“Goldilocks” data has given the bulls confidence

07/17/2023 — Equity markets rallied following a brief period of consolidation, with the S&P 500^® Index touching the highest level since last April and to within 6% of an all-time high. The S&P 500 has gained 18% this year and is up 26% since the October low. The recent rally is notable for the improving breadth, with the equal-weighted S&P 500 Index outperforming the market-cap-weighted version since the beginning of June. Interest rates have dropped significantly since the surge last week, with the 2-year yield down 0.40% since last Thursday. The dollar index is worth watching, touching the lowest level since last April, adding to inflationary pressure but acting as a tailwind for earnings.

Bulls were energized by the prospects of a "goldilocks" scenario of an improving macro backdrop with steadily easing inflationary pressure. A Wall Street Journal poll of economists has decreased the expectation for a recession over the next 12 months to 54% from 61%, the largest monthly drop in nearly three years. This sharp shift in expectations is highlighted by the estimate for second-quarter growth at 1.5%, up from 0.2% in the last survey. The shifting outlook was also seen in hedge funds and algorithmic traders covering shorts at the most aggressive level in nearly three years. Sentiment indicators suggest the market is overbought, though the strong degree of momentum makes the market difficult to bet against.

We are starting to check off on every criticism of this market. All the arguments that gave the bears ammunition – high inflation, over reliance on mega cap tech, earnings in a downward trajectory – are starting to fade at the same time as the number of bears are starting to fade. We’re now seeing economists as the next pessimistic domino to fall, illustrated by the sharp drop in recession expectations month over month.

With all these factors at play, I’m less optimistic for the market today than I was three or six months ago simply because I question whether we’ve priced in the transition too aggressively. The question ahead is can we start delivering the fundamental improvement needed to tip the scales?

News

Last week continued the trend of encouraging economic data, led by better-than-expected readings on CPI and PPI. Consumer sentiment popped to 72.6 from 64.4, the best level in nearly two years, driven by notable strength in both current conditions and expectations, while the outlook for inflation is at the lowest level in more than two years. Per Nationwide Economics, sentiment climbed for all demographic groups except for lower-income consumers. Other notable releases this week included an improving NFIB Small Business Index, positive real wage growth, and falling unemployment claims. The Citigroup Economic Surprise Index touched +75, the best level in over two years, as economic data releases are consistently outperforming expectations.

Earnings season unofficially kicked off last week, led by reports from Citigroup, JPMorgan, Wells Fargo, and Blackrock. JPMorgan saw a surge in revenues of 34%, driving a solid beat to earnings. "The U.S. economy continues to be resilient," CEO Jamie Dimon said. "Consumer balance sheets remain healthy, and consumers are spending, albeit a little more slowly. Labor markets have softened somewhat, but job growth remains strong." Dimon added that there were "salient risks in the immediate view" including dwindling consumer balances, the risk that interest rates would be higher for longer than expected, and geopolitical tension such as the Ukraine war. Citigroup delivered better-than-expected revenues and earnings, driven by personal banking and wealth management, while Wells Fargo beat on the top and bottom lines as well. With less than 10% of the S&P 500 having reported, the current forecast is for an 8% drop in earnings on flat revenues.

The FOMC meeting is next week, with the Fed Futures curve embedding a 96% chance of a hike at the meeting. Things are less clear beyond the July meeting, with a 20% chance of an additional hike in either September or November, with cuts beginning to be priced in by the middle of next year. The terminal rate is currently priced at 5.40%, down slightly from last week, but well above the 4.97% from the beginning of the year.  A wave of speeches by Fed officials came this week, with Fed Governor Waller arguing for higher-for-longer rates, with two more hikes needed this year, while New York President Williams warned that the full effects of policy actions taken have not yet been felt by the economy.

What to watch

This week’s headlines will be led by earnings, as the FOMC meeting is the following week. Economic data includes retail sales and industrial production on Wednesday, housing starts on Thursday, and existing home sales and leading indicators on Friday.