An Unillustrated Rally
I hope this exercise will be useful. Here goes:
Everything that happened in the financial world while I was away fell more or less exactly in line with expectations. The Federal Reserve hiked by 75 basis points, as foreseen. The US gross domestic product number for the second quarter showed a second consecutive quarterly decline, as predicted by the Atlanta Fed’s own nowcast. That prompted a predictable and reasonable political debate over whether the US is already in a recession. Corporate earnings proceeded with few surprises of either a positive or a negative variety. The Personal Consumption Expenditure inflation print for June, an important but lagging indicator, refused to show any easing. It’s still rising, and subtler measures of core price pressures, such as the Dallas Fed’s trimmed mean PCE, confirmed that picture. June, according to the Dallas Fed, saw an increase in core prices of 6.9%. In June of last year, when the inflation scare was already under way, this number was only 2.5%
Beyond the strictly economic, there were again few surprises. The Ukraine conflict drags on, with the Russian position continuing to appear to strengthen; President Joe Biden continues to be knee-deep in political trouble, although arguably very slightly less than a few weeks ago. That’s in part because oil prices, and the all-important price of gasoline at the pump, are doing him a favor and falling for a change.
So, I didn’t miss much.
Rallies for the Ages
Except I did. Bear markets always include fierce “bear-market rallies” when it appears that all the selling is over and that it’s safe to take risks once more. They’re great ways to lure people in to losing more money. There’s a good chance that this will prove to be another one. But it’s now quite a surge. More importantly, the bond market is also rallying.
Last week was the best for the US stock market in more than two years. For the month as a whole, the S&P 500 gained 9.22%, with growth stocks beating value, while MSCI’s All-Country World index excluding the US gained 3.42%. As this would appear to show returning risk appetite, it’s odd that emerging markets didn’t join in, with MSCI’s benchmark index down slightly for the month.
As for bonds, Bloomberg’s aggregate for long Treasuries gained 2.67% last month, while 30-year US TIPS (inflation-protected) rose by 8.55%. That’s an awful lot in one month.
Longer-term trends remain intact. The S&P has shed 4.64% over the last 12 months, while the long bond index is down a stunning 19.22%. Its average return since 1926, according to the quants at AJO Vista in Philadelphia, has been a positive 5.5%.
This isn’t just about the US. In the eurozone, Italian bond yields have dropped from 3.64% to 3.01% in only six trading days. Anxiety about eurozone cohesion, rampant when the ECB announced that it was moving ahead with rate hikes, appears to have dissolved. Over the same period, German 10-year bund yields dropped from 1.395% to just below 0.8%. They’ve completed an extraordinary three-month round trip surging from 0.8% to 1.9% and back again, as the notion that inflation really could settle into Germany took hold and then dissipated.
Anyone investing on the basis of “risk parity,” aiming to balance stocks and bonds, has just had a great month, after a trying year. The US once more dominates returns elsewhere.
Why the excitement? The bond market seems to be positioned for a world in which the Fed brings down interest rates soon, while inflation also comes swiftly under control, all without damaging corporate returns enough to dent the stock market. Which brings us to the Fed.
What exactly happened at the Federal Open Market Committee meeting Wednesday to cause so much excitement? Here is the key paragraph from Fed Chair Jerome Powell’s statement. Emphases are mine:
Over coming months, we will be looking for compelling evidence that inflation is moving down, consistent with inflation returning to 2%. We anticipate that ongoing increases in the target range for the federal funds rate will be appropriate; the pace of those increases will continue to depend on the incoming data and the evolving outlook for the economy. Today’s increase in the target range is the second 75 basis-point increase in as many meetings. While another unusually large increase could be appropriate at our next meeting, that is a decision that will depend on the data we get between now and then. We will continue to make our decisions meeting by meeting and communicate our thinking as clearly as possible. As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.
Like Christine Lagarde of the European Central Bank the week before, Powell has now eschewed forward guidance in favor of following the data. As with Lagarde, this is more of an honest admission that the Fed doesn’t know what the economy is going to do next than anything else. Other than that, he set a high bar for altering policy (he wants “compelling” evidence that inflation will come all the way back down to 2%) while explicitly leaving open the possibility of another 75 basis-points hike in September.
Those who wanted an excuse for dovishness, however, could latch on to his speculation that the “pace of increases” would likely slow down. That doesn’t sound that dovish to me, as 75 basis points every meeting would soon pile up into very restrictive policy indeed. But trading on Wednesday suggests it was that line that prompted bond yields to fall and stocks to rally.
Under questioning, Powell said that “we need to get policy to at least a moderately restrictive level” (again I don’t quite see how this was the cue for buying stocks), and drew attention to the latest “dot plot” or governors’ predictions from June, which suggests the fed funds rate will reach between 3% and 3.25% by the end of this year. He added that “we think it’s necessary to have growth slowdown” and doused recession excitement about the forthcoming second-quarter report by saying, “You tend to take first GDP reports, I think, with a grain of salt.”
