The first week of conflict did not hit the markets; equities were flattish, rates down, and bonds finally up. As long as the conflict does not escalate to Iran seems relatively manageable for the markets, but abound in caution. Cash, USD, CHF, and commodities could act as safe havens. Reassessing the economic/rates scenario; the disinflation expected in 2H23 might not materialise. Biggest tail risk is inflation staying high(er for longer), forcing the Fed to continue to hike to and beyond 6%.  

Major market events 16th – 20th October 2023 

Highlights for the week

Mon: JP Industrial Production, EU Trade Balance, US NY Empire Manufacturing Index 

Tue: UK Unemployment Rate, DE ZEW Economic Sentiment, US Retail Sales, US Industrial Production, US Capacity Utilisation

Wed: CN GDP, CN Unemployment, CN Industrial Production, UK CPI, UK PPI, EU CPI, US Beige Book 

Thu: JP Trade Balance, US Initial Jobless Claims, US Fed Chair Powell Speaks, US Fed’s Balance Sheet

Fri: JP CPI, CN PBoC Loan Prime Rate, UK Retail Sales 

 

Performance Review

Index	6/10/2023	13/10/2023	WTD	YTD
Dow Jones	33,407.58	33,670.29	0.79%	1.61%
S&P 500	4,308.50	4,327.78	0.45%	13.17%
Nasdaq 100	14,973.24	14,995.12	0.15%	38.04%
Euro Stoxx 50	4,144.43	4,136.12	-0.20%	7.26%
Nikkei 225	30,994.67	32,315.99	4.26%	25.66%

Source: Google

* The first week of the conflict between Israel and Hamas was dramatic, while its impact on the markets, luckily, was not. In Equities, we had a flat, uneventful week, where risk on did better than (I) expected; certainly, the decline in yields helped to that end. The economic data (PPI and CPI) was ahead of forecasts, even though the Core CPI (a preferred measure of inflation by the Fed) was in line. But risks abound – James Bullard, former CEO of the St. Louis Fed, reminded markets on Friday that the biggest tail risk is inflation not receding, forcing the Fed to increase rates to as much as 6% or 6.5%. In short, higher rates are here to stay; and breaking the long-term declining trend of yields in interest rates on the 10-year treasury will lead almost certainly to an overshoot. This additional conflict seems to be manageable by the markets (any loss of life is much regrettable), provided it does not escalate to another important regional player like Iran, which would be a game-changer. Should that happen, turn to commodities, USD, and CHF (but watch out for gold’s triple top) as safe havens. The CME FedWatch tool sees the US Central Bank on hold in November and sees a hike in December or January with a 30% chance. I would like to state, however, that what is different this time is that inflation is not driven by consumer or corporate spending alone, but there are other factors at play, including the rising cost of energy, politics, and the progressive de-globalisation taking place pretty much across the world. If a full-scale war does develop we really should brace for (much) higher rates. There’s no question in my mind about the Fed’s hawkishness – they are clearly looking at inflation and if in order to win the game they will send the economy into a recession, so be it. Data will be key in driving the Federal Reserve going forward, but under the current environment talking about 6% (or more!) is no longer taboo. The market is definitely not sold on Fed cuts and fears we have yet to touch the summit in rates.

* In this immense confusion, growth managed to have a decent week, trumping value at the margin. Technology continues to do well but is very sensitive to any further rise in yields. The next two weeks will be full of earnings reports and hence very important; my initial feeling from Friday is that earnings will be mostly good, but the guidance might not. Interest rates will continue to be in the driving seat for at least the next 6 months, and everything else will be a reflection of that. Therefore the current recommendation is to be very prudent on both equities and bonds and prefer cash, the USD, the CHF, and commodities. Don’t put all eggs in one basket, but reinvest periodically at higher rates which are likely to be available in the near to mid-term future.

