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- Major indices dropped about 2.6% last week on a toxic combination of earnings, fluctuating rates, and geopolitical concerns.
- On the earnings front, companies are mostly reporting solid beats.
- But investors are penalizing any signs of weakness, while not rewarding companies that do deliver blockbuster results.
- There is growing sentiment that the 10Y Treasury yield may be nearing a peak at 5%. But we see some risk that technicals could push it to 5.5%.
- If this view becomes more widespread, we could see a rebound in the beaten down homebuilders and regional banks. But it is still early for that trade.
- Some 325 companies report this week, but all eyes will be on Apple (AAPL) on Thursday.
What We Learned Last Week
It was another rough week for those of us who still view underlying economic fundamentals as sound, with all three major indices (S&P 500 (SPX), NASDAQ 100 (NDX), and Russell 2000 (RTY)) dropping by a near identical 2.6%. Earnings, fluctuations in US Treasury yields, and geopolitical concerns drove the decline, with investors understandably not wanting to be overly long over the weekend.
Earnings Solid But…
Earnings remain robust, with SPX registering a 7.4% beat at about halfway through the earnings season. The NASDAQ is running about 12% above forecasts, which is even more impressive given that analysts have pencilled a 10% increase in earnings quarter-over-quarter.
Yet most investors are focusing on any negative in earnings reports and using that to sell. One big issue is revenue – posting beats of 0.9% and 1.15% for SPX and NDX, respectively. These beats are more modest than recent quarters, and arguably signal slowing momentum. Another more constructive interpretation is that many companies are not raising prices as rapidly as analysts assumed but have become more efficient at controlling costs. However, the focus now is on the glass being half empty rather than half full.
Other companies are still working through inventory problems or weak demand in certain sectors, or still adjusting to higher costs. And even as they post solid earnings, this is clearly viewed as not good enough.
Alphabet reported robust earnings but sold off by 10% on slower-than-expected growth in its cloud business. Boyd Gaming (BYD) indicated that demand remains strong but sold off by 5% due to still high costs. Companies that delivered strong results, such as Microsoft (MSFT) and Amazon (AMZN), rallied but ended the week little changed. In short, disappointments were hit hard; strong results were mostly not rewarded.
Rates Near a Peak?
Over the weekend, the Financial Times led with a front page headline stating ‘Investors Snap Up Long-Dated Treasuries.’ The catalyst was record inflows into US debt funds. There seems to be growing sentiment that with the 10Y Treasury yield near 5%, rates are near a peak. The underlying expectation is that rates are high enough now to slow the economy, and that the Federal Reserve (Fed) is done with raising rates.
A key element in our neutral posture on equities is that the Fed’s policy actions so far (as opposed to Fedspeak) has been dovish and will remain so. If the Fed’s priority were corralling inflation, it would be on track to push the Fed Funds rate to upward of 7%. The Fed is trying to walk a tightrope between maintaining full employment (or avoid recession) and reduce inflation, with a bias toward the former. Should the economy show signs of material weakening, we expect the Fed will err on the side of easing.
That said, we see some risk that long-term rates could rise further. One key technical point to watch is the 10Y Treasury yield versus Fed Funds – in past tightening cycles the 10Y Treasury yield has traded above the Fed Funds rate. Granted, many things about this cycle are different from past ones, but we can Treasury yields rising to 5.5% before the selloff ends.
In that scenario, there would be continued pressure on interest rate-sensitive sectors – particularly homebuilders and regional banks, represented by ETFs XHB and KRE, respectively. The rise in the 10Y yield from 3.5% to 4% had little impact, but during the journey from 4% to 5%, SPX fell 8.5% and XHB and KRE fell about 13% (Chart 1).
The flip side is when investors more broadly believe rates have peaked, equities could rally. Also, any sustained decline in rates could engender a feedback loop as lower rates increase confidence in the economic outlook.
The Week Ahead
The earnings tsunami rolls on, with some 325 companies in our Russell 1000 universe slated to report. The key reports will be Caterpillar (CAT) on Tuesday and Apple (AAPL) on Thursday. Other companies to watch include:
- Avis Budget Group (CAR).
- Caterpillar (CAT).
- Emerson Electric (EMR).
- Pfizer (PFE).
- Advanced Micro Devices (AMD).
- AirBNB (ABNB).
- Caesars Entertainment (CZN).
- Clorox (CLX).
- Eaton Corp. (ETN).
- Mondelez International (MDLZ).
- Apple (AAPL).
- Cummin Inc. (CMI).
- MGM Resorts International (MGM).
- New York Times (NYT).
- Starbucks (SBUX).
- Yum! Brands (YUM).
- Zillow Group (Z).
- Amgen (AMGN).
- Coinbase Global (COIN).
- DoorDash Inc. (DASH).
- Expedia Group (EXPE).
- Johnson Control (JCI).
- Monster Beverage (MNST).
- Royal Caribbean (RCL).
- Under Armour (UAA).
- Warner Brothers Discovery (WBD).