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- Equity markets remain choppy with a lack of clear momentum.
- Next week's start of the earnings season should at least give us some trend.
- Financial stocks to open earnings season as per usual.
The first earnings season under the super-sized inflation conditions gets underway next week and will demonstrate just how well or poorly companies are able to deal with inflation. History shows us that for the most part, equities are actually a pretty good hedge against inflation, as companies push up prices in response to rising input costs. The early stage of an inflationary cycle is where equities tend to do best. After time, consumer sentiment sours, demand falls as prices rise, and so company revenues and margins suffer. But currently, we are at the early stage of this inflationary cycle, so we expect earnings to hold up. Next week kicks off with financials, who would usually benefit from rising yields anyway as this increases their net interest margin. The energy sector also should report huge numbers on the back of surging energy prices. So for now, we remain in the moderately bullish camp, albeit with some serious buffeting along the way. Headwinds to buffet, include some familiar themes from last year, supply chains, and semiconductor issues and now include energy costs also.
Unemployment is now below the long-term trend for the US and indicates that the US economy has now peaked. Again taking to the history books, once inflation tracks below the long-run average, a recession is usually about 12 to 18 months away. Again this is looking more likely and indeed Deutsche Bank nudged its forecasts of the US economy to recession before 2023 is out. The oft-cited yield curve inversion also usually indicates a recession within a year. This would be consistent with the Fed raising rates at probably one of the fastest paces in living memory and inflation running riot. Inflation is usually not contained by Fed policy but by recessions. Markets are forward-looking by nature and the macro investors are certainly worried. But for now, corporate earnings and corporate buybacks at record levels should just about be enough to avoid a bear market in 2022. 2023 however is a different case.
Sector performance
Defensive and value-orientated names led the way as investors increasingly took a cautious tone. Consumer staples (XLP) was the strongest sector of the week closely followed by healthcare (XLV) and utilities (XLU). Tech was the biggest loser (XLK) dropping 3% on the week. Momentum names (MTUM) once again lagged value stocks (VLUE) as wannabe Buffets continued to catch up and indeed surpass pandemic era gains from momentum.
Sentiment readings and financial conditions
The latest readings show financial conditions tightening somewhat. No surprise given the hawkish commentary from Fed officials and rising yields. The usual and oft-cited measures of sentiment have turned more bearish in the past week. The CNN fear and greed index has moved moderately but the AAII (American Association of Individual Investors) has shown a strong rise in bearish sentiment. This is despite a reasonable week for equity performance. Yes, the main indices will close lower on the week but moves were far from dramatic. But we did notice a strong move in the MOVE index, excuse the pun. This is the bond market volatility index, akin to VIX. Bond markets are nervous over how the US economy is going to react to markedly higher rates. The hawkish minutes and commentary from Brainard and Daly during the week only added to already stressed bond markets. Yields again were marked higher.
Source: AAII.com
Source: CNN.com
The various financial condition indices show financial conditions tightening across the country. The Goldman Sachs and Chicago Fed financial conditions indices both rose to the highest levels since 2010.
S&P 500 (SPY) price prediction
The S&P 500 (SPY) has retraced to the value area at $448 and is now choppy around this level with a serious lack of direction. The fact though that the double top at $458 was broken indicated that the market may be ready to progress. Earnings season could and should be this stimulus in our view.
Nasdaq (QQQ) price prediction
Choppy range trading is also the order of the day here but the index is technically weaker than the SPY above. The last rally failed to break $370 and QQQ remains in a choppy directionless range. This is unlikely to be resolved before big tech earnings in a few weeks. The underperformance versus the SPY is likely to continue early into the earnings season with financials and energy earnings likely to continue the outperformance for the SPY. Ultimately we expect earnings season to see $370 finally broken but again volatility will be a feature. This will be a harder trend to establish that in 2021.
The Nasdaq is often cited as the yield-sensitive index. It is correct of course that high-growth stocks will suffer more from higher rates. But real rates are more important. As we have discussed companies can raise prices more easily at the start of an inflationary cycle than at the end. Real interest rates (the prevailing interest rate – inflation) are running at all-time historical lows and are lower than after the 2008 crisis and have recently gone below the 1980 oil crisis rate. See the chart below.
US 10 Y yield – US inflation yearly
There is a strong correlation between the Nasdaq performance and real yields as shown below. The blue line is the inverse of the Nasdaq so when real yields go lower so does the inverse of the Nasdaq, ie stocks go higher. The .com bubble in 2000 sees the blue line soar, this is the Nasdaq bubble collapse, real yields were also moving higher and partially caused the panic. Currently, as mentioned real yields are at multi-decade lows and despite everything, the Nasdaq and S&P remain close to all-time highs.
Real yields (US 10Y – inflation), overlapped with a correlated Nasdaq inverse.
Earnings week ahead
The week ahead will finally see some clarity for equity markets with earnings season kicking off. As ever financial stocks lead the way and one expects these to normally benefit from a rising yield environment.
Source: Benzinga Pro
Economic releases
The highlights here will be the CPI data on Tuesday. Expectations are for another shocking rise in prices and this will then feed through to the Michigan Consumer Sentiment Survey on Friday. Higher prices will eventually lead to a retraction in consumer activity so it is just a matter of when.
The author is long GGPI and BABA and short Tesla.
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