Markets resilient in face of slowing fundamentals

Thoughts

• Equity markets continue to march slowly higher despite weakening fundamental data, with the S&P 500® Index gaining in five of seven weeks and finishing at the second-best level of the year. April’s 2% return was the fifth gain in the past seven months, with a return of 16% since September. The 9% return through April is impressive, though the performance continues to be top-heavy, with seven technology-focused companies (Apple, Nvidia, Microsoft, Meta, Alphabet, Amazon, and Tesla) accounting for roughly 80% of the return of the S&P 500. The market cap-weighted index is beating the equal-weight S&P 500 by the most extreme level since 1999. We will now test if the market cliché of “sell in May and go away” holds, with the next six months being the worst seasonal period dating back to World War II.
• Investors will be acutely focused on the FOMC meeting next week, with the Fed Futures curve embedding an 85% chance of a 0.25% hike. This was reinforced by a slightly hotter-than-expected reading of core PCE inflation on Friday. At this point, the market expects the Fed to pivot, with a 62% chance of no move in June, a 28% chance of one more hike, and a 10% chance of a cut. If 5.25% is indeed the terminal rate, the cycle would have seen 5.00% in hikes over 15 months, the fastest pace in 40 years, bringing the rate to the highest level since 2001. The Fed is walking a delicate tightrope in raising rates with a slowing economy, disruption in the banking sector, and tightening financial conditions. On the day of the past 19 FOMC meetings, the S&P 500 has been positive in 10 and negative in nine. The weekend news of JPMorgan Chase acquiring First Republic Bank is likely to settle markets but is also a reflection that the Fed has more ways to impact the economy than just with interest rates.
• We are seeing a bifurcation between the success of big tech in the market and the lack thereof for other industries. This is concerning as investors are beginning to overly rely on a small number of tech names. SoftBank’s Arm filing for an IPO is just an example of this. Although it may seem like an opportunity to inspire the IPO market, it is unlikely to do much of anything other than ignite the narrow part of the market that has already been leading – tech.

News

• First-quarter earnings have largely surprised to the upside, with the S&P 500 trending towards a 4% decline from a year ago on 3% sales growth. Of the more than half of S&P 500 companies that have reported, 82% have printed upside surprises per Factset, ahead of the historic average of 77%. The large technology space was the big winner last week, led by strong results at Microsoft and Meta (Facebook’s parent). Overall results are 7% better than expected, though that slightly lags the 8% historic average. Themes include strong pricing power, healthy consumer spending, and a recovery in housing and autos, though there are clear signs of an economic slowdown.
• Economic data continues to send mixed signals, though the pattern clearly shows slowing. First quarter GDP rose at a 1.1% annualized pace, weaker than the 2% estimate and down from the 2.6% pace in the fourth quarter. Estimates show continued slowing in the second quarter and negative in the third quarter, with the overwhelming consensus for a recession in late 2023 or 2024. The core PCE index rose 4.6% from a year ago, slightly higher than the 4.5% consensus, roughly equal to the level seen in the previous three months. The headline PCE index (including food and energy) rose just 4.2%, down sharply from 5.1% in February. Personal spending data reflects a still healthy consumer, growing 6.2% from a year ago, while personal income rose a strong 6.0%. The personal savings rate increased to 5.1% from 4.8%, the fastest pace since 2021.
• The House passed the GOP’s debt limit bill in an opening bid to spur negotiations with the White House, raising the debt ceiling and cutting $4.8 trillion in spending over the next decade. President Biden has continually said that he will only pass a “clean” debt limit increase, refusing to negotiate on spending cuts. This bill will have little chance of passing the Senate, though there are at least three Senate Democrats that favor negotiating with the House. There is no clear deadline for when the US will default, though analysts estimate it is in June or July. Credit default swaps to protect against default over the next 12 months have surged from 0.15% to 1.76% since the beginning of the year. In a similar fight in 2011, the S&P 500 fell 19% between May and October, losing 12% after the deal was signed on the US debt downgrade, the EU debt crisis, and other macro challenges, though there was an impressive 28% rally through the following May.

What to Watch

• The FOMC meeting will likely take the baton from earnings as the primary focus of investors this week. Data this week includes PMI manufacturing on Monday, durable goods and JOLTS on Tuesday, PMI Services on Wednesday, quarterly productivity on Thursday, and the monthly payroll report and consumer credit on Friday.