Markets attempt a bounce on encouraging earnings

Thoughts

• Equity markets posted their best week since June, as better-than-expected earnings results and hopes for a Fed pause drove the gain. Despite historic levels of investor pessimism, the S&P 500® Index has shown 2% gains in six sessions in the past month in an effort to bounce. This is similar to the market behavior near the bottoms in 2002, 2009, 2011, and 2020, reflecting the willingness of institutional investors to dip their toe back in the water.
• There has been a melt-up in bond yields, with the 10-year touching 4.30% Friday, up nearly 0.70% from earlier in October before retreating modestly. The move is largely in reaction to a recalibration of Fed rate hike expectations, with the terminal rate up to 5% in May, up half a point from a month ago. The Fed Futures curve embeds a 50% chance of 0.75% hikes in November and December, with a 50% chance that December sees a slowdown to 0.50%. The Fed has moved into a blackout period ahead of the November 2 FOMC meeting. The bond market this year has been subject to the emotional swings generally observed in the equity market. Bonds are currently sending mixed signals, with surging rates and volatility (as measured by the MOVE Index) at the highest level since the financial crisis, while spreads and stress metrics are more normal.
• We are now entering a stage where all signs point to a recession – assuming we aren’t already in one. However, that doesn’t mean the markets aren’t a step ahead. On average, we see a 30% price drop during recessions, which is only 5% the decline of values we’ve already witnessed in this bear market. The recession may already be priced into the markets, in which case the next bull run may be faster and come earlier than many investors expect.

News

• Earnings season is roughly one-fifth complete, with 72% of companies beating earnings estimates and 70% reporting a revenue surprise, though the degree of beats is well below average. The positive reactions to results, however, indicate the pessimism priced into the market. Growth is trending at 2%, which would be the slowest quarter in two years. Themes from the quarter include a healthy consumer, rising macro uncertainty, easing supply chain backlogs, and a slowdown in housing. Margins are contracting from the second quarter on continued inflation and wage pressure, though profit margins remain well above the historic average. Margins are currently forecast to accelerate each of the next three quarters, which has many observers skeptical.
• Bloomberg data puts the odds of a recession over the next 12 months at 100%, with the global economy in tougher shape than ours, as indicated by the strength of the dollar. The yield curve (spread between the 10-year and 2-year) remains inverted, and the index of leading indicators was negative for the second month, suggesting a recession is on the way. PMI data reflect the global slowdown, with eurozone composite PMI well into correction territory at 47.1, with deceleration in manufacturing (46.6) and services (48.2). Results in the U.K. reflect the recent political and financial market disruption, with a collapse in business confidence and the manufacturing and services sectors in correction territory. China’s third-quarter GDP beat estimates but remains sluggish, as President Xi secured an unprecedented third term while imposing Covid lockdowns in the manufacturing hub of Guangzhou.
• Institutional investors remain at historic levels of defensiveness, with cash levels (6.3%) at the highest level since 2001, and the underweight to equities is at three standard deviations per Bank of America data. Global growth expectations are a net -72%, near the lowest on record, with financial market stability risk metrics at an all-time high and earnings expectations at a record low. CIOs are encouraging CEOs to reduce debt (60%), increase cash (17%), and increase buybacks and dividends (17%). The most crowded trades are long the U.S. dollar, short E.U. equities, and long ESG assets.

What to Watch

Earnings season will dominate the news this week, with one-third of the S&P 500 companies reporting and many high-profile technology names. Economic data include PMI data Monday, consumer confidence on Tuesday, housing starts on Wednesday, durable goods and third-quarter GDP on Thursday, and consumer sentiment, personal income and spending, and the ever-important PCE deflator on Friday.