Record high equities embed optimistic assumptions

Thoughts

• Equity markets remain remarkably resilient, with the S&P 500® Index, Dow and NASDAQ all managing to close at record highs last week despite increased volatility. The reflation trade continues to unwind as worries arise around peak growth in the economy and earnings, with growth continuing to gain versus value, small caps now lag large caps for the year, and emerging markets up just 2% for the year. Investors continue to lean towards a buy-the-dip mentality, though it is increasingly happening in the “security blanket” areas of leadership over the past decade (growth, large caps, and technology) rather than the pro-cyclical leadership from earlier in the year. Historically, deteriorating breadth is a negative sign for markets, but it has been less predictive in recent years as returns have been driven by a small group of names.
• Interest rates continued to drop, as growth concerns have replaced inflation worries in investors’ minds, with the 10-year briefly touching 1.25% last week before bouncing to 1.35%. The market could be tested this week, however, with $120 billion of issuance. Inflation expectations continue to moderate, with the 10-year Breakeven Inflation Rate down to 2.22%, the lowest level since March as investor fear shifts from inflation to a Fed policy error. Real yields (adjusted for inflation) are hovering around -1.0%, forcing investors further out the risk curve, at a time when yields on the high-yield index are at record lows.
• The equity and bond market continue to reflect two vastly different outlooks for the economy.

News

• Inflation will be in focus this week, with CPI on Tuesday and PPI on Wednesday, with the consensus estimate for CPI at 4.9% from a year ago. While the Fed has the market convinced the impact is transitory, economists are beginning to revise estimates. A recent WSJ survey showed an expected reading of core PCE (measure favored by the Fed) at 3.2% by the end of the year, and roughly 2.3% in 2022 and 2023. This three-year average of 2.6% would be the largest jump in nearly 30 years and well above the Fed’s 2% goal. This could force the Fed to raise interest rates earlier than guided data of 2023. Core PCE averaged just 1.7% between 1995 and 2019.
• Earnings season unofficially kicks off this week, led by reports from several large banks. Earnings for the S&P 500 are forecast to grow 64% from a year ago, marking the best growth since the end of the financial crisis. Upside to expectations is likely, as the assumptions underlying the estimates don’t fully reflect the economic rebound since last year. Upside earnings reports, however, do not guarantee boosts to stock prices, as healthy beats in the last two quarters resulted in modest moves. Given the current forward price-to-earnings ratio of 22x, the market embeds optimistic assumptions on the strength and duration of earnings growth.
• The Senate returns from a two-week recess today with a full docket before leaving again for a month in early August. Work continues on the $1.2 trillion bipartisan infrastructure deal, and leadership still has work to do to avoid a Republican filibuster. Democrats have been clear that they only support this bill if it is paired with a larger, partisan reconciliation bill that addresses domestic spending wishes. This all comes against a debt-ceiling and government funding fight likely in September.

What to Watch

• A busy week of data awaits, led by inflation data mentioned above. Other economic data include NFIB Small Business on Tuesday, the Fed’s Beige Book on Wednesday, industrial production on Thursday, and retail sales and consumer sentiment on Friday. Fed Chair Powell testifies to the Senate Banking Committee on Thursday.