Markets bounce, though trends remain difficult

Thoughts

• Equity markets are attempting a rally from bear market conditions, with the S&P 500® Index gaining over 6% since mid-June. Little positive news has accompanied the bounce other than the realization that the “pendulum” of sentiment may have swung too negative. Emotions remain high, with 2% daily ranges in seven of the past 12 sessions. For the year, it has happened in 42% of sessions, compared with 5% of days last year. Despite the painful market, the current level of market P/E, unemployment rate, and high-yield spreads are substantially better than previous market bottoms, per Strategas.
• Investors have subtly shifted their attention from inflation to recession fears. The switch is particularly notable in the bond market, which is beginning to price in decelerating inflation and rising recession odds. The 5-year breakeven inflation rate (derived from the TIPS market) fell below 2.5% last week from a high of 3.6% in March. The Fed Futures curve continues to reflect aggressive rate hikes through year-end, but the curve has begun to price in rate cuts in 2023, and the spread between the 10-year and 2-year is negative, suggesting a recession is near. Bloomberg data shows the probability of a recession over the next 12 months at 38% and over the next 24 months at over 98%. The Atlanta Fed’s GDPNow model forecasts second-quarter GDP to fall by 1.2%, which would be the second quarter in a row with negative growth, though a recession isn’t official until the National Bureau of Economic Analysis (NBER) makes the determination.
• Expect any recession in the US to be quick and less painful than previous large-scale recessions. Because fundamentals remain solid and markets love the gridlock that follows a midterm election, we see a calmer outlook ahead. Twelve months from now, today will probably have looked like a good buying opportunity, but the path to get there will be choppy.

News

• Bulls continue to cling to earnings as a primary driver of optimism, as revisions for 2022 and 2023 have yet to reflect the elevated recession fears. Earnings season unofficially kicks off next week, led by reports from several high-profile banks. Second-quarter earnings are expected to grow 6% on 11% revenue growth, suggesting margin compression. Estimates have been remarkably resilient given the anecdotal warnings from several companies, deteriorating macro data, continued input cost and supply chain pressures, and a headwind from the dollar. Goldman Sachs expects estimates to gradually moderate, with margin pressure expected to bring growth in 2023 down to 0% from the current estimate of 10%.
• Payrolls grew by 372,000 in June, well ahead of the 275,000 expectations, but down slightly from 384,000 in May. Growth was led by education/health services (+96k), professional/business services (+74k), and leisure/hospitality (+69k), while retail was the weakest (-44k). The unemployment rate held steady for the fourth straight month, while the labor force participation rate unexpectedly dropped to 62.2% from 62.3%. Wages grew at a better-than-expected pace of 5.1% versus a year ago, though the rate was decidedly negative on a real basis. The strength of this report is at odds with initial unemployment claims at the highest level since January and is not consistent with the broad weakening of economic data.
• Noted Fed hawks, Governor Waller and St. Louis President Bullard, both backed a 0.75% hike at the FOMC meeting on July 27, downplaying inflation fears. “We need to move to a much more restrictive setting in terms of interest rates and policy, and we need to do that as quickly as possible,” Waller said Thursday. The Fed Futures curve embeds a 92% chance of a 0.75% hike in July to 2.5%, and a median target of 3.5% by year-end. The curve begins to embed a cut in the Fed Funds rate by the middle of 2023 as investors are increasingly worried about a recession.

What to Watch

Inflation is back in focus this week, with readings on CPI on Wednesday and PPI on Thursday. Other interesting data points include the NFIB Small Business Index on Tuesday, the Fed’s Beige Book on Wednesday, and retail sales, industrial production, and consumer sentiment on Friday. Earnings season also unofficially begins.