Equities bounce, rates down, and bonds up. Approaching turbulent September with greater care (and prudent risk management). Finally, S&P 500 Earnings are being upgraded (for the first time since 3Q21). Continue in general to be positive on equities, and warming up on bonds. As usual, 3Q23 earnings (starting in October) will be key. The Fed should pause in September, again.
Major market events 4th – 8th September 2023
Highlights for the week
Mon: DE Trade Balance, CH GDP, US Labour Day (Markets Closed)
Tue: RBA Interest Rate Decision, EU Services PMI, UK Composite PMI, EU PPI
Wed: AU GDP, DE Factory Orders, US Trade Balance, US ISM Non-Manufacturing PMI, BOC Interest Rate Decision
Thu: CN Trade Balance, DE Industrial Production, EU GDP, US Initial Jobless Claims
Fri: JP GDP, DE CPI
|Euro Stoxx 50||4,236.25||4,282.64||1.10%||11.06%|
- A positive week last week gives some perspective amid the summer turbulence. The main change that occurred over August, was that rates shot up pretty much across the world with the notable exception of Japan, whose BOJ is still in dovish mode (Japan might be the only large country that loves inflation). Soaring yields dampened the appetite for equities and for risk assets in general. Equities did not fare too badly in the ‘correction’; Europe saw the worst of it. There is increasing evidence, supported by last week’s ADP and NFP, that disinflation is underway: the US economy is still very much robust, but creating fewer jobs than before (and I’d like to think Governor Powell’s rate hikes are finally having their impact). Max is warming up on bonds and so am I, although the path to lower rates was – and most likely will be – way bumpier than most market pundits (including us) thought. Once again, data will be key in driving the Federal Reserve going forward, but under the current environment talking about 6% is no longer taboo. Will see if Fed Funds will touch that level, and how quick the Fed will cut rates when it becomes clear that the economy is slowing (hopefully after having the key inflation target of 2% in sight).
- On a bounce week, growth did shine pretty much as expected. Even though I feared that IT and the Magnificent 7 lost their leadership, more recent results from Nvidia and Salesforce.com reassured investors (and propelled the two stocks higher, NVDA to a new all-time record). In Japan, recent changes in the Yield Curve Control by the BOJ have not changed the current narrative by much. Goldman Sachs forecasts a sustained decline of the JPY to levels not seen for 30 years if the Japanese Central Bank persists with its dovish stance. 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 700bps on a YTD basis. 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.
- While the Nasdaq 100 did have another impressive performance, it took second place as it was pipped by the Nikkei 225 for the top spot. 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. There is an almost perfect consensus – 94.0% – according to the CME FedWatch tool – for the Fed to be on hold in September – which would be the second time this year. While staying the course (holding) seems to be the leading perspective in November, there is a 35.4% chance that we will see higher rates then, and a 32.5% chance in December. 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. Indeed, the Atlanta Fed’s GDPNow model is currently forecasting 3Q23 growth of 5.6%. This has led analysts to increase EPS forecasts for the first time in the last 2 years (since 3Q21). Goldman Sachs, which has been spot on in its forecasts on the economy, is now forecasting a 20% chance of a recession in the US in the next 12 months, with lots of disinflation to take place in 2H23, and at the same time, it 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 trough in 2Q23 and bounce in the back half of the year.
- We are reaching the end of the 2Q23 earnings reports, and soon we will be able to witness results for 2 months of the summer from companies that report a month early like Oracle.
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 3Q23, which at 5.6% would account for staggering growth. As before, there is a meaningful difference between this forecast and the consensus for Blue Chips; they will have to converge at some point. 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 2%.
Source: Blue Chip Economic Indicators and Blue Chip Financial Forecasts
The recent labour reports have been more benign: job growth has moderated, and particularly average hourly earnings have declined, pushing unemployment up to 3.8%, up from 3.5% in July, though still below 4% which is considered the border between a restrictive and expansive policy. The chart below shows the peaking relationship between job openings and unemployed and is yet another signal that the Fed is done. Hopefully, that will also mean lower yields going forward.
Source: BofA Global Investment Strategy, Bloomberg, 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 70.65%. I would further note that when this level was so high, a recession promptly ensued. This time is different?
Source: Federal Reserve Board, Federal Reserve Bank of Cleveland, Haver Analytics
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. With analysts upgrading earnings forecasts for the first time since 3Q21 and with positive GDP forecasts as a tailwind, we can now see some evidence that earnings can rebound in 3Q23 after finding their trough in their current (2Q23) quarter.
