No recession – full steam ahead! US GDP above estimates and inflation is slowly coming down. Equities on a roll, rates up, and bonds down. Correction/consolidation likely to persist for another week; NFP on Friday. Continue to be positive on equities, even if the market does feel extended (Nikkei 225 and Nasdaq 100 in particular) and prone to consolidation/correction, and neutral on bonds.
Major market events 3rd – 7th July 2023
Highlights for the week
Mon: CH CPI, DE Manufacturing PMI, EU Manufacturing PMI, UK Manufacturing PMI, US ISM Manufacturing PMI, US Independence Day (US Markets close at 1 pm ET).
Tue: US Independence Day (US Markets closed).
Wed: JP Services PMI, CN Composite PMI. UK Composite PMI, EU PPI, US Factory Orders, US FOMC Meeting Minutes.
Thu: UK Construction PMI, EU Retail Sales, US ADP Non-Farm Employment Change, US Initial Jobless Claims, US Trade Balance.
Fri: US Non-Farm Payrolls, US Unemployment Rate, US Average Hourly Earnings.
- No recession – full steam ahead! Another very solid week for the equity markets just when I thought that another breather was necessary. The US GDP in 1Q23 grew at a 2% rate, well ahead of forecasts, and all major banks fared better than expected in the yearly Fed’s stress test and rose as a result. More fundamental positive news: Micron rose after hours as its CEO is calling this the bottom in the memory-chip market, and as I write Tesla beat 2Q23 car deliveries once again and set a new record. This is a shorter week than usual – due to Independence Day – albeit with a bang, as the NFP will be with us on Friday and will provide a useful clue into the Fed’s next moves. Hence this week’s macro, and next week’s micro (with the big banks being, as usual, the first to report).
- Value shone this week, even though growth didn’t do too badly. Europe came back with a vengeance – even though it still trails the S&P 500’s performance on a year-to-date basis. The S&P 500 set its new record for the year, the Nasdaq 100 reconquered 15,000 points, and the Nikkei 225 continued its amazing pace. We also had the best performance for the Nasdaq and Nasdaq 100 in the first six months of the year on record. Obviously, at this point, caution abounds, and market pundits are inundated with calls not to expect the same results in the second half of the year. If you would like to test the waters (this is particularly true for the Nasdaq 100 and Nikkei 225), I recommend having a weekly stop of 3% as timing the market is now even more difficult. If the world economy continues to perform well, I think the JPY will continue to weaken (which in turn will be a positive for the Japanese economy) – look after your hedges!
- Europe for once led the markets last week. Its performance, both in the week and on a YTD basis was remarkable, and it is finally getting closer to its previous high set in July 2007 (4524.45). Should it manage to make a breakout above that level it would signal another leg up for equities, and a confirmation of the positive trend, given that both the S&P 500 and the Nasdaq 100 are now chasing their all-time highs. There is an ever-growing consensus – 84.3% – according to the CME FedWatch tool – for another 25bps hike in July, and another one might well follow in September or November. It must be mentioned that the Fed has categorically excluded the possibility of rate cuts in 2023, and hasn’t ruled out hiking in back-to-back meetings (July and September), and the equity market seems to have digested that as well. European markets are in a more complicated position: for starters, the ECB is well behind the Fed in its quest for the terminal rate (as is the BOE), and needs a sustained performance of broader equities (not technology) to go higher still.
- We’ve heard for some time about a hard (more likely) or soft landing for the economy, with a recession that was supposed to begin as early as in 2Q23, and the US economy seems to have performed better than anyone expected. The Fed is worried about inflation not slowing quickly enough, but Goldman Sachs, which has been spot on in its forecasts on the economy, is expecting a lot of disinflation to take place in 2H23, and at the same time maintains higher than consensus estimates for US GDP. 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, although we need to see if earnings will indeed trough in 2Q23 and whether they will bounce in the back half of the year. 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. It is also very important to check if the 7 leading companies (MAGMA – Microsoft, Apple, Google (Alphabet), Meta, and Amazon. plus Tesla and Nvidia) continue to perform in line with 1Q23 and if there is an expansion of breadth (which would be very important for the market) and a follow through to other companies.
