Equity markets look to rebound following a three-week losing streak that has erased more than half the year-to-date gain. The initial optimism over a Fed pivot has shifted following strong economic data, elevated inflation, and hawkish Fed commentary, sending interest rates higher and valuations lower. The short-covering rally has stalled, as pessimism remains near-universal for institutional investors, and a surge in rates drove skepticism over valuations. Retail investors had a rare week of outflows, as momentum and confidence faded.
A pause was natural following a strong start to the year, though the lack of negative move in both equities and bonds has echoes of the first half of last year. Bond investors continue to trade with the volatility and emotion historically seen in equity markets. The terminal rate for Fed Funds eclipsed 5.4% in September, 0.50% higher than a month ago. The 10-year is approaching 4% for the first time since November, while the 2-year yield hit the highest level (4.8%) since 2007, and the MOVE Index (measuring bond market volatility) has surged this month. This, along with the sharpest contraction of money supply on record, has caused a tightening of financial conditions, reinforcing the cautious comments from many Wall Street strategists. Bulls continue to point to a resilient consumer and strong job market. Earnings revisions will continue to be critical, though the pace of deterioration has slowed notably.
The pendulum is starting to swing back to pessimism as we head into a predictably weak period in the market. Given the inconsistent behavior in January and February, the pullback from institutional investors following last week’s PCE number is to be expected. This week, retail earnings will be an important telltale sign of consumer health. The three things investors should watch for are consumer demand for goods and how they’re paying for them, supply chain and labor issues improving, and pricing power coming to a balance after a long period of heightened inflation.
An economic release on Friday was a reminder of the current economy’s strength and the challenge the Fed continues to face in controlling inflation. Compared with a year ago, spending, income, and inflation all accelerated in January. Income growth was at the strongest pace since December 2021, and real income was positive for the first time in over a year. Inflation rose to 5.4% from a year ago versus 5.3% in December, and the 1.6% month-over-month growth is the fastest pace in nearly two years. The odds of a recession are still elevated, though Bloomberg’s Recession Probability Forecast declined this week for just the second week since May 2021 to 60% over the next year. The Citigroup Economic Surprise Index surged to the best level since last April, gaining 60 points since mid-January, with data that measures current activity remaining strong, while survey-based and leading data are weak.
The relationship between U.S. and China continues to be strained on multiple fronts as the U.S. prepares to send more troops to Taiwan. Tensions rose following the shooting down of a Chinese balloon that the U.S. considered a spy balloon, but China claims was an off-target weather balloon. Strain also exists surrounding China’s call for a ceasefire between Russia and Ukraine despite comments from President Biden and Secretary of State Blinken that China will supply Russia with weapons. Last week, China sanctioned Lockheed Martin and Raytheon for arms sales to Taiwan and banned the use of the Big 4 U.S. accounting firms. The U.S. Energy Department has determined that a lab leak was the most likely source of the Covid-19 pandemic, potentially further complicating the relationship. The deterioration in the relationship will put structural pressure on margins and inflation, as globalization has had a deflationary impact for decades.
Share buybacks are back in focus following comments from Warren Buffett at Berkshire Hathaway’s annual meeting, saying repurchases boost per share intrinsic value. Buybacks have added 1% to earnings growth annually over the past decade. Buybacks are estimated to top $1 trillion this year, with a record level of authorizations in the first six weeks of the year. The bulk of activity is seen in the technology, financial, and energy sectors, where cash flows are elevated and a cloudy macro picture has limited management willingness to engage in capital spending. Bank of America data shows that corporate clients have repurchased about $14 billion this year, ahead of last year’s pace and more than offsetting selling pressure from institutional and retail clients.
What to Watch
A broad spectrum of economic data is on tap for this week, including durable goods and pending home sales on Monday, consumer confidence on Tuesday, PMI and ISM data on Wednesday and Friday, and quarterly productivity on Thursday. Volatility could be elevated given end-of-month positioning.
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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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