Shifting sentiment continues to drive market rebound

Thoughts

• Equity markets continue their impressive rebound, with the S&P 500® Index on a four-week winning streak (longest since November) and has now regained more than half of the year-to-date loss since mid-June. The technicals of the market have sharply reversed, with more than 90% of the S&P 500 companies above their 50-day moving average (best since April 2021), less than two months after 90% were below, a historically strong omen for forward returns. Recent market activity has been characterized as “risk-on,” with the Russell 1000® Growth Index outperforming the Russell 1000® Value Index by nearly 5% (+14.7% versus +9.9%) in the past month, while small caps have beaten large caps by a similar margin.
• There has been a notable shift in investor sentiment, with the Investor’s Intelligence poll showing 44.4% bullish versus just 27.8% bearish. Bulls point to peaking inflation (gas prices below $4.00 versus above $5.00 in June), improving supply chains, cooling housing prices, encouraging second-quarter earnings, and a strong jobs market. Institutional investors and hedge funds remain conservatively positioned, share buyback activity will accelerate as earnings season ends, and companies front-run the excise tax next year. Bears point out that inflation remains historically high, valuations are above historical averages with risk to 2023 earnings, and retail investors have yet to have a capitulation moment.
• This year has been a strong reminder of the power of sentiment. Underneath the surface, we’re seeing a decline in the S&P 500 of only 4% from a year ago – a noteworthy recovery if you consider the rapid slowdown in economic activities, decades-high inflation, earnings headwinds, and negative real wages. While we continue to be in a period of confusion, sentiment is shifting rapidly as the markets swing positive. Historically, this kind of momentum has durability.

News

• While investors are becoming increasingly sanguine on the prospects for a soft landing in the U.S., global growth continues to exhibit signs of stress. China’s economy unexpectedly weakened in July, as continued Covid pressure impacted consumer and business spending. Leaders are hedging on their target for GDP growth this year of 5.5%, while unexpectedly cutting a key policy rate as protests and mortgage-payment strikes intensify ahead of President Xi’s election for a third term. In Europe, a Bloomberg Survey of economists now has the odds of a recession in the next year in Germany at nearly 60%.
• The University of Michigan reading on consumer sentiment saw an impressive bounce in August to 55.1, ahead of the 52.3 consensus and solidly higher than the record low of 50.0 in June. Next week will give additional clues on the health of the consumer, with housing data and retail sales. Existing home sales are expected to fall by more than 14% from a year ago, as high prices and rising mortgage rates impact affordability. The Case-Shiller Index showed home prices surge 30% between the beginning of the pandemic and last December, a more rapid pace than leading into the financial crisis. Additionally, earnings reports from Walmart and Target will detail the current state of the consumer, along with an update on inventory, discounting, and margin headwinds that were described last quarter.
• Investors reacted enthusiastically to the readings on consumer price inflation (CPI) and producer price inflation (PPI) this week, as expectations for Federal Reserve rate hikes were quickly adjusted. The Fed Futures curve went from a 70% chance of a 0.75% hike in September to a 70% chance of a 0.50% hike in the past week. Inflation data was better than feared, though much of the decline was due to energy prices, with food prices and shelter remaining stubbornly high. Headline CPI rose 8.5% from a year ago but was flat versus June, while core CPI (excluding food and energy) was up 5.9% year-over-year and 0.3% sequentially. While investors are encouraged by the improving trend, flat readings on a month-to-month basis through year-end would only bring the year-over-year reading to 6.3% by December. This suggests that the Fed Future’s curve embedded expectations for rate cuts in the Spring are ambitious.

What to Watch

• Economic data this week will focus on the consumer, including housing starts on Tuesday, retail sales on Wednesday, and existing home sales on Thursday. Other data include industrial production on Tuesday and leading indicators on Thursday. The minutes from the recent FOMC meeting will be released on Wednesday.