The S&P was mostly resilient again last week if we consider the barrage of disappointing economic data, which implied the chances of a “hard landing” are higher than previously thought (this was before the weekend news that bank lending dropped the most in two years, something that will undoubtedly weigh on the economy going forward).
That resiliency lies in a series of mostly positive assumptions investors and the market have made including: 1) A dramatically more dovish Fed, as markets are pricing in fed fund futures at 4.25% by year-end (reflecting nearly 100 bps of cuts from the peak fed funds rate of 5.125%). 2) An economic soft landing. 3) No more fallout from the banking stress and 4) Stable earnings.
Any material disappointment in any of those assumptions (expected Fed rate cuts, soft/hard landing, bank fallout, or earnings declines) will lead to a 5%ish pullback, and any disappointment in two or more opens up a 10%ish pullback possibility.
As such, we think the near-term risk/reward at these levels remains unattractive, and we are maintaining our defensive tactical stance. Moreover, we think slowing growth remains the biggest and clearest trend in markets right now, and we want to insulate portfolios from that impact. That was demonstrated last week as defensive sectors handily outperformed as growth concerns grew, and we think that continues as growth slows.
Focus this week will be on inflation and the start of earnings, so if there will be disappointment it’ll come from 1) CPI not falling fast enough (and challenging the expected number of rate cuts by year-end) and 2) Earnings possibly falling from the current $225 2023 S&P 500 expectation and $240 2024 expectation.
For several months we and others have cautioned that inflation needed to fall faster than growth for the Fed to achieve a soft landing and markets to sustainably rally, but last week’s soft economic data implied the opposite is happening (growth falling faster than inflation) and if that is confirmed by this week’s inflation data, then worries about a hard landing or stagflation will rise and markets will likely get volatile.
The key report this week is Wednesday’s CPI, the bottom line is that we need to see CPI decline (and preferably come in under expectations) and signal that disinflation has reengaged.
Secondary in importance with regards to inflation will be Thursday’s PPI and, to an even lesser extent, today’s New York Fed Inflation Expectations and Friday’s University of Michigan five-year inflation expectations.
Bottom line, if CPI is light this week that will help ease hard landing concerns because markets will become surer the Fed can cut rates later this year. However, the more inflation indicators this week that signal disinflation the better, as the Fed can cut sooner to support growth (if needed) if it has comprehensive data showing inflation is indeed quickly returning to its target. I’m not saying that will happen this week, but if economic data is suddenly rolling over, then investors need inflation to drop quickly and sharply, otherwise stagflation/hard landing become the most likely outcome.
Finally, we will also get the FOMC (Fed) minutes from the March meeting this week and markets will be looking for any sign that shows the Fed will hike just once more or, perhaps, not at all. And any hints of those comments will be welcomed by markets (at least short term). Don’t count on it, as I believe that we have at least two if not three more moves.
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