Equity markets break out on technical and fundamental strength

Thoughts

• Equity markets broke out of the recent trading range, with the S&P 500® Index at the best level since August following the third-straight weekly gain, bringing the year-to-date return to 12%. Volatility has collapsed, with the VIX at the long-term average of 15, approaching the lowest level since before the pandemic. The lack of market breadth continues to pose a concern, as evidenced by the NASDAQ® 100 Index’s remarkable 32% increase, reaching an all-time high, while value and small-cap indexes remain flat this year. The performance gap between the NASDAQ 100 Index and the Russell 2000® Index is at a record high. May concluded with a fractional yet positive return, having achieved gains in three consecutive months and six out of the last eight since September of the previous year. The period saw a remarkable rally of 19%.
• Last week saw a technical breakout above 4,200, with fundamental support from a strong payroll report. The bull’s narrative includes a strong labor market, moderating inflation, encouraging earnings trends, a resilient consumer, easing banking stress, and conservative institutional positioning. Bears point to weak breadth (reliance on large tech), a higher-for-longer Fed, looming recession, tight liquidity, the West coast port strike, and concern over China’s reopening. Retail investors continue to allocate to equities, while institutional investors, while still pessimistic, continue to close their absolute and relative shorts.

• The sentiment of many economists and strategists is beginning to swing incrementally positive, driven by three changes in fundamentals: a significant drop in the VIX, encouraging market behavior in response to stronger-than-expected payroll data, and an improving earnings outlook. All this is beating expectations, which will drive positive performance and an improving institutional and retail investor sentiment. If this keeps up, it may stand a chance of creating a virtuous cycle and a durable rally.

News

• Payrolls rose by 339,000 in May, the highest since January and almost double the estimated figure of 190,000. This marks a noticeable acceleration from the upwardly-revised 294,000 in March. Results have exceeded economist estimates for 14-straight months, reflecting the pessimism embedded in forecasts. The unemployment rate rose to 3.7% from 3.5% despite flat labor force participation, reflecting the relative weakness of the household survey component of the report. Average hourly earnings slowed modestly to 4.3% from a year ago, reflecting strong but controlled wage growth. Job openings bounced in April, back above 10 million, reinforcing the strength of the labor market. Strength in the labor market is critical for the “soft landing” thesis, as consumers with comfort in their jobs tend to spend, supporting economic growth.
• President Biden signed the debt ceiling bill into law on Saturday just ahead of the June 5 deadline and avoiding a default. Moody’s stated that the deal was in line with its expectations and is not considering a downgrade from the Aaa rating. The agreement raises the debt ceiling beyond next year’s presidential election into 2025. House Speaker McCarthy highlights the work requirement for federal aid, a two-year government spending cap, and a clawback of unspent Covid funds, while Senate Majority Leader Schumer notes that this does not limit spending on defense, disaster relief, or other important national issues.
• Earnings optimism continues to improve, with companies posting the best results relative to expectations since 2021, with both the percentage of companies and the magnitude of surprises above the long-term average. Bank of America’s Global Earnings Revision Ratio improved to the best level in over a year, with better-than-average positive guidance and less negative guidance. More than 40% of companies raised their annual sales guidance, the second-best pace since the data began in 2015. Data this week reinforced the trend of moderating inflation, with the ISM manufacturing prices paid at 44.2 versus 53.2 in April, with 85% of respondents noting prices either stable or falling. The Fed’s Beige Book showed growth slowing in several districts, while the Goldman Sachs Supply Chain Congestion Scale moved to the lowest level since before the pandemic.

What to Watch

• This week may be void of catalysts, with few economic releases and earnings reports, the debt ceiling resolved, and an FOMC meeting a week away. Data include PMI and ISM reports on Monday, and consumer credit on Wednesday.