are very few differences yet. Of note, Information Technology growth is negative by -1.0%. While Amazon issued weak guidance for AWS in April, all large tech companies made upbeat comments, so the softness is surprising.

Source: Factset

The S&P 500 has its revenue growth estimates at 2.4% revised upwards from last week at 2.3%. Financials are still leading the pack in terms of revenue forecasts. Information Technology revenue growth has been cut to 0.7% from 1.3% on Mar 31st. The sector seems to be doing better on the top than on the bottom line, perhaps signaling the reason for some of the layoffs.

Source: Factset

Let’s take a look at EPS for 2023 and 2024, which last week had the first upward revision in quite a while. The forecast for 2023 has now been updated to $221.09 from last week’s reading of $221.11; while 2024 is currently forecasted to be $246.37, compared to last week’s reading of $246.33.

Source: FactSet

This is the detail for 2Q23. While the market might be more concerned about rates and recession than earnings at this point, the latter’s deterioration is continuing to get me worried as the downward revisions have been relentless and guidance very muted. It seems almost a miracle that the market managed to stay afloat with these shrinking earnings. 1Q23 is almost over, but 2Q23 looks to start much in the same fashion, with a significant earnings decline.

Earnings, What’s Next?

The earnings season is now entering in full its 1Q23 reports. Here’s a list of companies reporting this week. Highlights include Nvidia (Wednesday, After Close), and Ulta (Thursday, After Close).

Source: Earnings Whispers

Market Considerations

Revenue growth estimates for 2024 are forecasted to grow by 4.8% (5.0% on Mar 31st) and earnings growth estimates for 2024 are predicted to grow by 11.6% (12.1% on Mar 31st), so the future looks to be bright. While we continue to debate whether the US economy will fall into a recession or not and what will be the peak rates for Fed Funds, we should take note that almost every strategy has seen a more defensive positioning in the last month.

We are probably shifting from a monetary risk to a macro risk, where the performance of the economy is more important than what the Fed does. We should be mindful that the economy is probably just doing ok, even though passing the peak in rates will remove the overhang present on the market. If and when rates will diminish in importance, earnings (and top-line growth) will hopefully pick up their pace.

So the breakout happened, with both the S&P 500 and the Nasdaq 100 ahead of their previous Feb 2 highs. The strong performance of the Nikkei is a contributor to the global rally in equities. I suggest seeing if the Feb 2 highs will be tested this week and what will be the outcome; however, despite being several pressures again, tactically continue to suggest staying long on Equities, as long as the S&P 500 Nasdaq 100 stays above the Feb 2 peaks. If those levels hold, it would open a new leg up for equities and for the market; if they don’t, we fall in double-top territory with the markets possibly revisiting their recent lows. Regarding bonds, the trajectory is that yields will eventually fall, albeit with a few bumps on the road.

For the less volatility prone of you, it may make sense to take all opportunities to alter the weights of your asset allocation by increasing the weights of safety assets at the expense of more risky assets by lightening up in equities and reinvesting in bonds at attractive (approx 4%) yields. For those willing to look besides US treasuries, investment grade bonds (LQD ETF) could also be a good compromise: 1.2% pickup over government bonds for the safest part of the credit complex may still be compelling. 10-Year yields were turbulent last week, both in the US and Europe, though the ceiling should be near for both. For those wishing to keep their money in Equities with lower volatility, suggest switching to Japan as the company with the most stable outlook (the country with the more precise picture of rates at the moment) until rate perspectives become clearer in the US and Europe. They got a boost given the recent buy recommendation by Warren Buffett, and the oracle is very rarely wrong. So Japanese Equities are now investable regardless of the lower volatility derived by being the only nation in G7 not to raise rates in the current environment. Just watch out for the JPY – if the current strength in the economy and markets is to continue, you may want to hedge it as it will likely continue to slide (against all major currencies).

Happy trading and see you next week!

InflectionPoint

Disclaimer

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