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Summary
- Geopolitics, primarily in the Middle East, rates, and earnings together drove the S&P 500 (SPX) down 2% last week – we expect this pressure to continue into next week.
- We are reluctant to move to an underweight in equities as we see the selloff of recent months as a rational response to higher rates rather than the beginning of the herd rushing for the exits.
- Low unemployment, a dovish Federal Reserve (Fed), and rising earnings continue supporting equities. If this continues, we think a major selloff is unlikely.
- It is a blockbuster earnings week, with some 300 companies in the Russell 1000 reporting. The most important ones are the tech giants – Alphabet, Amazon, Apple, Meta Platforms, and Microsoft. Caterpillar is also a key bellwether.
Market Implications
- We still like a tactical overweight in consumer staples via the ETF XLP. We also like unwinding an overweight in Coca-Cola as it has significantly outperformed XLP and SPX this month.
What We Learned Last Week
The S&P 500 fell 2% last week on three big persistent risks.
Geopolitics – Tensions between Israel and both Hamas and Hezbollah simmer, with conflict escalation still a real possibility despite international efforts to prevent a worst case scenario. We do not think this was a big factor in the selloff so far but it is contributing to downward pressure. If the war escalates significantly, equities will sell off sharply. Will they rally in the unlikely scenario that tensions ease? Probably not, or at least not much.
Rates – With the 10Y Treasury yield now dancing around 5%, some see signs of a top and are looking to reestablish longs. We will not try calling the top – but for now the risk is clearly tilted toward higher even if only briefly. Equities will continue to be pressured as rates rise further, until the Fed signals that it is no longer raising rates.
Earnings – We still see a pattern of most companies posting comfortable beats, but their stocks selling off on soft outlooks or expectations of worse to come.
A key example is regional banks – most so far report better-than-expected earnings, higher-than-expected deposits, and lower-than-expected loss provisions. Yet the regional bank ETF KRE fell 3.3% (versus 2.4% for the S&P 500) on concerns that rising rates will crimp net interest margins in coming months.
Airlines are another example. United Airlines (UAL) and American Airlines (AAL) also posted beats, with both saying demand for air travel remains robust, but the JETS ETF sold off 4.8%. UAL said it was cancelling flights to Israel, triggering demand concerns. Energy and jet fuel prices are also worrying.
We expect further downward pressure on equities in coming weeks – but are reluctant to call for an outright underweight on equities. The selloff so far has been mostly a rational response to higher rates and risks of a slower economy. But we also note that equities keep trying to rally on more positive news (Chart 1). Several underlying factors support equities.
Low unemployment – If the labour market remains robust, there is little chance of a recession.
Dovish Fed – Given the level of inflation, the Fed’s posture so far has been remarkably dovish. We believe the Fed will have to push the Fed Funds rates to 7% or higher if it wants to corral inflation. The Fed may raise rates another notch or two, but so far it has given no indication that a more aggressive stance might be in the cards. The bottom line is that the Fed wants to maintain the recovery. Equities may be unable to rally much with rates at these levels but they are unlikely to suffer a sharp selloff.
Earnings – Investors may get upset by outlooks that are on the soft side, but the bottom line is that analysts are still looking for rising earnings.
Maintain Tactical Overweight in Consumer Staples
After lagging SPX for much of October, the consumer staples ETF XLP is now outperforming by 1.1%. We like holding this tactical overweight for now. We also like unwinding the overweight in Coca-Cola (KO) before it reports earnings on Tuesday – it is up 5% versus SPX and 3.8% versus XLP.
The Week Ahead
It is a block buster earnings week, with about 300 companies in our Russell 1000 universe slated to report.
The most significant reports will be those of the major tech companies – Alphabet (GOOG), Amazon (AMZN), Apple (AAPL), Meta Platforms (META), and Microsoft (MSFT). If they as a group disappoint either on earnings or outlook, SPX and NASDAQ 100 (NDX) will take a hit.
Caterpillar (CAT) is also a key bellwether for US and global infrastructure and construction spending.
Monday
- Package Corp. (PKG).
- Whirlpool Corp. (WHR).
Tuesday
- Coca-Cola (KO).
- Corning Glassworks (GLW).
- General Electric (GE).
- Sherwin Williams (SHW).
Wednesday
- 3M (MMM).
- Alphabet (GOOG).
- Archer-Daniels (ADM).
- IBM (IBM).
- Mattel (MAT).
- Microsoft Inc. (MSFT).
- Texas Instruments (TXN).
Thursday
- Boeing Inc. (BA).
- Chipotle Mexican (CMG).
- Comcast Inc. (CMSCA).
- Ford Motor Company (F).
- Harley Davidson (HOG).
- International Paper (IP).
- Meta Platforms (META).
Friday
- Amazon Inc. (AMZN).
- Apple Inc. (AAPL).
- Caterpiller Inc. (CAT).
- ExxonMobil (XOM).
- US Steel (X).