Weekly Market Update:

by Michael Reinking, CFA - Sr. Market Strategist

Today was the official close of Q3. It has been a treacherous environment for financial markets throughout 2022 and this quarter encapsulated that. The quarter began with a sharp rebound as the S&P 500 rallied ~19% from the mid-June lows. A better than feared earnings season helped equity markets stabilize but it was hope that inflation was peaking and that the Fed was getting close to being done with its tightening cycle that propelled stocks higher.

However, that rally stalled in the middle of August almost exactly at the declining 200d moving average. The downside momentum accelerated at the end of August following a uncharacteristically blunt and direct message from Fed Chair Powell at his Jackson Hole address where he declared his war on inflation would be unwavering, and would likely lead to "pain" within the US economy. Markets aggressively re-priced Fed hiking expectations but even those didn't keep pace with what was projected in last week's Dot Plot. This swift repricing led to sharp moves higher in yields and the US dollar index which have been weighing on equity markets (see tables). 

Coming into this week the S&P 500 had fallen in 5 of the last 6 weeks with four of those declines exceeding 3%. This had put the index into deeply "oversold" short-term technical readings which had many looking for a snap-back rally. However, last Friday there was a warning shot across the bow. In the UK a sweeping fiscal package was proposed which had sent the Pound sharply lower and local yields surging. When wrapping up last week's note and discussing the environment I quoted Robert Frost saying, ""the best way out is always through". That is where we are and we'll need to take the medicine and hope that there is nothing that breaks along the way."

One of the big themes of the year has been the return of volatility across asset classes. Equity volatility is one thing but when it spreads to currencies (Chart 1 from ESRB Risk Dashboard but dated) and fixed income markets (Chart 2), like we've seen recently, that becomes a completely different animal which is what had my spidey senses on high alert last week. The thing about volatility is that it exposes leverage in the system, which is exactly what happened in the UK this week. The list of countries that have been forced to intervene in either fixed income/currency markets continues to grow adding the UK and China to Japan, Korea and Taiwan.

According to the FT, UK pension funds have deployed "about £1.5tn of assets, which is about two-thirds of the UK’s GDP, or the size of the entire gilt market" into an investment strategy known as Liability Driven Investments (LDI) which in theory help funds manage risk in meeting future pension liabilities. Toby Nagle's articles provide a bit more background but to oversimplify within these investment strategies there are interest rate derivatives which are backed by long gilt collateral. So as gilts sold off sharply this was creating large margin calls for pension funds, forcing additional sales which caused the BoE to step in to restore market function.

For those of us who still have PTSD from the 2008 episode, when you start to hear about three letter acronyms for highly levered derivative investment products it makes the hair on the back of your neck stand up. The concern about the last week's events is that this is yet another canary in the coal mine, signaling things to come with the sharp move higher in rates impairing collateral in the system. Last week the European Systemic Risk Board issued a General Warning identifying three systemic risks one of which was exactly this scenario. Fed Vice-Chair Brainard also warned of these risks in the current environment in her speech today.

There have been multiple Fed officials speaking this week and none have suggested that this week's events were playing into their thinking about the future path of policy, but for everyone who has been looking for a Fed pivot be careful what you wish for. I will say there has been more discussion about the risks of overtightening coming in this week's Fed commentary.

The broader macro concerns have been wearing out the investment community but this week the micro news has not helped either. Recent corporate commentary at investor conferences had been reasonably sanguine about the environment. There have been a growing number of negative preannouncements over the last few weeks. Those have primarily been within materials and chemicals with most companies highlighting weakness coming out of Asia and Europe. The FedEx pre-announcement two week's ago increased concerns about the global slowdown. However, there was still hope that like Q2, earnings season could turn out to be another better than feared situation.

That seems less likely after this week's early cycle earnings, which were not good, with high profile misses by CarMax, Micron and Nike. The  common theme amongst the three was macro headwinds hitting demand leading to large inventory builds. This is primarily on the goods side but Carnival Cruise also had a revenue miss. Rent-A-Center, whose customer base tends to be on the low-end, also highlighted the macro environment that has been impacting "traffic and customer payment behavior".

The earnings cuts have started to accelerate with Q3 estimates now revised lower by 6.6% since the end of Q2 according to FactSet Earnings Insight, the largest cut since Q2 of 2020. 2023 estimates have continued to hold up but seem to be at risk only ~4% off their peak early this year.

We ended the week on a sour note. The S&P 500 ended at session lows off ~1.5% and was capped off by the largest quarter end closing auction in history with ~820ml shares trading. Total losses for the month of September were 9.3%, the worst decline since March of 2020. This was also the third consecutive quarter of declines for the first time dating back to the 2007 - 2009 timeframe (six straight quarters).

The one other thing I'd highlight from the action this week is that the market is now starting to shoot the generals. Apple was the last man standing and got hit for ~8%. Other defensive sectors have also started to come under pressure led by Utilities, which was the only sector outside of Energy, which was up YTD coming into this week which got hit by nearly 9% this week.  Consumer staples  was the next worst performing sector. This is the type of behavior you see as you progress through bear markets where there is nowhere to hide. Here is the updated chart which I had hoped to retire.