The problem is that September and October are difficult months for the stock market. Never mind that the St Leger’s Day falls on September,16th the charts below tell us that it is primarily in the back half of the month that troubles arise. So, I’d advise to wait before ‘coming back on St Leger’s Day’.
Source: Yahoo! Finance, ISABELNET.com
Source: Carson Investment Research, Factset, Ryan Detrick
The Temporary Help Services from the Federal Reserve Bank of St. Louis are also signalling a recession. I’d note that in 2020 the recession was short, and the index quickly recovered.
Source: FRED St. Louis Fed, ISABELNET.com
Checking up on the economy: the ugly
Valuation certainly isn’t cheap. It is even less so considering such appealing yields. This has led some to speculate that the current P/E is unsustainable. The current forward P/E of 18.8 is higher than the 5-year average of 18.7 and the 10-year average of 17.5. 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 below chart offers a snapshot of valuation metrics across different markets. There is no question that multiples are expensive. Still, if we can compare the current AI frenzy to the dot.com boom of 1999-2000, back then the S&P 500 was trading at a multiple of 24x, and the Nasdaq 100 of 100x. As for the poster child of this rally, NVDA, it currently has a 2024 P/S valuation of 22x. In 2000, Cisco was trading at a valuation of 100x on the same metric. Markets can stay irrational longer than you can stay solvent. (J.M. Keynes). Going forward it will be imperative for earnings to shine and lower the multiples a little – at least by 1 point. Still, I’d rather buy the US at 19.4x, or Japan at 14.4x, rather than Developed Europe at 12.2x. What is cheap (Europe) can get cheaper still.
Source: Goldman Sachs Global Investment Research, ISABELNET.com
This is really ugly. The chart below shows the plight that investors in the US – and pretty much around the world – have been suffering for three years now. It is a first – but when long-term trends are violated, they tend to do so in a very meaningful way. Rising yields are a problem not just for bond investors, but for equities and other risk assets too. Let’s hope there is an end to this nightmare soon …
Source: BofA Global Investment Strategy, Bloomberg, Global Financial Data, 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 back in Greed territory, ending the week with a reading of 56, up from 53 last week.
Source: CNN Business
The lagging AAII Sentiment Survey saw an increase in bearish positions this week, getting them to a relative majority.
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 growth, at the expense of interest-sensitive investments such as Utilities and TIPS.
Source: BofA Global Investment Strategy, ISABELNET.com
Cash is still very much king. In a world where equities are deemed too risky by some, and with the bond market limping through weekly losses, cash seems the only game in town, hoping for a decline in inflation.
Source: BofA Global Investment Strategy, Bloomberg, ISABELNET.com
The forward 12-month P/E ratio for the S&P 500 is 18.8x, which is above the 5-year average at 18.7x and the 10-year average at 17.5x. The present, bottom-up level ($222.45) is hovering just below Goldman Sachs’ top-down $224 forecast, but it did manage to reverse its course after 2Q23. It will be key to continue to monitor whether these increases in estimates continue as reporting for 3Q23 comes in, as forecasted to happen in the back half of the year.
For 2Q23 the blended EPS decline for the S&P500 on aggregate is -4.1%. 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 3Q23 earnings growth (0.5%), has been positive if compared to 30 Jun’s 0.0%; we won’t have much to wait for the actual results, which could be better than what is currently forecasted. 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 1.2% year on year, vs 0.5% 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 by 3%, and greatly outstripping both earlier negative forecasts (of as much as -1%) and their Jun 30th previous reference (0.7%).
The S&P 500 has its revenue growth estimates at 2.4%, level with last week’s. Consumer discretionaries are now leading the pack in terms of revenue forecasts. Information Technology revenue growth has been revised upwards to 1.8% from as low as 0.7% and is now better than 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 $222.45; while 2024’s EPS are currently forecasted to be $248.54.
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. Once again the market repeated its 1Q23 feat, by having a lower-than-forecasted loss for 2Q23 and forcing analysts to upgrade their estimates. Stay tuned.
Earnings, What’s Next?
The earnings season is now ending its 2Q23 reports in earnest. Here’s a list of companies reporting this week. Highlights include: ZScaler (Tuesday, After Close), and DocuSign (Thursday, After Close)
Source: Earnings Whispers
Source: Carson Investment Research, FactSet, Ryan Detrick
Revenue growth estimates for 2024 are forecasted to grow by 5.6% (5.0% on Jun 30th) and earnings growth estimates for 2024 are predicted to grow by 12.0% (11.7% 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). September and October are traditionally two difficult months, so my optimism is somehow tempered here, even though the strong performance so far should prevent a catastrophe.
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 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, even though taking a break and bring home the profits might well make sense given the difficult seasonality, 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). 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 (4%+) yields. 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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