Equity markets broke out of an extended period of slumber, with the S&P 500® Index jumping to the best level since August, delivering the first directional move over 1% for the first time in seven weeks. Markets were able to rally despite the overhang from the debt ceiling, with the deadline nine days away. The Index has now returned 10% for the year and 9% over the past 12 months, though the year-to-date rally has been dominated by the largest eight tech firms that have averaged a return of 41%.
Bulls and bears have wildly different perspectives in the current environment. Bulls point to the better-than-expected consumer data, settling of the disruption in the banking sector, and the contrarian benefit of near-universal pessimism. Sentiment indicators continue to reflect substantial bearishness among retail and institutional investors, economists, and Wall Street strategists. Positioning data show large-cap funds with the lowest beta in a decade, CBOE Skew data showed downside protection positioning at the highest level since 1990, institutional money market assets are a record $3.4 trillion, and allocation to bonds is at a 14-year high. Bears note a higher-for-longer Fed, softening macro data, uncertain geopolitical risks, and deteriorating valuations.
Below the surface, there’s underlying excitement carrying us into this week: 1) The markets broke out from a well-defined trading range to the upside, and moved higher on Monday as traders await continuing debt ceiling negotiations, 2) there’s momentum behind that rally despite the onslaught of bad news – from the risk of a default, rapidly changing expectations of Fed policy, geopolitical uncertainty and more, and 3) anecdotally, we’re starting to see the pendulum shift from universal pessimism to neutrality as Wall Street strategists eye the technicals, which matter more than fundamentals at inflection points. The caveat, of course, is the heavy reliance on a small number of big tech names. For a rally to be sustainable, we need to course correct.
Negotiations continue in D.C. on the debt ceiling less than two weeks ahead of the X date identified by the Treasury Department. The White House is willing to discuss the work requirement for Medicaid being pushed by the GOP, and both sides seem to agree on raising the debt ceiling into 2025 in exchange for caps on discretionary spending, repurposing unused Covid relief funds, and easing the energy permitting process. Despite significant hurdles and internal factions within both parties likely to push back, the goal is to negotiate a deal by Sunday and hold a House vote next week, despite talks breaking down on Friday. The Treasury Department has been spending down its Treasury General Account to support the market with liquidity in recent weeks, adding $188 billion in net liquidity over the past three weeks, per Strategas.
Expectations for Fed policy are adjusting in real-time, as encouraging economic data is raising hopes for a soft landing. The Bloomberg Economic Surprise Index is at the best level since January 2022, while the Atlanta Fed’s GDPNow model points to second-quarter growth of 2.9%. The odds of a rate hike in June increased to 40% Thursday, compared with a 5% chance of a cut following this month’s FOMC meeting. The current outlook is for a net two rate cuts through next January, two less than was expected two weeks ago. A wave of Fedspeak came this week, with Dallas President Logan and St. Louis President Bullard saying that data over the next few weeks could support an additional hike in June. Chair Powell’s speech on Friday stressed the commitment to returning to the 2% inflation goal, and that tighter financial conditions are likely to weigh on economic growth and jobs.
First-quarter earnings season has mostly concluded, with a wave of retail earnings this week. Results were considered an upside surprise, with 78% of companies beating estimates by an average of 7%. Margins surprised to the upside due to easing input cost pressures, with the lowest number of companies citing “inflation” in their conference calls in nearly two years. Margins will increasingly be the story, with significant operating leverage expected next year (5% revenue growth resulting in 11% earnings growth), driving margins higher by 1% to a record high.
What to Watch
An interesting week of data awaits, providing a view into multiple aspects of the economy. We get PMI data and new home sales on Tuesday, revised GDP, and pending home sales on Thursday, and the PCE deflator (the inflation metric preferred by the Fed), personal income, and personal spending on Friday. The minutes from the May FOMC meeting will be released on Wednesday.
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