Good news for the economy is bad news for the market
ANTHONY SAGLIMBENE – CHIEF MARKET STRATEGIST, AMERIPRISE FINANCIAL
WEEKLY MARKETS COMMENTARY — October 10, 2022
Stocks finished last week higher, snapping a three-week losing streak, which saw the S&P 500® Index slide lower by roughly 12.0%. Last week, the S&P 500 gained +1.5%, the NASDAQ Composite rose +0.7%, and the Dow Jones Industrials Average finished higher by +2.0%.
Energy jumped +13.9% on the week as West Texas Intermediate (WTI) crude prices rose +17.0% — oil's biggest weekly gain since March. OPEC+ members, including Russia, agreed last week to reduce crude supplies by 2 million barrels per day starting in November — the biggest production cut since 2020. Yet, based on outdated production baselines, most expect the physical reduction of barrels from the OPEC+ cut to fall by roughly half that amount. With that said, OPEC+ actions should act to keep energy inflation more persistent over time, in our view. Based on last week's jump in oil prices, that seemed to be the market's assessment as well.
On the week, Industrials (+2.9%), Materials (+2.2%), and Financials (+1.8%) outperformed the broader market, while Real Estate (down 4.3%) and Utilities (down 2.6%) underperformed. Treasury prices ended the week lower, with the 2-year U.S. Treasury yield closing at 4.31% and the 10-year Treasury yield ending at 3.89%. The U.S. Dollar Index rose +0.6%, while Gold finished up +2.2%.
While stocks closed the week up, volatility was high
Outside of energy and oil, last week's price action on its own could infer a relatively tame investing environment at the start of the fourth quarter. However, that couldn't be further from the truth. During the first two days of trading last week, the S&P 500 Index jumped +5.6%. According to Bespoke Investment Group, the +5.6% jump in the Index over the first two days of October, and where the U.S. benchmark gained at least +2.0% in each of those days, has happened only one other time going back to 1953 (i.e., August 1984).
Yet, the two-day bounce faded quickly as the week wore on. Stocks bounced higher at the beginning of the week due to very oversold conditions at the end of the third quarter and extremely bearish sentiment among investors. However, the credibility of the bounce on Monday and Tuesday was almost immediately chalked up to typical bear market rallies that tend to see outsized moves over short periods. And helping to carry some of that bullish momentum earlier in the week was increased speculation of a Federal Reserve policy pivot after the Reserve Bank of Australia (RBA) unexpectedly slowed its pace of rate hikes. RBA officials cited that they wanted to see how previous hikes were affecting the economy. Nevertheless, Fed pivot hopes were quickly dashed by the steady drumbeat of Fed officials delivering speeches all week noting that the inflation fight isn't over, the need for rates to push higher remains in place, and we are a ways off from the Fed pausing rate hikes. Unfortunately, the September nonfarm payrolls report on Friday placed an exclamation point on those factors.
While stocks closed the week higher, equities fell aggressively on Friday following the closely watched jobs report. September nonfarm payrolls rose by +263K, while the unemployment rate fell to 3.5% (matching a 50-year low). Moreover, employment growth last month was broad-based. Several industries, including in healthcare, leisure/hospitality, and construction, added to payrolls in September. And while wage inflation moderated from August levels on a year-over-year basis, tight labor conditions continue to keep upward pressures on hourly earnings.
Investors monitor Fed policy expectations
As a result of a still strong labor market, the Federal Reserve is very likely to keep pressing rates aggressively higher this year. The CME Fed Watch Tool now suggests a roughly 80% chance the Federal Open Market Committee (FOMC) will raise rates by another 75 basis points at its next meeting in early November. Such a jumbo rate hike would mark the fourth consecutive meeting of 75 basis point moves and take the fed funds target to 3.75% - 4.00%, from 3.00% - 3.25%. Note: At the beginning of the year, the fed funds target rate sat at essentially zero. Importantly, monetary policy actions take time to work through the economy. The speed and level at which the Fed has already raised rates have not been fully absorbed, creating risk the central bank sends the economy into a more material downturn as it lifts rates higher from here.