- We will be starting in earnest with the 2Q23 reports next week. Hard to call them, but so far I am encouraged by positive growth in the economy to sustain those of its main corporates. And with NVDA the best stock in 1H23, the company would better deliver! AI will help,
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 slowly being shifted to 2024. 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 an issue. Introducing the Atlanta Fed GDPNow estimate for 2Q23, which at 2.2% would account for very solid growth, revised higher from 1.9% previously. As before, there is a meaningful difference between this forecast and the consensus for Blue Chips; at some point, they will have to converge. It is good and notable to see that these are in positive territory and that they have been improving (=no recession) in the last two months or so, with the Blue Chips consensus moving towards 1%.
Source: Blue Chip Economic Indicators and Blue Chip Financial Forecasts
As mentioned before, Goldman Sachs (which is more positive than competitors on US GDP growth) expects a strong disinflation in 2H23 and a gradual decline of core PCE and CPI.
Source: Goldman Sachs, ISABELNET.com
As the time passes market pundits increasingly believe that recession is going to be pushed out, with the majority of them thinking it will be a 2024 issue.
Source: dbDIG Survey, Deutsche Bank, ISABELNET.com
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. While the debate is very much alive and the jury’s still out, there are some indications that show the economy to be in trouble and likely to fall into a recession. One of these is the probability of recession as calculated from the yield curve, currently showing a probability of 78.8%. I would further note that when this level was so high, a recession promptly ensued. This time is different?
Introducing some new, bearish forecasts from Morgan Stanley that see S&P 500’s earnings cut from $195 to $185 (bottom-up consensus: $221; top-down consensus: Goldman Sachs $224, J.P. Morgan $205, Bank of America $200). Should such a scenario (which would include a rather severe recession) come true, the market would undoubtedly be under much pressure, hammered by a powerful double whammy of a hit on its multiple and its earnings.
Source: Federal Reserve Board, Federal Reserve Bank of Cleveland, Haver Analytics
A better than expected economy brings with it higher rates, and Governor Powell has been clear that he sees higher rates still in order to tame inflation. The market has had to discount higher rates, and the timing for potential rate cuts moved firmly to sometime in 2024.
Source: The Daily Shot
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 18.9 is higher than the 5-Year average of 18.6 and the 10-Year average of 17.4. 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.
The staggering performance of the Magnificent Seven (MAGMA + Nvidia and Tesla) was in part fuelled by the AI boom, as these are the companies most exposed to this trend. This has, in turn, inflated their market capitalization, and increased their valuation to as much as 30x earnings. The chart below shows the performance of MAGMA stocks this year vs the rest of the index – even subtracting Nvidia and Tesla, their performance is absolutely astounding. While this is far away from the excesses of the dot.com boom (with Cisco Systems trading at 100x forward revenues (!)) it is enough to raise eyebrows. Should any of these falter (and if one does, it might trigger a falling domino effect), then the index, with its ‘engines’ out, would fall precipitously. Watch out!
Source: FactSet, Goldman Sachs Global Investment Research, ISABELNET.com
Goldman Sachs has done a comprehensive study of many different methodologies to value stocks, and all of them look expensive. In the US we should definitely not expect a multiple expansion in the future. It is possible that we might continue to trade on a multiple of 19x earnings, but it’s those that should drive the market (and lower the multiple) going forward. The chart below is sending us a message: there’s no room for error. If I had to pick 3 markets based on valuation as shown in this chart and their perspectives , I’d say: 1) Japan, 2) US, 3) Dev Europe. I think positively about the World and AC World, but roughly 50% of these are US stocks, and so you’re probably not going to go very far unless you think that the US can perform well. Call me an optimist, if you will – or one of those crazy 1999 guys!
Source: Goldman Sachs Global Investment Research, ISABELNET.com
Sentiment and what the market is telling us
The market goes up and it’s only fair to find the Fear and Greed Index in Extreme Greed territory, made it back into Greed territory, ending the week with a reading of 80, up from 77 last week, This is another reason which brings me to approach the next week with a bit more caution, but if the economic numbers are good, the market will go up!
