STRAIGHT FROM THE TRADING FLOOR
by Michael P. Reinking, Sr. Market Strategist
Patricia Medina, Market Strategy Analyst
DOW 33,964 (-107), S&P 500 4,320 (-10), Russell 2000 1,777 (-5), NYSE FANG+ 7,334 (-3), ICE Brent Crude $93.83/barrel (+$0.53), Gold $1,945/oz (+$5), Bitcoin ~26.5k (-95)
Most major US indices fell for the third consecutive week. The negative seasonality that we highlighted coming into August has been playing out. Over that two month window the S&P 500 has fallen nearly 6%. The clouds historically tend tend to linger into early October before lifting in anticipation of the holiday season as we approach November.
This week was all about central banks with over 10 rate decisions. Markets have been on a treadmill where the focus shifts from the labor market data, to inflation data followed by the central bank response. Unfortunately that is a dynamic that is likely to continue for the foreseeable future as central banks take a data dependent approach (calendar of key eco data through year end below).
While rates did move higher there really wasn't a very big shift within Treasury markets as it relates to the expectations for the path of monetary policy going forward - things did just shift out a bit. Markets are now more split as to whether the Fed will hike rates in November or a later meeting and the first rate cuts have been pushed out to the September time frame from mid-year recently.
However, a further acceptance of the higher for longer message and the thought that the long run neutral rate may also be higher has put pressure on equity market valuations which led to this week's selloff. The S&P 500 was down just nearly 3%. Within the index sectors heavily weighted to tech/growth stocks, whose valuations are more sensitive to moves in interest rates, underperformed . The NYSE FANG+ index was down just under 5%. Consumer discretionary led to the downside sector with casinos some of the worst performing stocks after reported cyber attacks. Mounting concerns related to the consumer and housing affordability also weighed on stocks within this group. Defensive sectors like healthcare, consumer staples and utilities outperformed though all closed lower by >1%.
Most global indices also traded to the downside this week. Markets with the most exposure to the more rate sensitive technology sectors like Japan and Korea underperformed. The China Shanghai Composite/Hong Kong Hang Seng indices outperformed following a sharp rally overnight amidst reports the government was considering easing foreign ownership rules to attract capital and hopes of further steps by the government to stabilize the economy. This morning there was also an announcement that the US/China were forming working groups to address financial and economic issues, the most recent sign of thawing relations.
Central Banks/Economic Data
Most of the week was spent discussing the Fed and you can check out the Recap for a deeper dive.
As mentioned above there were a couple of other surprises this week but the biggest was probably the Bank of England. Coming into this week markets had expected a 25bps rate hike. However, the day before the meeting CPI came in better than expected and those odds began to shift dramatically. In a very close vote (5-4) the central bank decided to leave rates unchanged the first pause in nearly two years. There was one other interesting development as officials decided to ramp up the pace of its QT program to 100B£ from 80B£.
This is a reminder that the level of interest rates is only one aspect of monetary policy that is at work. and even if rates are at their peak (assuming inflation cooperates) - financial conditions will continue to remain restrictive.
There was some concern heading into last night's BOJ rate decision after Governor Ueda recently suggested that there could be evidence by the end of this year for the central bank to end its negative interest rate policy. However, last night he downplayed that during his press conference. Keep in mind the minor policy shift to widen trading bands for its 10y bonds was one of the catalysts that kicked off the most recent rise in global yields, as the anchor was being lifted (this also was the catalyst for equity reversal).
The data in the US this week continued to point to the resilience of the economy. Initial and continuing claims both fell to the lowest levels since January with initial claims testing 200k. Leading indicators continued its year and a half long streak of declines.
This morning's Composite PMI reading held just above the demarcation line of growth. Manufacturing continued to contract albeit at a slower pace. Services data hit an 8 month low with new orders declining. Hiring hit its highest level since May but it did sound like this was due to worker availability, which is not necessarily a bad thing from a Fed perspective as it show the labor market is moving back into balance. The prices components ticked higher driven by prices paid while the prices received remained more contained. This is becoming a more prevalent dynamic (highlighted in the Beige Book as well recently) and I believe this will become a bigger topic as we approach earnings season as it will pressure margins (more on this below).
For the week US yields were up about 10bps across the curve hitting the highest level since 2007, but we did back off a bit today.
The US Dollar Index was a touch higher this week. The Pound and Yen were the weakest following the dovish central bank actions.
There was a modest widening of credit spreads in high yield. US spreads widened more than both European/Emerging markets. Investment grade spreads actually tightened up a bit.
