Equity View: Why We Do Not Trust This Rally

Summary

• Whatever Jerome Powell meant to say, equity markets heard one simple message – inflation is dropping and the Fed will cut rates. Hence a remarkable two-day rally especially in the NASDAQ 100.
• Will disappointing earnings from Alphabet, Amazon and Apple slow the juggernaut? Probably, but not enough to move equities out of the range of the past six months. Investors are likely to blame 4Q 2022 factors and keep looking ahead to falling inflation and robust 2H economy.
• We cannot see why the Fed would cut rates in that scenario after being stuck near the lower zero bound since 2008. That is hardly supportive of an upward and onward rally.
• If the Fed does cut rates, it will be because of a sharp recession, a jump in unemployment and falling inflation. None of this augers well for equities.

Market Implications

• If the Fed sticks to its message of ‘higher rates for longer’, we expect equities will struggle to break above the trading range of 2H 2022.
• If those higher rates choke off the economy, equities will trade through the bottom of that range.
• We suggest investors take advantage of the rally to reduce equity exposure.

Powell Gets the (Wrong?) Message Across

Analysts are scratching their heads trying figure out how to rationalise the sudden market rally after Fed Chair Jerome Powell’s press conference. Over the past two days, the S&P 500 (SPX) is up 2.5% and the NASDAQ 100 (NDX) a remarkable 5.8% – thanks in part to a boost from Meta Platforms (META).

To us, Powell provided limited new information. But that is not what the market heard. It decided that inflation will drop sharply in coming months, and the Fed will start cutting rates. Yes, the next quarter or maybe two may be sluggish, but all the good stuff will be backloaded in 2H! SPX earnings growth will match or beat the 9% that analysts have pencilled in. The projected 15% growth in NDX earnings is surely too conservative.

Why Cut Rates if Things Are So Good?

Let us think this scenario through. The economy slows a bit but keeps chugging. The labour market remains tight. MoM inflation keeps coming in around 2-2.5% so headline YoY inflation drops steadily.

Dumb question, but, why would the Fed cut rates in this scenario? It spent over a decade chained to the lower zero bound, fretting that it had no cushion, no ammo to fight another crisis. It tried to raise rates during 2015-2018 and got to 2.5%, but that did not end well when the economy seized up in late 2018. When the Covid crisis hit in 1Q 2020, its cushion was a scant 1.5%.

So, the Fed experienced what amounts to a near-death experience with rates too low for comfort. If the economy is chugging along with Fed Funds near 5%, why should it cut rates? Why not keep as much ammo as possible to fight a serious recession or survive the next crisis?

That raises the question – what would it take for the Fed to cut rates? Well, a meaningful pickup in unemployment would help. An economy clearly in recession due largely to the pain of high rates would help. We say ‘would help’ because a necessary condition to cut rates will be sharply lower inflation. If inflation ends up stuck around 3.5-4% even with a recession or only slows gradually from that level, the Fed might not cut rates.

Our point here being, to get that rate cut, something bad will have to happen – something bad for corporate earnings and equities.

Why Soft Tech Earnings Could be Bullish (for Now)

Which brings us to the disappointing earnings reports from Alphabet (GOOG), Apple (APPL), and Amazon (AMZN). They were not so bad that we can reasonably expect a sharp selloff. Indeed, it might be easy to blame them largely on 4Q 2022 problems and keep looking ahead to that elusive big bump in earnings in 2H.

So, yes, this rally might run a bit further. If Friday’s payroll labour report comes in on the soft side, following the weak ADP employment report (+106,000 versus +180,000 expected), markets could take that as an indication that the Fed will indeed have room to cut rates sooner rather than later.

Or more likely, the market could just settle back into the range of 2H 2022 for now.

Reality Bites

At some point one of two realities must hit markets. Either it realizes the Fed will not cut rates soon; or the economy and labour market essentially collapse and inflation slows, necessitating rate cuts.

In the first scenario, it is difficult to see equities exiting the range of the past eight months. In the second scenario, equities will likely drop below the low end of that range.

There is a third (and market-preferred) scenario – it turns out to be a Goldilocks year, the Fed cuts rates, earnings pop, and equities keep rallying.

We prefer to take advantage of this rally to reduce exposure to equities.

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.

(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.)