Fear for yet higher rates dominates. Equities retrace (badly in Europe), rates up, and bonds down. Correction/consolidation likely to persist for another week; CPI/PPI on Thursday/Friday and big banks on Friday. Continue to be positive on equities, even if the market does feel extended (in particular Nasdaq 100, and Nikkei 225), and neutral on bonds.
Major market events 10th – 14th July 2023
Highlights for the week
Mon: CN CPI, CN PPI.
Tue: UK Unemployment Rate, DE CPI.
Wed: JP PPI, US CPI, US Beige Book.
Thu: CN Trade Balance, UK GDP, EU Industrial Production, US PPI, US Initial Jobless Claims.
Fri: CH PPI, EU Trade Balance.
- And then the correction came, although the usual suspect (Friday’s NFP) was not the main culprit. Instead, an unlikely supporting actor (ADP Payrolls) rose to fame with a bang. With evidence that the labor market shows no sign of abating, and fearing a blowout NFP number the following day, the market started to fret about future rate hikes, with the perspective that the terminal rate has to be repriced higher once more (maybe to as much as 6%). This prompted the correction, which was more striking in Europe and in value, while growth managed to pass through the turbulence largely unscathed. Friday NFPs did not quite live up to expectations – the headline number was lower than forecasts, but the average hourly earnings came back above the forecast and the Fed is not going to like any of this, unfortunately. Governor Powell has very vocally stated that inflation is declining too slowly and that he won’t refrain from future rate hikes if necessary. So no recession for the time being – most market pundits forecast it to happen in 1H24 – but a bitter medicine to swallow. All eyes on US CPI and PPI this week, and on the unofficial start of the 2Q23 reporting season this Friday – with the large US Banks.
- Curious to note that in a down week value was hammered and growth did not do too badly. It sounds rather amusing to acknowledge that Europe was hit hard because rates in the US are probably going higher (although I admit this might well mean that rates in Europe are headed higher too). Still, the reality is that the European market has proved to be more fragile than its American counterpart, showing weakness even in the defensive sectors. It is now trailing the US by more than 500bps on a YTD basis. The Nikkei 225 did see a correction after a stellar performance, but once again I found evidence of inflows in Japanese Equities. And of course, in this rather eventful week, the JPY managed to recover some ground against major currencies. 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. The stop loss would have hit on European markets last week – I’d keep an eye open to see if the US Markets resume their upward trend before re-entering.
- Once again the Nasdaq 100 was the star market of the week – even more impressive as this happened on a down week. Europe needs to consolidate and lick its wounds before trying to resume the climb to its previous high set in July 2007 (4524.45), so the leadership will in all likelihood continue to be provided by the S&P 500 and the Nasdaq 100 which are now chasing their all-time highs, despite last week’s setback (a minor bruise). There is an almost perfect consensus – 93.0% – 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 also digested that. 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. In a survey taken last week, most of the participants have shifted their focus to 1H24 for the recession to start, and most expect one will take place before 2024 – so in the possible case of no landing many people will be surprised. 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.
- We will be starting in earnest with the 2Q23 reports this week. Thursday will see PepsiCo, and Friday all the big banks. Fasten your seat belts!
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 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 2.1% would account for substantial growth, revised lower from 2.2% 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 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
The upcoming presidential cycle (with elections scheduled next year) and seasonality are supportive of further upside for the market, even though further consolidation might be necessary before that can take place.
Source: Goldman Sachs, ISABELNET.com
This Goldman Sachs indicator of risky vs safe assets fund flows is positive notwithstanding the market’s performance. This is further supported by the large inflows in US large-cap equities.
Source: Datastream, Haver Analytics, EPFR, Goldman Sachs Global Investment Research, 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. At the moment consensus is forecasting only a 2% decline in earnings, while strategists are bearish (see below); and what if this decline were more pronounced or significant? That would be a really bad development for the market, and we have yet to see evidence that earnings can rebound in 3Q23 after finding their trough in their current quarter.
Source: BofA Global Investment Strategy, Bloomberg, ISABELNET.com
Perhaps as a consequence of the unexpected performance of the markets in 1H23, the average US strategist is bearish and forecasting a negative 2H23 for the S&P 500. One of the few dissenters is Goldman Sachs’ David Kostin, who has set a target of 4500 points at the end of the year for the index.
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.
Of course, earnings can thrive only if the economy does not in a recession. The chart below shows the chances of having one in the next 12 months according to different methodologies, with the average being 45%. Goldman Sachs is currently forecasting a 25% probability to have a recession in 2013, but that doesn’t say anything about 2024 when most market pundits believe the recession will start.
Source: Haver Analytics, Datastream, Worldscope, Goldman Sachs Global Investment Research, ISABELNET.com
This is really ugly. The chart below shows that eventually when the Fed hikes the labor market is hit – just a question of time. This is one of the quickest and surest ways to trigger a recession while bringing down inflation and taming consumer spending. The problem is that Governor Powell and the Fed are keeping the labor market in check, and will continue to hike until there are signs that inflation is under control and proceeding toward 2%. This is one of my biggest worries at the moment …
Source: BofA Global Investment Strategy, Bloomberg, 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 78, down from 80 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, and additional hikes are averted, the market will go up!
Source: CNN Business
The lagging AAII Sentiment Survey saw an increase in bullish positions this week, getting them almost to the absolute 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 Japanese equities and High Yield bonds, at the expense of interest-sensitive investments such as Utilities and TIPS.
Source: BofA Global Investment Strategy, ISABELNET.com
The recent performance of the US equity market, and particularly of US large caps, has been noted by many, and therefore it shouldn’t be too surprising to see big inflows in almost 8 months.
Source: BofA Global Investment Strategy, EPFR
The forward 12-month P/E ratio for the S&P 500 is 18.9x, stable from last week’s reading of 18.9x, which is above the 5-year average at 18.6x and the 10-year average at 17.4x. The present, bottom-up level ($220.36) 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 -7.2%. 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 (-7.2%), 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 0.8% year on year, vs 0.8% on Jun 30, while revenue is forecasted to grow by 2.4% vs 2.4% on Jun 30.
With estimates now measured against the forecasts as of Jun 30th, 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 level with the 1.5% recorded on Jun 30th. 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 $220.36 from last week’s reading of $220.68; while 2024’s EPS are currently forecasted to be $246.15, compared to last week’s reading of $246.37.
This is the detail for 3Q23. 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 starting its 2Q23 reports in earnest. Here’s a list of companies reporting this week. Highlights include: PepsiCo (Thursday, Before Open), J.P. Morgan (Friday, Before Open); Citigroup (Friday, Before Open), Wells Fargo (Friday, Before Open), and UnitedHealth (Friday, Before Open)
Source: Earnings Whispers
Source: Carson Investment Research, FactSet, Ryan Detrick
Revenue growth estimates for 2024 are forecasted to grow by 4.9% (4.9% on Jun 30th) and earnings growth estimates for 2024 are predicted to grow by 12.4% (12.3% on Jun 30th), 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. That’s the message in the chart above: after a stellar performance in the first half, some consolidation is needed before the market can march to new highs.
We are probably shifting from a monetary risk to a macro risk, where the economy’s performance 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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