Markets retest lows as pessimism surges

Thoughts

• Equity market momentum reflects the near-universal pessimism of investors, with the S&P 500® Index falling in five of the last six weeks and briefly breaching the June low on Friday. Tightening global financial conditions is pressuring bond yields, with the 2-year Treasury yield at the highest level since 2007 and the yield curve at the most inverted level since 2000. As we head for quarter-end next week, the Bloomberg US Aggregate Bond Index is heading for the worst year on record by a factor of four, while the S&P 500 will likely be at the fifth weakest in return through three quarters since 1928.
• Market observers are searching for signs of capitulation, with equity markets retesting the June low. Equity indexes are at oversold conditions consistent with June, with only 4% of the S&P 500 companies above their 50-day moving average. There may be a light at the end of the tunnel, however, as September ends, as we enter the best seasonal quarter of the year and approach the midterm election that has historically led to strong gains over the subsequent six-month period. Additionally, market breadth and momentum indicators have broken down. The degree of pessimism by executives, consumers, institutional investors, and retail investors is at historic levels, potentially leading to a contrarian rally.
• From a contrarian perspective, there is reason to be as bullish as at any time in the past year. The things we were uncertain about in June in terms of potential capitulation are now confirmed. With a VIX at 32, the put/call ratio weekly average at 1.06 and a surge in outflows from retail funds, capitulation has likely begun. The indicators and investor sentiment have reached an incredibly negative level and although June didn’t look like a bottom, this does.

News

• Investors continue to digest the news from Wednesday’s FOMC meeting where the committee unsurprisingly hiked rates by 0.75% to a target of 3.0-3.25%. The statement was little changed from July, though the Summary of Economic Projections (“dot plot”) rose the median rate to 4.4% by year-end, implying that the Fed Funds rate will jump 1.25% additionally over the next two meetings. The terminal rate moved to 4.6% from 4.4%. In his press conference yesterday, Fed Chair Powell ominously used the concept of “pain” to describe the requirements to control inflation, including impacts on growth and employment. Despite the Fed’s insistence that they will remain vigilant in combatting inflation, the Fed Futures curve continues to embed a peak of rates next May, with one or two cuts predicted by the end of 2023.
• Expectations for global growth are deteriorating, with the Atlanta Fed’s GDPNow model now projecting growth in the third quarter of just 0.3%, down from the 1.5% expected two weeks ago. This suggests we may see the third negative quarter in a row, driving the odds of a recession higher. The trade-weighted dollar index has gained nearly 19% this year, with the euro well below parity with the dollar at $0.97 and the pound now down 20% year-to-date. This would solidly exceed the previous record of 2014 which saw a 13% gain.
• Concern over earnings growth is rising as we approach the end of the third quarter. The current estimate predicts 3% earnings growth in the quarter, down from 11% expected at the end of May, largely on moderation in margin expectations, as sales are still expected to grow by 9%. There is substantial debate about the path of earnings for 2023, with the current estimate for 8% growth, driven by 4% revenue growth and a bounce in margins. Headwinds from the strong dollar and the implementation of the global minimum tax could be a drag of roughly 3%, while rising interest rates will dampen growth.

What to Watch

Volatility will likely remain elevated this week as institutions position around the quarter end. Economic data includes durable goods, consumer confidence, and new home sales on Tuesday, pending home sales on Wednesday, revised second quarter GDP, and PCE deflator (inflation metric preferred by the Fed) on Friday.

Dollar Discussion

• The dollar is an important topic of conversation, both in terms of what the move reflects and also what the impact will be. The dollar can be viewed as a relative bet on the U.S. versus the rest of the world and as a gauge of risk and fear built into the market. DXY is within 5% of the 2002 peak, which was a historic period of fear and uncertainty.
  • Pound is 1.08, approaching the record since WWII of 1.04 in 1985, with futures showing a 60% chance of breaking parity
  • The euro at 0.97 is the first time below parity since 2002
  • The yen is within 5% of the 1998 record
• The trade-weighted dollar index has gained nearly 19% this year, with the euro well below parity with the dollar at $0.97 and the pound now down 20% year-to-date. This would solidly exceed the previous record of 2014 which saw a 13% gain.
• Impacts:
  • Our current issue with inflation and interest rates would be much worse without the move in the dollar. The “safe haven” nature of the dollar acts to dampen interest rates, as money flows to the U.S. for safety. A strong dollar is deflationary, as we buy global goods more cheaply
  • The dollar is a headwind to earnings, both in terms of global competitive positioning of our goods and the translation effect on international profits.