Simply put, good news for the economy is bad news for the market. Investors want to see softening employment trends over consecutive months after multiple Federal Reserve rate hikes this year. Yet, thus far, the labor market remains very firm. Notably, the September nonfarm payrolls report cranks up the soft landing versus hard landing debate. On the one hand, the Fed has inferred that a modest cooling in labor market conditions, in combination with weaker wage inflation and a reduction in job openings, could occur without significantly increasing unemployment (i.e., the soft landing scenario). To the Fed's credit, job openings in August dropped by 1.2 million, the largest monthly decline since April 2020. On the other hand, market participants also recognize that a persistently tight labor market and ongoing wage pressures could cause the Fed to raise rates more aggressively to stamp out inflation, which could be more disruptive to the U.S. economy over time (i.e., the hard landing scenario).
Unfortunately, the market's interpretation and reaction across stock prices currently sympathize with the hard landing scenario. Either way, the macro setup moving forward isn't necessarily conducive to growth and profits, in our view. We believe it's really a question of magnitude when discounting a further slowdown, which could keep stock volatility elevated at the start of Q4. That said, remaining invested with a more balanced and defensive bias today could help investors navigate the challenges ahead and be positioned to participate when the eventual rebound comes around.
Third quarter earnings season begins in earnest this week
This week, critical updates on inflation and the start of the third quarter earnings season should keep investors busy and stock prices on their toes. On Wednesday, the headline September Producer Price Index (PPI) is expected to fall to +8.4% year-over-year from the +8.7% pace seen in August. And on Thursday, the headline September Consumer Price Index (CPI) is also expected to fall to +8.1% year-over-year, modestly below the +8.3% level recorded in August. We do not expect either inflation report to affect Fed expectations for the November meeting. Finally, Friday will bring updates on September retail sales and a preliminary look at October Michigan Sentiment.
And on the earnings front, PepsiCo, Inc. will kick off the third quarter earnings season in earnest on Wednesday, followed by a slug of financial results at the end of the week, including from BlackRock Inc., JPMorgan Chase & Co, Wells Fargo & Co., and Citigroup, Inc. Given the high inflation and slowing economic activity experienced in the July through September period, Q3 S&P 500 profit estimates fell dramatically over the previous quarter. However, with analysts putting in a lower bar for results, investors are hoping companies can hurdle over expectations over the coming weeks and place a needed tailwind under stock prices. S&P 500 earnings per share (EPS) are currently expected to have grown by just +2.4% year-over-year on sales growth of +8.5% — down materially from the +10.3% EPS growth and +10.2% sales growth expected at the start of the third quarter. Unfortunately, earnings growth has been falling all year, and when Energy is excluded, S&P 500 EPS growth was actually negative in the second quarter on a year-over-year basis.
Notably, early Q3 results from a few S&P 500 companies suggest a strong U.S. dollar, high labor costs, and ongoing supply chain bottlenecks could remain challenges to the profit backdrop. And just last week, Advanced Micro Devices slashed its Q3 revenue estimates citing weaker PC demand. In addition, Levi Strauss cut its full-year 2022 guidance to reflect softer trends in North America and Europe.
Thus far, a strong demand backdrop has been a favorable tailwind for corporate America this year, allowing many industry leaders to pass on higher costs to protect elevated profit margins. However, as economic activity continues to slow in the face of higher interest rates, we expect the demand environment to normalize over the coming quarters. Higher demand, driven by pandemic effects or dislocations in supply chains, should continue to moderate, which should reduce companies leverage to hold prices high if volume is declining. What companies have to say about the current demand backdrop, their views of the business environment moving forward, and how they plan to maintain profitability levels heading into next year will likely be the essential factors to watch as investors begin to dissect the upcoming earnings season.
Sources: FactSet and Bloomberg. FactSet and Bloomberg are independent investment research companies that compile and provide financial data and analytics to firms and investment professionals such as Ameriprise Financial and its analysts. They are not affiliated with Ameriprise Financial, Inc.
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