Are markets bottoming or stalling before the next leg lowers?

Thoughts

• Equity markets are looking to bounce following a week that saw a loss for the S&P 500® Index of less than 1%. The last four weeks have seen two positive and two negative moves, and the S&P 500 is little changed over the past two months. Volatility is beginning to ease, with directional moves of 2% or less in the past three weeks following moves of 5% or greater in four of the previous five. There are signs that investors are shifting to “risk-on” mode, with growth indexes outperforming and Bitcoin touching the best level in over a month.
• Recession risks are rising, with the shape of the yield curve (spread between the 10-year and 2-year inverted) and the shape of the Fed Funds Futures curve (aggressive hikes in the near term, cuts beginning early next year) reflecting a Fed policy error. Bloomberg data show a 38% chance of a recession in the next 12 months and 98% over the next 24, echoing similar fears reflected in economist surveys. Other historic metrics that have historically predicted recessions are trending lower, including ISM surveys (new orders and employment contracting), consumer sentiment (record lows), initial jobless claims (four-week average at high since November 2021), and Federal Reserve surveys. Consumer behavior will be critical to monitor, particularly given signs of a peaking job market, historically weak sentiment, and negative real wages.
• This week is among the most important of the year as it will set the stage for the next two quarters. What to watch: any breakout directional market moves, signals ahead of the July FOMC meeting and the ramp up in earnings. We are cautiously optimistic that equities are in a bottoming pattern.

News

• Inflation continues to surprise to the upside, with a 9.1% reading on consumer price inflation (CPI) the highest since 1981. Some items like food and energy are likely to moderate in the coming months due to commodity price declines, but housing (nearly one-third of the calculation) is likely to remain stubbornly high. With wage growth of 5.5%, real wages fell 3.6% from a year ago. Excluding food and energy, core CPI rose 5.9%, ahead of expectations. Inflation expectations have eased on falling commodity prices, tightening financial conditions, growth concerns, and fear of a Fed policy error. The hotter-than-expected reading on CPI had markets pricing in an 80% chance of a 100-basis point hike at next week’s FOMC meeting. This would be the largest hike since 1982, when the FOMC went from 13% to 15%. Those odds fell to 35% over the weekend as policy makers hinted that 75 basis points is sufficient.
• President Biden’s trip to Saudi Arabia did not result in any additional production pledge, though he noted that the Saudis share his urgency and he expects further steps in coming weeks. OPEC+ meets on August 3, though production increases will likely be modest given the lack of space capacity. Crude prices bounced modestly, but remain below $100 per barrel after breaking through $122 in June. Beyond commodities, there are growing signs that the supply chain pressure is easing, with the Oxford Economics’ Supply Strains Index falling three months in a row, driven by easing freight costs and delivery times. In the U.S., however, ports remain a bottleneck, retail sales remain robust, and train congestion appears to be worsening ahead of a potential strike.
• Earnings will be the primary driver of market movement over the next several weeks as second-quarter releases dominate the news. Just 8% of S&P 500 companies have reported, with growth tracking towards 5% on 11% revenue growth, reflecting margin contraction. Banks have led the news to date, with a notable increase in provisions for loan losses but encouraging trends with consumers. Given the extreme pressure on share prices this year, managements are incented to “throw in the kitchen sink” in this and the next few quarters, with the hope of beating more achievable estimates. This could put pressure on estimates for 2022 and 2023.

What to Watch

• Earnings will be the primary focus this week as earnings season ramps. Economic data includes housing starts on Tuesday, existing home sales on Wednesday, leading indicators on Thursday, and PMI data on Friday. The FOMC meeting is the following week.