The Big Conversation
Episode 136: Is a rally bad for investors?
This week Real Vision’s Jamie McDonald uses Refinitiv’s best-in-class data to look at market positioning around a potential Fed pivot. With a strong rally in risk assets following the July FOMC meeting, the market seems to be pricing slower growth – and potentially lower inflation – which could lead an increasingly data-dependent Fed to curtail its rate hikes. But, as more recent rhetoric from policymakers has downplayed recession fears and reiterated the need to get inflation under control, could the rally provide an opportunity for the central bank to assert its hawkish bias?
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Last week saw July end, and in doing so, post the best returns for US equities since 2020. With the S&P 500 up almost 10%. And it wasn't just equities that had a move. Commodities rallied. The Dollar and bond yields fell. It seems riskier assets are back in vogue.
But why did this happen? You might ask. Well, in large part, it’s due to what the market is calling the Fed pivot. With many investors expecting a recession in the next 12 months, for those that don’t believe we are in one already, that will bring prices down and give the Fed enough wiggle room to start cutting rates once again. We recently saw a shift from bad news is bad, because the Fed has to hike anyway, to bad news is good, because now there's a chance the Fed will start cutting once the macro starts weakening.
So, if we are now in a topsy turvy world again, is in fact the rally of last month’s bad news for markets. And that's this week’s Big Conversation.
First, let’s take a step back and set the scene going into last week. We got the 75 basis point hike that seemed all but assured. But with some new language that suggested the Fed show more flexibility at coming meetings amid signs of a slowdown. Now, although Powell didn’t rule out another similar-sized increase going forward, he stepped away from the specific guidance that he gave at the June meeting.
And whilst Fed officials denied that the US was entering a recession, pointing to resilience in the labour market, the consensus focused on the potential for a moderation in the pace of future rate hikes, given renewed data dependence. With some investors even going as far as to call this the pivot.
Now, as debate ensued between Fed watchers, equity investors cheered the news with a decisive rally. Which saw the most speculative corners of the market, notably the high-beta long duration constituents of the NASDAQ and the ARK ETF posting outsized gains. Furthermore, they removed guidance altogether and said the pace of increases will depend on the data. Which means key figures like the ISM, which came out on Monday, are going to be a factor. And we'll come to that in detail later on.
As we said in the intro, yields also moved. But it wasn't just the broad decline in yields that supported the market’s dovish interpretation of Powell’s comments, if we look at the shape of the yield curve, we have now seen long end yields fall faster than short-dated yields. Which seems to support the interpretation that growth expectations are falling rapidly enough to force a pivot from the Fed.
Now, let’s talk about that rally. Because you might find it counterintuitive to pose the question, are rallies bad for markets? After all, aren’t we all here to make money? But remember, they are also a reference for monetary policymakers. Yes, the US monetary policy is fixated on prices and employment, but they do also watch the market. And higher asset prices themselves might well be considered inflationary, posing something of a circular reference problem for the Fed.
Now, this week, we got a perfect example of exactly that market awareness when Neel Kashkari, the President of the Federal Reserve Bank of Minneapolis suggested on Friday that investors had gotten ahead of themselves in anticipating that the Fed would soon begin to back off. His exact words were, I'm surprised by the market’s reaction.
Now, the inference of that is that the Fed did not get the reaction they expected. But they still might not be too disappointed by the rally.
For much of the last decade, the Fed was, arguably, acting with a dual mandate of targeting growth but also supporting asset prices. And whenever the economy wavered or the stock market wobbled, investors were conditioned to expect the Fed put. But with the Fed now explicitly targeting price or inflation above all else, the current dynamic is markedly different. Rather than the market buying the dip on the Fed support, we may be witnessing a role-reversal where the Central Bank sees a tactical opportunity to hike on market rallies.
And that's not to say that hikes are, by any means, contingent on equity market strength, but the rebound in July might well have provided more wiggle room for the Fed to continue pursuing its inflation target with further increases in the face of an economic slowdown. So, yes, rallies are good. Especially for fund manager performance. But perhaps not so much in the specific environment that we’re in right now.
Until inflation is under control, they may well be enabling the Fed to press ahead with larger rate hikes in the near term, and risk contributing to a recent inflation problem if asset prices rebound before the Fed has achieved its price mandate.
Now, let’s talk ISM for a second. July’s ISM manufacturing PMI came out on Monday and provided some valuable insights into the state of the US economy. Now, first of all, the headline index continued to signal expansion with a reading above 50. That also beat expectations and was only down 0.2 points on last month’s reading of 53.
Now, the bulls will rest easy claiming it suggests the economy is not in dire straits right now. Plus if you dig a little deeper into that number, the price index, which tends to provide a lead on changes in CPI, posted a surprise drop of 18.5 percentage points. Which was by far the biggest change in any component of the report. Although it may be premature to call for this as a peak in inflation on this basis alone, when taken in consideration of the softening in oil prices recently alongside the fastest hiking cycle in decades, this might carry more weight in foreshadowing a fall in CPI.