* Once again markets are licking their wounds, and while valuations are cheaper now, there needs to be a catalyst to trigger a recovery. This can be one of the following: i) lower rates, or ii) earnings growth. The first seems to be nowhere to be found and we are just about to find the second, and I just wonder – will it be enough to satisfy the needs of an uber-anxious market? Indeed some of the large banks have warned of tougher times ahead, even though the US economy seems to be doing well. Meanwhile, the CME FedWatch tool has updated the first cut to June/July 2024 – I just wonder if will it be possible? I fear this latest development in geopolitics means that rates will have to go up before they come down. Wars can last for years, as we have seen with Russia/Ukraine, unfortunately.

* I also believe that this increases the risk of a hard landing for the US economy, choked by the powerful double whammy of higher rates, and higher crude prices. The US is close to energy self-sufficiency; that is not true for Europe, whose lower rates might do little to absorb the shock of higher energy prices and higher inflation.  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 forecasting 3Q23 growth of 5.1%, up 0.2% from last week, with the Blue Chip consensus now nearing 3%. The New York Fed Nowcast, which produces an annual forecast, sees annual growth at 2.5%, stable from last week, and up from 2% in May. Even more interestingly, there is no recession forecast in their model, up to one sigma. Watch out for earnings, with a 0.4% growth now expected in 3Q23, compared with an estimate of -0.3% as of Sep 30th. Analysts have had to revise estimates upwards after the first results, and if confirmed this will be the first quarter of positive year-on-year growth since 3Q22. Revenue growth is faring a little better, at 1.9% in 3Q23, vs 1.6% as of Sep 30th, also revised upwards by 0.2% since last week.

Source: Blue Chip Economic Indicators and Blue Chip Financial Forecasts; Federal Reserve Bank of Atlanta

* Earnings are finally here – likely to meet/exceed estimates but watch out for the guidance. The current bottom-up estimate of $221.06 matches with the following forecasts: $224 from Goldman Sachs, $205 from J.P. Morgan, $200 from Bank of America, and $ 185 from Morgan Stanley. However, geopolitics is likely to obscure everything for a while. Hang tight!

 

Earnings, What’s Next?

3Q23 reporting will start this week, with many more crucial reports following in the next two weeks. Here’s a list of companies reporting this week. Highlights include Tesla (the first one of the Magnificent 7 to report) on Wednesday, After Close, and Netflix, again on Wednesday, After Close.

 

Source: Earnings Whispers

Market Considerations

Revenue growth estimates for 2024 are forecasted to grow by 5.6% (5.6% on Sep 30th) and earnings growth estimates for 2024 are predicted to grow by 12.2% (12.2% on Sep 30th), so the future looks to be bright. 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. October is traditionally a difficult month, often characterized by extreme volatility, so my optimism is somehow tempered here, even though the strong performance so far should prevent a catastrophe. However, I wish we didn’t have to deal with another war. We need to see whether this will be left to Israel and the Palestinians or whether it will include anyone else (Iran).

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 okay, 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 for the S&P 500, the Feb 2 peak held its own last week. As long as the index stays above 4179.76 then the downside should be relatively limited. The Nasdaq 100’s Feb 2 peak is a bit further down (12,803.14) and, barring a major escalation in conflict, or lousy earnings, should hold. My advice is to stay out of the equities market until we have greater clarity on where the rates are headed.

Regarding bonds, the expected disinflation in 2H23 might well not materialise, given an expected spike in the price of crude. The Brent may well go to $100 per barrel soon – it all depends on how the geopolitics scenario will unfold. Once again, until we have more clarity on any peaceful resolution of the conflict between Israel and Hamas, I advise staying on the sidelines and investing any liquidity in the money market (up to 1 year).  

Cash (money market funds), USD, CHF, and commodities are a few of the asset classes that make sense now. Japanese equities might well be more defensively positioned, but they are facing an increase in rates as 10-year JGBs at 0.80% are currently on their way to the upper band set by the BOJ (1%). Before the great fall to negative rates, 10-year JGBs were yielding 2%, and it might well be that it is there that they are heading. Watch out for the JPY as it may slide further as the world becomes once again centered on the USD. Still, they might be the more investable part of equities right now, thanks to good economic performance (GDP above estimates) and a still dovish Central Bank.

Happy trading and see you next week!

InflectionPoint

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