Source: CNN Business
The lagging AAII Sentiment Survey saw an increase of neutral positions this week, even though the bulls are still in the relative majority. I share their constructive view on equities, despite any weakness that there might be near term.
Source: AAII Sentiment Survey
What are the Flows telling us?
In the chart below it is clearly shown that the preference of investors went to government bonds (the long dated ones performed very poorly, until very recently), and cash.
Source: BofA Global Investment Strategy, EPFR, ISABELNET.com
The recent performance of the Japanese equity market has been noted by many, and therefore it shouldn’t be too surprising to see big inflows in the last 4 months.
Source: BofA Global Investment Strategy, EPFR, ISABELNET.com
The forward 12-month P/E ratio for the S&P 500 is 18.9x, up from last week’s reading of 18.8x, which is above the 5-year average at 18.6x and the 10-year average at 17.4x. The present, bottom-up level ($220.68) is hovering around 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 2Q23 the blended EPS decline for the S&P500 on aggregate is -6.8%. If correct, it will mark the third consecutive quarter in which there has been an earnings contraction, and it will represent the largest decline since 2Q20, when it was -31.6%. The upward revision to 2Q23 earnings growth (-6.8%), has been surprisingly negative if compared to 31 Mar’s -4.7%; we won’t have much to wait for the actual results. 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 0.9% year on year, vs 1.1% on Mar 31, while revenue is forecasted to grow by 2.4% vs 2.1% on Mar 31.
With estimates now measured against the forecasts as of Mar 31st, there are very few differences yet. Of note, Information Technology’s growth is now positive, and greatly outstripping both earlier negative forecasts (of as much as -1%) and their Mar 31st previous reference.
The S&P 500 has its revenue growth estimates at 2.4%, level with last week’s. Financials are still leading the pack in terms of revenue forecasts. Information Technology revenue growth has been revised upwards to 1.5% from as low as 0.7% and is now slightly up of the 1.4% recorded 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.
Let’s take a look at EPS for 2023 and 2024, which last week had a downward revision. The forecast for 2023 has now been updated to $220.68 from last week’s reading of $221.17; while 2024’s EPS are currently forecasted to be $246.37, compared to last week’s reading of $246.92.
This is the detail for 2Q23. While the market might be more concerned about rates and recession than earnings at this point, the narrative is changing from rate risk to macro risk where earnings will be of paramount importance. While the negative revisions to 2Q23 are a bit troublesome, I’m encouraged by the fact that on a yearly basis, there have been small declines lately, which is remarkable considering the very limited breadth of the market. It is also well possible that earnings for 2Q23 will also surprise on the upside following a very positive 1Q23. Stay tuned.
Earnings, What’s Next?
The earnings season is now drawing to an end in its 1Q23 reports and a few 2Q23 reports are starting to trickle in. We will have another glimpse of 2Q23 (or at least the first two months of it) from companies that report a month early. Here’s a list of companies reporting this week.
Source: Earnings Whispers
Source: Topdown Charts, Refinitiv Datastream
Source: Real Investment Advice, Lance Roberts
Revenue growth estimates for 2024 are forecasted to grow by 4.9% (5.1% on Mar 31st) and earnings growth estimates for 2024 are predicted to grow by 11.7% (12.2% 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 welcome the arrival of a new bull market for the S&P 500 (+20% from the October lows), near-term it is quite possible that we see a consolidation around current prices after such a big jump. The two charts above seem to tell two sides of the story, but they are not in contradiction of one another. On the top chart, you can see that the S&P 500 had a breakout and successful retest, hence the future looks to be bright; on the bottom chart you can see that the market is quite overbought at the moment, and hence it will be difficult to achieve a meaningful performance near term (NFP permitting).
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. Next week will probably be sideways/down again, as the market consolidates and forms a base around current levels. Still, I tactically continue to suggest staying long on Equities, with a 3% weekly stop, despite a possible consolidation/correction, as long as the S&P 500 and the Nasdaq 100 stay above their Feb 2 peaks (4,179.76 and 12,803.14 respectively). 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, although given the new Fed’s forecast, we might have to wait until 2024 for that.
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!
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