Heavy rain with S&P 500 and Nasdaq 100 on a correction. Rates recede a little, giving some much-needed respite to bonds. Cash, USD, CHF, and commodities could act as safe havens. Reassessing the economic/rates scenario; the disinflation expected in 2H23 might not materialize – watch out for US ADP and Nonfarm Payrolls. Earnings so far have disappointed, despite the headline numbers, but reports continue this week (Apple). The biggest tail risk is inflation staying high(er for longer), forcing the Fed to continue to hike to and beyond 6%.  

Major market events 30th October – 3rd November 2023 

Highlights for the week

Mon: DE GDP, DE CPI, JP Industrial Production   

Tue: CN Manufacturing PMI, JP BOJ Interest Rate Decision, FR GDP, EU GDP, EU CPI, US CB Consumer Confidence

Wed: UK Manufacturing PMI, US ADP Nonfarm Payrolls, US ISM Manufacturing PMI, US JOLTs Job Openings, US Fed Interest Rate Decision

Thu: CH CPI, DE Manufacturing PMI, DE Unemployment Rate, EU Manufacturing PMI, UK BOE Interest Rate Decision, US Initial Jobless Claims, US Factory Orders 

Fri: DE Trade Balance, UK Composite PMI, UK Services PMI, EU Unemployment Rate, US Nonfarm Payrolls, US Unemployment Rate, US Average Hourly Earnings US Services PMI, US ISM Non-Manufacturing PMI

Performance Review

Index	20/10/2023	27/10/2023	WTD	YTD
Dow Jones	33,127.28	32,417.59	-2.14%	-2.17%
S&P 500	4,224.16	4,117.37	-2.53%	7.67%
Nasdaq 100	14,560.88	14,140.82	-2.88%	30.18%
Euro Stoxx 50	4,024.68	4,014.36	-0.26%	4.10%
Nikkei 225	31,259.36	30,991.69	-0.86%	20.51%

Source: Google

* It doesn’t stop raining. Yet another tough week for equities, while rates managed to step back a little and gave bonds some respite. Both the S&P 500 and the Nasdaq 100 are now officially in a correction, with the former having broken some key supports on the way down. Last week the fall could not be blamed once again on rates, so Lt. Columbo must deepen its investigation. The reality is that earnings were overall underwhelming and not what the market was expecting. In themselves they are a conundrum because 3Q23 forecasts rose dramatically from -0.4% last week to +2,7% this week; however, this increase was not enough to lift meaningfully the forecasts for 2023. Barring any incremental dramatic move or escalation, the conflict in the Middle East seems to have had a neutral impact on markets. Secretary of the Treasury Janet Yellen commented that rates are higher because of the strength of the US economy, not because of deficits. While GDP Growth for 3Q23 came in at 4.9% and the labour market is certainly healthy, she sees a healthy slowdown which would help in fighting inflation. At the moment – and this is going to be a long and painful exercise, I fear – the market has to become confident that inflation is at least stabilizing, and stop sending rates on haywire. 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. If a full-scale war does develop we really should brace for (much) higher rates, due to a likely massive spike in oil and imported inflation. Data will be key in driving the Federal Reserve going forward, but many well-respected market pundits such as Mohamed El Erian are questioning that view, as under the current environment talking about 6% (or more!) is no longer taboo. The market is not sold on Fed cuts and fears we have yet to touch the summit in rates.

* Europe strikes back – last week it was the US to lose, with the spread between the performance of the two most relevant equity markets narrowing by more than 2% in a single week. I’d say that two things helped: the ECB’s decision not to increase interest rates and lower valuations. There is no question that growth is slower in Europe, compared to across the Pond, and this might be of help in controlling inflation. I spoke with a well-respected market pundit (thanks Carlo!) on whether by year-end the yield on the 10-year treasuries will be above or below 5%, and his thoughts were that slowdown was coming, and hence yields could only moderate from here. This resonates with Tom’s thoughts regarding the Atlanta Fed’s GDPNow forecast – while useful, it makes more sense to follow the New York Fed’s Nowcast as it spans a year rather than a quarter and gives a better feeling for what comes ahead. Actually, for 4Q23, they are more or less aligned – at 2.3% GDPNow and at 2.58% Nowcast (which is a yearly forecast). Carlo also mentioned that 3Q23 was the last quarter of solid growth and that it was going to get slower from now on, and while consensus estimates for 2024 forecast more growth (which on a year-on-year basis has been lacking since 3Q22), Goldman Sachs is well below the consensus at $237 vs an average of $250 (BofA $235, Morgan Stanley $228). Interest rates will continue to be in the driving seat for at least the next 6 months, and everything else will reflect 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. This is not meant to chase yields – if you have any liquidity, be disciplined and put at least half on the money market; with the rest you can reinvest at the higher yields available, bearing in mind that while the ride is going to be a rollercoaster, if the issuer doesn’t default these will always be reimbursed at par on expiry.

