Earnings Outlook: Equities Head to the Races

Summary

• Equities powered through the fog of the debt ceiling imbroglio, finally rallying above the trading range of the past several months.
• Driving the rally is an unshakable confidence that the US will not default, and that the US economy is on a roll.
• We agree that default is extremely unlikely; however, markets have not focused on the Treasury’s ability to avoid default by prioritising payments – or the implications for the US economy if it does.
• The extreme right-wing House Freedom Caucus will push into that murky realm if it does not get its way. What happens then is anyone’s guess.
• About 38 companies report earnings this week, largely in the retail sector.

Market Implications

• We expect increased volatility in equity markets, although it will take a major shock to drive equities much below the trading range of recent months.
• For those concerned about downside volatility, we like to buy puts on the equity volatility index VIX. It is now below 17%, near the low of the past 18 months.

What We Learned Last Week

Unlikely as it may seem, large cap equities finally broke free of the narrow trading range that has prevailed since early April, even as the debt ceiling game of chicken accelerates toward a cliff-edge. The S&P 500 (SPX) rallied 1.6% to 4191; the unstoppable NASDAQ 100 (NDX) jumped 3.6% to 13803.

Probably the best explanation is that equities markets view the Washington drama as nothing more than a game – and a rigged one at that. Rigged as in the debt ceiling will be resolved.

President Joe Biden said that the US will not default on its debt. House Speaker Kevin McCarthy promised that the House will vote on a new package in coming days. Markets rallied on those pronouncements and all but ignored the inability of negotiators to stay in a room together long enough to exchange pleasantries let alone talk business.

We have seen this script before. We know how it goes – buy!

In addition, the labour market is booming, companies are profitable and see no recession coming, and the Federal Reserve (Fed) appears to be settling into a holding pattern. Meanwhile, the promise of AI riches is triggering yet another tech minibubble.

Talk about a win, win, win situation!

What Could Go Wrong?

We agree that outright default is highly unlikely. Okay – all but inconceivable. Death by a thousand cuts is another story.

On X-day, when the Treasury can no longer pay all its obligations (likely in early June), it can prioritise payments and simply not pay some of its bills while continuing to service debt.

Treasury Secretary Janet Yellen has warned that such a scenario will quickly lead to a fiscal implosion and sharp economic slowdown.

This is unprecedented, so the outcome is uncertain – but we are about to find out.

We know that any agreement that McCarthy might strike with the White House will fail to pass muster with the House Freedom Caucus. Republicans have shut down the Federal government on multiple occasions in (vain) attempts to achieve their budget goals. We assume they will attempt to push the Treasury into the murky world of prioritised payments, thereby allowing both Biden and McCarthy to keep their promise that the US will not default.

It could be another couple of weeks before that scenario plays out. What happens if it does is anyone’s guess. We expect that initially it may be like a government shutdown, but that could soon change, especially if Yellen proves to be correct.

Between now and then, look for Biden and McCarthy to keep reassuring voters and markets that the US will not default, although their words lose effect if negotiators will not parley. So far, the press has barely mentioned the option to prioritise payments or what the implications of that might be. We think this will receive more attention in the coming week.

We remain cautiously neutral on equities. We do think they are in for a bout of volatility, and there is risk they could drop below the trading range of recent months if the debt ceiling mess drags on. Upside is limited in our view by sticky inflation and the ongoing risk that the Fed will have to raise rates further.  

Downside Risk Makes VIX Puts Attractive

The equity volatility index VIX is below 17%, near the low of the past 18 months. For investors concerned about downside risk, we like to buy puts on the VIX.

The Week Ahead

Some 38 companies report this week, largely in the retail sector. Are they losing market share to the big box Walmart (WMT) and Target (TGT)?

Monday

• Zoom Video Communications (ZM) will update us on how the return-to-the-office push by bosses is affecting its business.

Tuesday

• Autozone (AZO) may give a contrarian indicator on the health of the consumer – when it does well, consumers are usually retrenching and working on their car themselves.
• Dick’s Sporting Goods (DKS) is one consumer discretionary retail that will probably benefit as people turn to outdoor recreation.
• Will Lowe’s (LOW) confirm Home Depot’s bearish take on consumer demand?
• Homebuilder Toll Brothers (TOL) will likely confirm that homebuyers are turning to new homes due to tight existing home inventory.

Wednesday

• Given that Nvidia (NVDA) stock has more than doubled so far in 2023 (and 10% in the past week), investors clearly expect great news. Any disappointment will be punished.

Thursday

• Best Buy (BBY), Costco (COST), Dollar Tree (DLTR), and The Gap (GPS) will round out the earnings and outlook picture for the retail sector.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)