The three positive things the market has going for it are sentiment/positioning, short-term oversold conditions and the seasonal headwinds now become a tailwind.

Corporate spreads did widen out this week and there have been significant moves in corporate and sovereign CDS markets. Total return for the ICE BofA High Yield and Corporate Bond indices were -1.3% and -1.9% this week. I've also included the NY Fed Corporate Bond Market Index which was released this week (through 9/23). Overall levels have remained elevated with the most strain seen in investment grade markets.

Equities remain in a short-term oversold state with the RSI around 28.50. The post BOE Wednesday rally likely caught traders who were trying to catch an oversold bounce wrong footed. This was relief valve for some of that oversold condition and brought in fresh sellers who ultimately needed to stop out of those positions. Part of the issue is that the market is oversold short-term but longer term indicators are not confirming this. We did close right on the 200W moving average ~3,590. This did act as support during selloffs in 2016, 2019 and to a lesser extent in 2020.

Levels to watch:

Downside

3,505 50% Fibonacci Retracement of pandemic rally and level we broke out from post 2020 elections

3,400 High prior to Covid selloff

Upside:

3,636 June Low

3,720 this week's high

3,815 38.2% Fib.

3,900 this week's high and the declining 20d (~3,930)

Last Week

To start the week the S&P traded in a pretty tight range but was never able to reclaim 3,900 before trading sharply lower following the FOMC decision. The index did break other support levels on the way to testing the June lows today. The move lower has been swift and momentum has picked up to the downside with RSI hitting extreme levels (<30). This typically is a sign of exhaustion and could lead to a tradeable bounce. There was a little bit of a bottoming tail today, just like last week but once again not putting a lot of weight on that as it was a logical spot to try and get a little bounce. It does feel like we will need to undercut these lows first and the backdrop doesn't feel like one where you want to be a hero.

The VIX did touch YTD highs ~35 earlier this week and pulled back. It was interesting that the VIX did end lower today despite market weakness which could potentially just be people not wanting the Theta bleed over the weekend. It might also suggest the weakness into the close was more related to quarter end rebalancing. The overall market selling has been orderly thus far. Futures still signaling some strain but not extreme.

Last Week

Considering the backdrop the VIX has remained reasonably well contained there is a belief that is because positioning is so light and hence investors are not reaching for protection. It did break above recent highs this week ~28. Starting to see a little bit of stress in the futures market but it is not extreme. It does feel like we could get a volatility swell here.

10yr broke above 3.5% and surged to 4% before reversing on BoE announcement. One interesting thing is that we are not seeing a flight to safety bid show up here yet.

USD had a bit of a short-term reversal pattern at the upper end of the recent channel with an outside day on Wednesday following the BoE intervention. It had gotten extended short-term so a pull back is not surprising. Watching this week's low ~111.50 for some downside follow through. A retest of the recent breakout ~110 would not be surprising below that watch the rising 50d ~108.5. The list of interveners has been growing.

Last week

The uptrend has remained in place with the explosion higher in the back half of the week. This is a big area of concern from a macro perspective. This are still some negative divergences brewing on a shorter-term basis.

However, as we've highlighted on a long term basis this was an important move higher in March and then the full breakout in June. The long term target on that range break was to 118 and we've gone about 2/3 of the way there. On a monthly chart this is getting to extreme levels (RSI just under 80).

ICE Brent - No downside follow through after range break. It did bounce back to retest the low end of that range.  

Last week

After the inside week last week this failed at the 200d and finally broke to the downside. Initial targets on this break are to high 70's.

Nat Gas - This pulled back and tested the 200d but has held thus far.

Last week

This broke the key 7.50 level yesterday on inventory data and has accelerated lower. First target rising 200d ~6.43.

Gold - Some interesting action here. A little oversold bounce back to broken support with a bit of a positive divergence. Keeping an eye on this as it has really just become a dollar proxy so could give some clues.  

Last week

Just to adding back this week with the break of the key 1,675 level. This is not displaying the old flight to safety or inflation hedge characteristics as it has just become a dollar proxy. Look for 1,600 on the break here could potentially lead to much bigger move.

It is the kickoff of Q4. Central banks will remain in focus with rate decisions from Australia and New Zealand and a plethora of Fed speakers. The ISM surveys will be closely watched but next week is all about labor markets. JOLTS job openings will be released on Tuesday, the ADP Jobs Survey on Wednesday and the BLS Employment report on Friday. There are a couple other macro events to keep an eye on. On Sunday there are first round elections in Brazil with former President Lula da Silva leading in polls. That lead is projected to be big enough that there may not be a need for a runoff which could lead to a non-market friendly cabinet. However, the bigger concern centers around potential violence following accusations of election fraud. On Wednesday there is an OPEC+ meeting with expectations for a production cut of between 500k-1ml b/d. On Friday the Office of Budget Responsibility (OBR) in the UK is expected to released its first projections for the proposed fiscal agenda. Following this week's referendums Ukraine also remains in focus. Enjoy the weekend!

Have a great weekend!

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