Markets pause as geopolitical tensions rise

Thoughts

• Investors look for a rebound in equities following the second weekly decline of the year, as bulls and bears debate the path forward for markets. The S&P 500® Index fell roughly 1% last week but remains up 7% this year and up 14% since the end of September. Bond investors are equally conflicted, following a 10% bounce in corporate bonds since October’s bottom, though the 10-year Treasury yield is at the highest level since early January.
• Institutional investors and Wall Street strategists remain highly skeptical of the strong market rally since September. Morgan Stanley’s Wilson says, “Price is about as disconnected from reality as it’s been during this bear market.” The average strategist target for the year-end S&P 500 price is 4,050 (2% lower than the current level), with Wilson at 3,900, down 4%. While institutional investors remain pessimistic, hedge funds have aggressively covered shorts and allocation funds have lessened their underweights. Retail investors continue to be more enthusiastic than institutional investors, with the AAII Sentiment Survey showing bulls at the highest level since December 2021 at 38%, and bears down to 25%, the lowest since November 2021.
• While big tech led the market rally in 2023, the sector is in for a reality check. For the last three decades, major industries – e.g., financials, healthcare, manufacturing – have all been in a winners and losers world with aggressive competition for market share. We might have reached the point where the tech industry has matured enough that companies within it will need to start competing more aggressively with each other and focusing more on efficiency and financial management – that’s a new reality for investors (Exhibit A: “The AI Wars”) and something they need to consider.

News

• Economists expect inflation to continue to moderate with the announcement of consumer price inflation on Tuesday. The consensus estimate is for 6.2% growth from a year ago, versus 6.5% in December and a peak of 8.9% in June. The easing of inflation pressure is driven by core goods, including autos, with shelter becoming less of a drag. The metric remains elevated, however, due to services, which are increasingly impacted by wage pressure. Investors are likely to react due to the perceived impact on Fed policy, though Fed officials tend to prefer the PCE deflator as an inflation metric.
• The prospect of a soft landing is increasingly being discussed, with a “no landing” scenario being debated given the reacceleration of economic data and normalization of inflation. The optimism has driven the implied Fed Funds terminal rate (derived from the Fed Futures curve) to 5.2%, up from 4.8% at the beginning of February. The historic “canaries in the coalmine” that have accurately predicted recessions remain stressed, with the inversion between the 10-year and 2-year Treasury yields at the most extreme in 40 years, and the index of leading indicators negative on a year-over-year basis negative for the past six months. The data, however, do not reflect an impending recession, with the Atlanta Fed’s GDPNow model forecasting growth of 2.2% in the first quarter versus the consensus of economists that is at 0.0%.
• Geopolitical tension is ramping on news that the U.S. shot down four flying objects over U.S. and Canada in eight days. The Biden administration is targeting Chinese companies over their links to the balloons, while Chinese officials deny that they were spy balloons. China announced it is preparing to shoot down an object flying over a naval base, noting that the U.S. has sent more than 10 similar devices over China’s airspace since the beginning of 2022.

What to Watch

• Inflation will be in focus this week, with a reading on consumer price inflation on Tuesday and producer price inflation on Thursday. Other notable releases include the NFIB Small Business Index on Tuesday, retail sales and industrial production on Wednesday and the index of leading indicators on Friday.