Bulls seek to gain control as midterms approach

Thoughts

• Equity markets will try to reestablish positive momentum following a decline last week, as investors prepare for a CPI reading and the results from the midterm election. Equity and bond markets continue to be positively correlated, with the S&P 500® Index and the Bloomberg US Aggregate Bond Index moving in the same direction in two-thirds of weeks this year. This compares to just over one-third of weeks in the decade leading into the pandemic. Institutional investors are increasingly willing to allocate to equities given their historic level of conservatism and the fact that the best six months on a four-year calendar come following midterm elections.
• The tug-of-war between bears and bulls has been largely won by bears this year, though there are signs that bulls are resurging. Bottoming processes are rarely clean, and even if bulls are gaining control, pockets of weakness are inevitable. Bears point to the Fed and global central banks aggressively tightening financial conditions, stubbornly high inflation, and likely negative earnings revisions. Bulls point to historical conservatism among institutional investors, a likely peak in the pace of Fed tightening, renewed corporate buybacks, strong seasonality, and a resilient consumer and job market. Investor sentiment has improved, and market risk metrics are not reflective of a weak environment.
• Looking ahead, the case for a bull market is compelling. Technical factors are strong, and the markets have rebounded from extreme pessimism. If we continue to see a resilient consumer and a return to normalcy between the bond and equity market, we’ll feel even more confident in the bull case.

News

• Cracks are beginning to develop in the labor market, as nonfarm payrolls rose 216,000 in October, slightly above the 200,000 estimate but below the 315,000 seen in September and the smallest gain since December 2020. The unemployment rate rose to 3.7% from 3.5% despite a decline in the labor force participation rate to 62.2% from 62.3%. Wage growth remains robust, up 4.7% from a year ago, but remains below the pace of inflation for the 19th straight month. Several high-profile companies have announced hiring freezes and layoffs, including Twitter, Amazon, Apple, Lyft, and Morgan Stanley. Fed officials have pointed to the strong labor market as cover for their aggressive tightening path and a signal that the economy remains robust. This deceleration may be an indication of a weakening labor market, but the Fed will need to see a continued pattern before shifting policy.
• The battle between the Fed and inflation continues to rage following last week’s 0.75% hike. Commentary from Chair Powell was viewed as hawkish, stating that “the ultimate level of interest rates will be higher than previously expected.” Consumer price inflation will be released on Thursday, with a consensus estimate of 8.0% headline and 6.5% core versus a year ago. A recent study showed that 72% of consumers plan to be increasingly price-sensitive in holiday shopping. The National Retail Federation expects growth of 6-8% during November and December after a jump of nearly 14% last year, though that pace may not keep up with the pace of inflation. Substantial declines are expected in computers and electronics, home furnishings, and apparel.
• The tone of management commentary in earnings season continues to highlight increased global macro uncertainty, led by worries in Europe and China. Lingering issues around the strong dollar, inflation pressure, and supply chain issues were highlighted, though some easing is seen in transportation and labor. Substantial pressure is being reported by companies that were winners during the pandemic, with technology companies highlighting longer sales cycles, weakening advertising, and a shift towards cost-cutting. Nearly 85% of the S&P 500 companies have reported earnings, with growth trending towards 2% on 11% sales growth, as margin compression has been a major drag. Consensus estimates show a flat fourth quarter, and estimates for 2023 have slid to 5%, down from 9% in June. Wall Street strategists continue to cut estimates for next year.

What to Watch

• Inflation will be in focus this week as earnings season begins to wind down, with consumer price inflation on Thursday. Other notable releases include consumer credit on Monday, NFIB Small Business Index on Tuesday, and consumer sentiment on Friday. Markets are likely to be volatile on Tuesday and Wednesday around the midterm election.