* Once again markets are licking their deeper and deeper 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 current forward P/E ratio for the S&P 500 is 17.1x – and while it is lower than the 10-Year (17.5x) and the 5-Year (18.7x) averages, it is not cheap enough to withstand such high interest rates. (Yes, back in 1999, multiples AND rates were both higher – but that is a past unlikely to return, as earnings for most of the magnificent 7 disappointed dramatically so far). As mentioned before, earnings were strong enough to lift the 3Q23 estimates to positive territory, but not enough to make the leading stocks go higher or to change the forecasts for this year and next. There is a total consensus (99.9%!), according to the CME FedWatch tool, for the Fed to stay on hold in November, but the real question is what lies down the road. Let’s have a look: a hike in December has gone down to 19.3%, rising to 27.4% in January, while starting from March we should be back in the current 525-550% range, with even a small chance of a cut. The first cut – with a 64.5% chance – has been brought forward to June. Looking at these numbers, and at the shock in rates, one could argue that the Fed is effectively on hold and has reached the top in rates and the next move will be down not up – 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. Unfortunately, wars can last for years, as we have seen with Russia/Ukraine. There is more to tell – the inverted US yield curve has recently seen a strong steepening, which is a predictor of a recession. Check out this great chart from Game of Trades.

Source: Game of Trades

* 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. This recession, however, is only posticipated by 1 year and is now forecast to happen in 2H24. Looking at 4Q23, the Atlanta Fed’s GDPNow model is forecasting growth of 2.1%, up 0.3% from last week, with the Blue Chip consensus presently below 1%. The New York Fed Nowcast, which produces an annual forecast, sees annual growth at 2.58%, plus 0.03% from last week, and up from 2% in May. Even more interestingly, there is no recession forecast in their model, up to one sigma (and it was there in May). Earnings are expected to come in at 2.7% in 3Q23, compared with an estimate of -0.3% as of Sep 30th. If confirmed it would be the first quarter of yearly earnings increase since 3Q22. Revenue growth is faring a little better, at 2.1% in 3Q23, vs 1.6% as of Sep 30th, up 0.2% from last week. This progress, however, seems to have eaten 4Q23 lunch, as 4Q23 earnings are forecasted to grow by 5.3% vs 8.1% as of Sep 30th, and revenue is forecasted to grow by 3.8% vs 3.9% as of Sep 30th. For the whole of 2023, earnings growth is forecasted at 0.9%.   

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

Source: Federal Reserve Bank of New York; New York Fed Staff Nowcast

* Earnings are finally here – likely to overall meet/exceed estimates but watch out for the guidance. The current bottom-up estimate of $220.57 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 and rates are likely to obscure everything for a while. Hang tight!

Earnings, What’s Next?

This is it – the first of the massive weekly reports. Truly a make-or-break moment. Here’s a list of companies reporting this week. Highlights include McDonald’s (Monday, Before Open), and Apple (Thursday, After Close).

Source: Earnings Whispers

Market Considerations

Revenue growth estimates for 2024 are forecasted to grow by 5.5% (5.6% on Sep 30th) and earnings growth estimates for 2024 are predicted to grow by 11.9% (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. Now that we are almost past September and October, which have been as horrible as feared, we are entering the last period of the year, which traditionally is more constructive, after making allowances for wars and rates (a big ask!).

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 the S&P 500 broke the Feb 2 support of 4179.76 and fell well below, which opens the door to more downside near term. The Nasdaq 100’s Feb 2 peak is a bit further down (12,803.14) and, barring a major escalation in the conflict, or lousy earnings, should hold, even though the overall market is without leadership and with even some of the Magnificent 7 having an issue or two. 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 materialize, 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. The BOJ might decide to drop its Yield Curve Control before the end of the year, leaving room for rates to increase and stop the decline of the JPY. It is still the safest part of equities, but I’d hold off from deploying any capital until the rates mayhem hasn’t settled. Watch out for the BOJ Interest Rate Decision this Tuesday, as it could be a game changer.

Happy trading and see you next week!

InflectionPoint

Disclaimer

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