On the face of it, this doesn’t make a good case to buy stocks. Which brings us to earnings season.
About three quarters of the S&P 500 by market cap has now reported numbers for the second quarter. This summary from Deutsche Bank AG’s chief strategist Binky Chadha shows that there was nothing truly “positive” so far:
• Beats have been about average at best, in line for the median company but below average in the aggregate;
• Earnings growth is strong at the headline level but is down sharply below the surface. On a year-on-year basis, S&P 500 earnings are on track to rise by a robust 9.4% in aggregate. However, there are three unusually large items in the quarter to consider in gauging underlying trends in earnings, two positive and one negative, but which together are providing a big boost to headline earnings in Q2: the massive increase in Energy earnings (+10.5 percentage point boost to S&P 500 growth); the return to profitability for the pandemic-impacted companies (+2pp); and the drag from banks provisioning for loan losses (-4pp). Excluding the impact of these three items, underlying earnings growth for the rest of the S&P 500 is only at a modest 1.2% year-on-year. On a sequential basis quarter-on-quarter, underlying earnings adjusted for seasonality [the second quarter tends to be strong] are on track to fall sharply by -4.5% quarter-on-quarter, one of the steepest declines over the last decade, comparable to those seen in the early stages of the pandemic;
• Forward estimates continue to fall at a much faster pace than is typical through an earnings season, but remain elevated especially for next year.
Again the emphases are mine. There is nothing in the news emanating from Corporate America, then, to suggest that a recession can be avoided.
Of course, when you buy a stock now, you aren’t buying any right to its past earnings, but to its future cash flows. So, is there reason to think that this corner has been turned? There isn’t, unless the interaction between the corporate sector and the economy proves to be very different from previous recessions – or if there proves not to be a recession.
Savita Subramanian, equity strategist for Bank of America Corp., points out that recessions generally hurt profits, and the stock market hits bottom once forward earnings estimates have been cut to a low. This time is different:
During the last five recessions, the S&P 500 bottomed after estimates were revised down, except in 1990 when forward EPS remained flat. But estimate cuts are just starting now and even with those modest cuts, forward EPS is still up 7% since the market peak.
If the bottom for the US stock market has already been made, then, that would imply that an earnings recession will be avoided altogether. That’s conceivable. It doesn’t seem likely.
The key force behind the potent July rally was the pessimism that preceded it. Investors were positioned for imminent disaster, with sentiment about as bad as it gets. Fund managers considered themselves overweight in bonds and underweight in stocks, which suggested something like true capitulation had happened. In such circumstances, as I wrote the week before leaving, “A little good news can go a long way.”
Put differently, Chadha of Deutsche points out that the word from corporate executives on earnings calls hasn’t been particularly positive. But, “It is fair to say that this earnings season has so far revealed pockets of corporates turning cautious but not a widespread move, and the market has put in one of the strongest rallies on record.”
A little good news, or even a little absence of bad news, from earnings announcements and the Fed were enough to drive a great rally.
It’s possible to say that this is stupid. It’s more reasonable to say that free markets are working as they’re supposed to do as they assimilate new and unfamiliar information. Sentiment swings too far in one direction, and then in another, as investors try to get it right. The current position is not necessarily any less defensible than the lows from a few weeks ago. Buying the last dip worked out well.
But bear market rallies are dangerous. As it stands, the market is now positioned for a Fed that quickly reverses course, which implies a declining economy and falling inflation, while corporate earnings sail on unscathed. That’s an unlikely scenario, suggesting great confidence in the Fed. Unless something changed really dramatically during my week in the woods, confidence in the Fed is in short supply.
Therefore, the odds favor that the pendulum has moved enough to create a selling opportunity for both stocks and bonds. But these are bizarre economic circumstances and it behooves all of us, like the Fed, to watch the data as it emerges.
Perhaps my most important tip is always to make sure you’ve forgotten nothing before leaving a vacation property, but most of you were probably sensible enough to do that already.
So one song to recommend. While on vacation I was lucky enough to see Norah Jones in concert. Amazingly, it’s now 21 years since Ravi Shankar’s daughter burst on the scene with her debut album Come Away With Me. She’s still wonderful, and her laid-back music sounds so much better when performed live, by Norah and a group of improvisational musicians. Try perhaps listening to Sunrise, which I enjoyed a lot.
And finally, I was saddened as a fan of the Boston Celtics to learn of the death of their talismanic hero Bill Russell. I was also saddened to read about his terrible experiences with racism. To learn more about this, try looking at The Main Event by my great colleague Stacy-Marie Ishmael. She also tells you about what Martin Luther King once said to Nichelle Nichols, best known as Lieutenant Uhura in Star Trek. Rest in peace, Bill Russell and Nichelle Nichols.
And do have a good week, everyone.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”
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