Markets pause despite increased calls for a soft landing

08/08/2023 — Equity markets look to rebound following the first decline in four weeks and just the third negative week in the previous 12, with the S&P 500® Index losing 2% for the first time since March. Investors have steadily upgraded their outlook for the macro backdrop, though higher rates, elevated valuations, and the overbought conditions resulting from the 28% rally since October are concerns. The decline is notable for the paired surge in volatility, with the VIX eclipsing 17 for the first time since May. Other risk metrics are beginning to reflect stress, including commercial paper spreads and global financial conditions.

The higher rate environment could become a headwind for stocks, as the 10-year Treasury yield approaches the highest level since 2007. The real 10-year yield (adjusted for inflation) is at the highest level since 2009, while the MOVE Index reflects greater volatility in bonds. The spread between the 10-year and 2-year yields is at the least inverted level since May, as investors increasingly bet on a soft landing or "no landing." Also putting upward pressure on rates was the downgrade of the US Treasury rating by Fitch to AA+, a predicted wave of new issuance, and large budget deficits. The short end of the curve is more stable, as the Fed Futures curve currently embeds less than a 20% chance of an additional hike, with more than four cuts between then and the end of 2024.

The market rally may be temporarily exhausted as of the end of July, as we will probably see sideways movement through the end of Q3 as we undergo a transition from technicals to fundamentals. While earnings remain strong, the recent surge in long-dated interest rates poses a threat, as it is not yet fully priced in. Though vulnerable areas like housing and commercial real estate may struggle in that environment, the fourth quarter is consistently the strongest quarter of the year–even more so in positive years–which could support markets into year-end. This week’s data on the health of consumer confidence, underpinned by the first consecutive months of real-wage growth in over two years, holds the key to next sustained bull rally.

News

Third-quarter earnings season continues to be a modest success, with 85% of the S&P 500 companies having reported. Earnings are on pace to fall by 5% on a 1% increase in sales, representing the worst earnings quarter since the beginning of the pandemic. Positive themes include the resilient consumer, continued travel and entertainment demand, and strength in auto, industrial, and homebuilding. Caution continues around macro uncertainty, negative operating leverage, and wage pressure. The performance gap by sector is stark, with double-digit gains for consumer discretionary, communication services, industrials, and real estate, and declines of greater than 20% for energy, materials, and health care. The movement of the dollar has been a significant driver, with domestically focused companies delivering growth, and internationally focused companies down by more than 20%.

Payrolls slowed in July to 187,000, below the consensus of 200,000 and 209,000 in June, and the lowest level since December 2020. The unemployment rate fell slightly to 3.5%, with the rate ranging from 3.4% to 3.7% since last March. The labor force participation rate was steady at 62.6%, as the strong market has not drawn retirees back into the market. Average hourly earnings jumped by 4.4%, relatively unchanged since March. This exceeds the pace of inflation for the third-straight month after a 25-month stretch of negative real earnings growth. Strength was seen in health care, social assistance, financial activities, and wholesale trade. Tuesday’s JOLTS report showed 9.6 million job openings, 1.7x the number of unemployed individuals.

Fitch Ratings downgraded the rating on US Treasury debt from AAA to AA+, warning about unsustainable growth in debt and political dysfunction. This downgrade echoes Standard & Poor’s 2011 decision and follows Fitch’s “negative watch” placement of the US in May. The release noted "the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions." Fitch predicts "general government deficits," including state, local, and federal budgets, will rise from 6.3% this year to 6.5% by 2025. The market had a muted reaction, though this move does put the spotlight on Moody’s with the lone remaining Aaa rating.

What to watch

As earnings season draws to an unofficial close, investor attention will refocus on economic data. Inflation data is the highlight, including CPI on Thursday and PPI on Friday. Other data include consumer credit on Monday, NFIB Small Business on Tuesday, and consumer sentiment on Friday.