The Technicals Still Matter:
Since the initial upside breakout in early June the index has been trading in a range between 4,300 - 4,600. After the selloff into mid August the bounce attempt was never able to sustainably hold above 4,500 or its 50d moving average. The range had tightened up ahead of the Fed decision this week and as we took out the lows of the past few weeks (~4,425) the downside momentum picked up.
Yesterday the index gapped just below its 100d ma and couldn't muster a rally today. Equities are starting to get into slightly oversold short-term but not dramatically so as we approach the low end of the recent range. A break below 4,300 opens the door for a retest of 200d and the area we just broke out from around 4,200.
The VIX moved back into the high teens this week sitting right at the 200d and near the highs during the August pullback. Those gains held into the close on Friday which suggests we're not quite done here. If we start to push higher here things could get more dynamic bringing in some of that systematic de-risking we always talk about.
We hit cycle highs across the curve this week. We've been highlighting that technically yields were not looking they were ready to move lower and the patterns were calling for further upside especially at the long end. Focusing on the 10yr (purely from a technical perspective) this break above 4.3% suggests this could move up to ~5.25% (which would obviously be painful). Things got a bit extended short-term yesterday and there was a bit of a reversal day today. So let's see if there is any downside follow through. The key will be to see how this reacts to a pullback into the 4.15%-4.25% levels.
There was a test of the 20d this week but this was more of a sideways week. We'll have to see if this is a pause that refreshes to push us out of the range that has been in place throughout this year. The 200d and rising 50/100d around 103 should provide some support.
We've been pretty positive here since July and its since taken out the downtrend from last year's peak and broken out of the range which target a retest of those highs (~$100). We got a good portion of the way there trading up to ~96 this week before leaving a topping tail as this started to get overbought. Watch to see how this interacts on the pullback to the 20d ~91.
The focus for the last few months has really been on the macro with the list of concerns growing - higher oil prices, the restart of student loan repayments, labor strikes and the end of the disinflationary process. As mentioned above the data dependence of central banks keeps much of the focus on economic reports. However, in about a month we will get a reprieve from that and the focus will shift back to the micro from the macro. With the idea that rate cuts are a ways off that makes it more difficult for equity gains going forward to come from multiple expansion and puts the focus on the earnings side of the equation.
As discussed in this space before inflation has helped margins increase as companies were able to push prices higher to offset the increase in costs. Those price increases are getting harder to push through in the current environment and as we highlighted from the survey data above companies are facing a reacceleration in costs.
The airlines industry is a prime example. In the past few weeks multiple companies revised their guidance due primarily to the increase in fuel costs. This industry is one of the most levered to oil prices given the high correlation of jet fuel (~0.74) and that input costs is about 50% higher than it was prior to the pandemic. Granted many firms use options to hedge this volatility but this will likely keep air fair prices elevated going forward. Trying to pass on those costs to a consumer that is tightening the purse strings will also be difficult.
So if companies are facing higher input costs and can't increase price, how do they protect profitability? Focus on efficiency. We saw efforts by tech companies at the end of last year pay dividends and FedEx was another good example this week. Oftentimes that focus on efficiency leads to a reduction in headcount. I believe the labor market has been the key to the economic resilience so this will be a key going forward.
One last note on supply and demand. Like all things, S&D drive price and that along with confidence/emotions drive prices in financial markets. There are two dynamics that are currently at play on this front. In Treasury markets we've seen the increase in issuance to refill the TGA and fund deficits adding to Treasury weakness. We have also started to see a pickup of capital market activity with a big increase corporate bond issuance and over the last few weeks there have been a few high profile IPOs. As this paper comes to market unless investors are sitting on cash they have to trim other positions.
On the other side of the equation a combination of higher interest rates and a refocus of using cash flow for capital expenditures has caused Q2 share buybacks for companies in the S&P 500 to fall around 20% q/q. These buybacks have been one of the drivers of EPS growth and has also literally put a bid beneath the market. If this is the start of a longer trend the question becomes when does that capex spending start to bear fruit on the bottom line.
What's on Tap
Next week is the final week of the month and Q3 so be on the lookout for some portfolio rebalancing. The focus will be on the economic data with global inflation data in Australia, Europe and Japan. On Friday, PCE the Fed's preferred gauge of inflation will be released. Other economic data in the US include consumer confidence and durable/capital goods orders. China's PMI data on Friday will also get some attention. Labor strikes will continue to be in focus with some escalation of the UAW strike today though there are signs the writer's strike nearing an end. It will be a big week of Treasury issuance with over $125B of 2yr-7yr paper coming to market. We'll also start to get some very early cycle earnings reports. Have a great weekend! Let's GO PSU!