And if the stronger than expected headline reading of 52.8 is a sign of things to come, then perhaps the Fed was right to deny the presence of a US recession. But then again, that too might be seen as a step too far. As elsewhere in the report, we saw new orders continued to drop while inventories rose.
Now, bears will be quick to point out the fact that every single time the spread between these two has fallen to this level, a recession has ensured. Now, again, as much as the Fed has tried to downplay recessionary fears, there are still many investors who believe that we are already in one. Or maybe on the cusp of one that just isn't too deep. But my point is that we know that data matters a lot now. So, keep an eye on it as it comes out.
And just sticking on the ISM for a second, because let’s just be clear, this is not just an equity story, in fact it never is. As we've said many times before, all asset classes are interlinked, so it’s important to keep an eye on all assets to get a better understanding of what's really going on. And it’s along those lines that we have a very interesting point to raise. Asset prices can imply a level of economic health of the market that they operate in.
Now, what I mean by that is US equities and US bonds have adjusted to levels that imply ISM readings. And by extrapolation, scenarios for the US economy. But what's startling here is that the two tell very different stories. The US 10 Year is generally agreeing with the latest data, suggesting that things are basically okay. In fact, bonds are pricing an ISM above 50 in expansionary territory, which provides a growth runway for the Fed to continue hiking.
Now, equities, on the other hand, are pricing in the ISM below 50. And much lower, if you look at the growth tech names. So, why the dislocation? Well, it’s important to note that the level of yields is likely to be supported somewhat by the hiking cycle that we are in the midst of. But the truth is that the two asset classes often tell different stories, and bonds are the less effervescent cousins of equities. But one of them must be wrong.
Now, another explanation of the dislocation is that equities do have a more emotional component in their pricing. And right now, investors in economies are at an edge walking a fine line through the [unclear] of inflation and low growth.
So, before we look ahead to how this scenario might play out, let’s quickly cover two other notable market inputs, earnings and sentiment. Now, with a majority of the S&P 500 having now reported, I think it’s fair to say that things haven't been as bad as investors were fearing. The percentage of companies beating on EPS is down slightly, but still close to the long term average of around 70%.
But if you think about where sentiment was going into earnings season, it wasn't going to take big beats to see stocks rally. Whilst there have been certain outliers, it seems that earnings beats have seen less of a reaction than misses. Which have tended to be punished harder.
Now, given that Q2 hasn’t been as bad as many expected, this has led some analysts to suspect that the weakness can now come later in the next quarter.
And that brings me on to my last point, sentiment. This market remains volatile and is adapting to a barrage of important information. But if you can think back to June, it was a month of despair with investors bracing for hard landings. Fast forward to now and we have a double-digit rebound in the S&P 500. A better than expected earnings season closed at the outlook for growth and inflation might not be as bad as feared. And a Fed that will pivot if needed.
But equity and bond positioning remains somewhat at odds. So, where do we go from here? Well, this is where we return to the story of whether good data is now bad for markets. Well, if this rally continues then the answer is yes. And increasingly so, as risk assets appreciate. Remember, just like Neel Kashkari said, never for a moment forget that bringing down inflation is the Fed’s priority right now and they’ll do whatever needs to be done to achieve that.
Other regional Fed speakers have said the same. The conclusion here is that the July rally has, arguably, put the Fed in a better position than before to forge ahead with hikes despite growth fears that preceded the latest ISM report. And given the Fed is now explicitly putting data front and centre, it’s going to be all eyes on the various economic indicators we get in August to show us where we go from here.
Now, despite the rally we saw in July, it’s always important to recognise what's going on with the US consumer. And to talk more about that, I got the chance to sit down with the Director of Consumer Research at Refinitiv, Jharonne Martis.
Jamie: Jharonne, welcome to the Big Conversation.
Jharonne: Thank you. It's good to be here, Jamie.
Jamie: One of the reasons cited for the recent rally in stocks, is that essentially Q2 wasn't as bad as people were expecting. Now, there are many analysts who say there is weakness coming, but it's just been delayed and it's going to come in Q3 earnings. So what I'd love to hear from you, is from a consumer spending perspective, what are you seeing at Refinitiv and what do you expect in Q2?
Jharonne: Sure. So retailers are about to start reporting earnings for the second quarter. So far, we have about 80 companies in our retail and restaurant index that have reported earnings so far for Q2. The overall index is looking at a -14.3% earnings growth rate for the second quarter, although this is still in a negative territory it is an improvement from the first quarter. And the strength that we're seeing in the second quarter is mainly from consumers who booked their travel at the beginning of the year and are going no matter how high gasoline prices are or despite the inflation right now. And this is also in line with a lot of the credit card data right, that shows that consumers are using their credit cards again, spending is going up, but it's mainly going for travel, restaurants and those experiences after being locked down for two years in their houses. So they're not using their credit cards yet for everyday expenses, but they are still spending and they are going no matter what on that revenge travel this summer.
