Equity markets have entered a period of relative calm, with the S&P 500® Index little changed in the first week of the second quarter, breaking a three-week winning streak. While the year-to-date market has been strong, it has been driven largely by a small group of names. Just 20 (mostly technology-focused) companies have accounted for 90% of the gain, echoing the market behavior seen through much of the post-financial crisis period. That said, the 7% gain in the first quarter represents the 17th-best start to the year since World War II. In the previous 16 occurrences, the S&P 500 finished positive for the year each time, by an average of 26%.
The equity and bond markets continue to provide conflicting signals on the economy, with the bond market pricing in a recession and the equity market more consistent with a soft landing. The equity market is flirting with the best level since August on optimism for a soft landing and Fed pivot, while the 10-year Treasury yield dropped to the lowest level since September on a flight to quality and expectations for the Fed to need to aggressively cut rates. Volatility has moderated in the equity market, with the VIX below 20 for eight consecutive sessions, while the MOVE Index (a measure of bond market volatility) remains near historic highs. There is also a dichotomy between the Fed’s guidance on rates, which suggests the threshold for cuts is high, and the Fed Futures curve, which embeds three cuts between May and next January and a rate below 3% by the end of 2024 (currently 5%).
Investors will closely watch earnings this week, especially on Friday when several global banks report their results. It’s unlikely banks will beat estimates because there’s little incentive to do so – they also have more earnings flexibility than just about any sector. Market reaction to this week’s earnings will determine whether we’ve priced in a recession. An up market, despite bad earnings, is a good signal for future growth.
The economy continues to provide mixed signals between a soft and hard landing. Last week, PMI and ISM data disappointed, following a period of acceleration in expectations for services and manufacturing. Commercial bank lending dropped nearly $105 billion in the last two weeks of March, the largest decline on record, as banks choose to retain capital and loan demand wanes. The commercial real estate market is a significant area of concern, with nearly $1.5 trillion of debt due through 2025, with Morgan Stanley estimating that office and retail property valuations could fall 40%.
March payrolls were in line with expectations at 236,000, a slowdown from the reading of 326,000 in February as the pace of hiring slows. The unemployment rate fell to 3.5% despite an increase in the labor force participation rate. Wages continue to moderate, with average hourly earnings up 4.2% from a year ago, the slowest pace since June 2021. Strength was seen in leisure and hospitality health care, government, and professional and business services, while retail and construction contracted. Dynamics in the job market are shifting however, with the JOLTS job openings report showing the fewest job openings since May 2021 and Challenger data showing job cuts up 319% from a year ago.
This week unofficially begins first-quarter earnings season, with a current estimate for a decline in earnings of 6% on 3% revenue growth. The 6% deterioration in the estimate through the quarter is nearly double the long-term average. Notable weakness is expected in materials, health care, technology, and communications, while consumer discretionary and industrials are expected to grow. Investors will be focused on management commentary around global macro conditions, inflationary pressures (including wages), pricing power, and consumer behavior. Significant pessimism is embedded in the estimates, though macro data in the first quarter has largely outperformed expectations, with the Atlanta Fed’s GDPNow model forecasting growth of 1.5%.
What to Watch
Another significant week of data is ahead of us, highlighted by March CPI on Wednesday and PPI on Thursday. Other notable releases include NFIB Small Business on Tuesday, and retail sales, industrial production, and consumer sentiment on Friday. The minutes from the recent FOMC meeting will be released on Wednesday.
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Merrill Lynch Volatility Estimate Index: a well-recognized measure of U.S. interest rate volatility that tracks the movement in U.S. Treasury yield volatility implied by current prices of one-month over-0th-counter options on 2-year, 5-year, 10-year and 30-year Treasuries.
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