Jamie: Very interesting. So when it comes to having fun in terms of travel and restaurants, people are willing to like still keep going to those?
Jharonne: Yes. And they're not shopping so much for clothing or shoes, but definitely they want those experiences regardless of how high, higher despite of higher expenses.
Jamie: Yeah. Okay. Well, that explains certainly some resilience. Now, one of the things that another thing that often gets cited is that inflation impacts different consumers in different ways. So what I was hoping to get from you is just a little bit of colour in terms of what trends you're seeing in the high end consumer and, you know, are people and what trends you're seeing in the low end consumer?
Jharonne: Absolutely. So the low-end consumer is being squeezed the most, because they're no longer receiving those the checks that they were the stimulus checks they were receiving from the government last year. On top of that, their spending power has come down because of inflation. So what they are doing, and we already seeing that low middle class consumers are doing, is that they're staying near their house. If they're shopping, for example, at the dollar stores and they're going there for all their necessities, but they're going to the nearest store. Now, the middle-class consumer itself, they are looking for value. They're cutting up their Netflix subscriptions and instead using that money to get a Costco, Sam's Club or BJ's membership in order to pay less money at the gas pump. They want to they're trying to find ways to save money. Now, the high-end consumer, they're firing at all cylinders. The luxury retailers are raising their prices and they're passing those on to that consumer who's willing and able to pay that. As a result, names like Louis Vuitton, Hermes and even Lululemon, they are expected to see stronger revenue and earnings compared to even pre-pandemic levels.
Jamie: Right. I see. So those higher end retailers are managing to ride this wave a little easier. Now, just in other things that, one thing that appears to be giving the Fed a lot of confidence is a tight labour market. So I'm wondering, is there any evidence to suggest in what you're seeing that, you know, this strong labour market is giving the consumer more confidence?
Jharonne: Absolutely. And this is reflected in our Refinitiv consumer confidence report. What we're seeing is that the consumer confidence sentiment consists of four sub-indices. And the one indices, the job indices, and that's the one that consistently has been positive throughout 2022, this year, however, it did decline last month, showing that consumers are starting to be a little bit concerned about their job security. But the fact that it's remained positive for most of this year is what's telling us that it's the reason why consumers have remained engaged. The one economic indicator consumers understand very well is the, is the unemployment rate, the job report. And if they feel that their friends and family, and they start seeing that they this their closest group of friends or family start losing their jobs, that's when they're going to put their hands in their pockets and hold back on spending. As long as that employment report remains positive and the unemployment rate remains at low levels as it has been throughout this year, we will continue to see the consumer remain engaged for the rest of the year.
Jamie: Okay. So when it does come to the outlook for consumer spending, keep a close eye on the unemployment rate because it really does make a difference?
Jharonne: Absolutely. There are strongly correlated one to the other.
Jamie: And Jharonne, if you don't mind, like one last question. Let's, let's talk about outlook for a second. Going out into Q3, how do you expect consumer behaviour to change? Has a lot of the maybe strength, let's say, that's come into Q2 from people wanting to still travel and go to restaurants, do you see that fading into Q3? What sort of trends are you looking for?
Jharonne: So retailers are reporting second quarter earnings right now. So about 80 companies, that's 40% of our indices have reported so far. Out of those 80 companies, more than half have reported that they're very much concerned about inflation. And nearly all of them, 70 of those 80 companies have, are still strongly vocal about supply issues into the third quarter. So as a result, we're receiving a lot of negative guidance for the third quarter from a lot of retailers who are telling us not to expect too much to them. And as accordingly, the analysts polled by Refinitiv are lowering their earnings guidance for the third quarter. This is also in line with what we see historically. Historically, what we see is that consumers do spend in the second quarter but then take a slight break ahead of the holiday spending in the fourth quarter. So don't be surprised if third quarter comes in slightly weaker than the second quarter, but then picks up into the fourth quarter. So far, even looking at the third quarter, just the strongest sector remains the hotels, restaurant and leisure group, because consumers, after the two years of being locked down and in the house, there's a lot of strong demand there. And they, like, like I mentioned before, they're willing and able to spend money on experiences, even if that means extending themselves and using their credit cards.
Jamie: Got it. So there is some seasonality in Q3 anyway, which people should watch out for. And I think if I'm right, something else you were saying is these higher-end retailers are just more able to pass on these price increases. So they seem to be in a little bit better position anyway?
Jharonne: Absolutely. And what's going to drive that middle-class consumer are those deals, especially during the Black Friday season, because as long as the retailers, and this is a strategy we've seen them using before, they lure the consumer in with a certain amount of discounts, but they won't have everything on discount in order to motivate them to pay full price for the other items.
Jamie: Got it. Jharonne it's been so great chatting with you. It's always a pleasure to have you on the show. Thank you so much.