The Weekend Edition # 143 - An Abundance of Caution

Welcome to another issue of the Weekend Edition!

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Here's what we cover

• Market Recap

• Macro - How many cuts?

• Earnings - Valuations are starting to matter

• Closing Thoughts - Abundance of Caution

• Calendars

Market Recap

Jul 29 - 02 Aug, 2024

Our big concern from last week was a weakening in the macro data given that election years tend to see a tougher summer, and earnings are showing signs of slowing. Thursday and Friday brought us just that.

Thursday saw a weaker ISM Manufacturing PMI at 46.8% missing the estimate of 48.8%. Under the surface, new orders decelerated and employment saw a relatively sharp decline. All this, while prices paid actually went up. So yet again, a slowing economy with higher prices - stagflation.

The bigger issue was the data on Friday - the Employment Report - that saw the unemployment rate spike to 4.3%. Nonfarm payroll additions also missed expectations coming in at 114k vs. the consensus estimate of 175k.

The market sold off drastically, with the Nasdaq entering correction territory, so to speak. The Nasdaq 100 closed down -11.7% from its peak.

Bond yields fell across the board, first pricing in a Fed cut, and then pricing in steeper cuts and a weaker economy. The 10Y yield fell by the most since 2008.

As far as commodities were concerned, only Gold closed in the green with risk-off and geopolitical fears being priced in.

Macro - How many cuts?

The Fed meeting ended up being pretty much in line with what everyone expected - a dovish hold. Fed Chair Powell certainly put cuts on the table for September but, there wasn’t a sense of urgency about the deterioration in the macro data, particularly unemployment.

The next two days changed all that with a weaker ISM Manufacturing Report and the unemployment rate spiking to 4.3%.

Traders are going overboard with the cuts

The calls for cuts are now getting out of hand. Friday’s headlines read - JPM and Citi were pricing in 4-5 cuts for 2024. In an extreme case, this indicates a possible 50-bp cut in September and November with one 25-bp cut in December.

We don’t think this will be the case, or at least it shouldn’t be.

We continue to stick with the idea that “cutting too much, too soon” will be worse because of inflationary pressures. The Fed’s own projections show inflation remaining above the current trajectory, and there is a matter of base effects that are likely to show up in Q3 and Q4.

The Fed will likely do an insurance cut in September of 25bps, given that the unemployment rate is ticking up to claim a soft landing. However, the truth is, a gradual easing scenario would not make much of a difference if the economy really is headed for a recession, which we still don’t think it is. But from an optics perspective, the Fed would have achieved its goal.

What if inflation starts to accelerate again?

The Fed Funds Rate will still remain considerably high for a while even if the Fed starts to ease. We believe the easing cycle will be shallow to begin with and unless we see definite signs of a recession, the Fed will likely follow the path that they’ve laid out into 2026, with the minor adjustment of starting sooner.

As of now, we see the likelihood of two 25bp cuts in 2024.

Earnings - Valuations are starting to matter

We’ve now had over 75% of the S&P 500 report earnings and the blended earnings growth has moved up to 11.5%. While that’s an enormous jump, we’re clearly not seeing the market react positively to that. Instead, we have a situation where investors are now scrutinizing the numbers and digging below the surface.

Coming into earnings season, the Mag 7 was expected to see a slowdown in revenue growth, and we were expecting this “earnings rotation” wherein, the Mag 7 gives up some of their growth in favor of the rest of the 493 companies and the market in general.

But clearly not everything was priced in.

Valuations are starting to matter

Investors are beginning to question capex spending on AI and the return on their investment. It was only a matter of time before this happened. We saw this issue start to happen with the metaverse hype but, companies were quick to pivot to the AI theme. It was a fortunate turn of events. While the AI story is not the same as the metaverse, there’s only so long that companies can keep talking about AI without meaningful results. We’ve seen some results but, most of the valuation baked into the AI story has been significantly inflated and the market is beginning to question that. Valuations are starting to matter, and we’re likely to see some moderation in earnings for the tech-heavy Nasdaq in favor of the rest of the market.

EPS growth is being gradually moderated

After what we’ve heard from companies, the market is starting to lose faith in high estimates and the elusive 14% earnings growth for this year. This chart from Morgan Stanley shows us that the breadth of earnings revisions is starting to move lower. This chart was from before the recent price action that we’ve been seeing and could be yet one more reason that we’re seeing the sell-off.

Decelerating Inflation & Pricing Power remains a concern

The other issue the market is concerned with is inflation. With inflation decelerating from their highs, the market is worried about the pricing power that companies had. Revenues tend to be far more correlated with inflation and that’s why we’re seeing far more revenue misses compared to earnings misses. Earnings can be propped up through buybacks, and cost controls. But there is little that companies can do, if people are not buying goods at the designated prices.

On the plus side, net profits are increasing. According to FactSet, the blended net profit margin is 12.3%, which is above the last quarter, last year, and 5-year average of 11.5%. Higher profitability leads to increased capex spend and returns to shareholders in 4 to 6 months. If the Fed starts easing in September, this timeline coincides with an easier rate environment.

Earnings Next Week:

Closing Thoughts - Abundance of Caution

What we’re seeing is a corrective impulse with orderly selling - de-grossing and de-risking. We’re starting to see things go wrong, but we’re not at a stage where sentiment and positioning have turned negative. Retail and money managers still remain relatively bullish. We have warning signs, though:

• Somewhat disappointing earnings from the Mag 7

• Election uncertainty increasing

• Weaker macro data

• Geopolitical risks escalating

Add to that, seasonality is not our friend with lower summer liquidity.

What comes next is an abundance of caution since we don’t think that this drawdown is over as yet. With the market in risk-off mode, and apprehensive about a recession, we want to add some exposure to defensives as the market sells off. We want to take a pause here in cyclicals, as we don’t think it’s time to buy the dip just yet.

Have a great week ahead!

Sincerely yours,

Ayesha Tariq, CFA

There’s always a story behind the numbers.

Articles this week from MacroVisor

Calendars

US Earnings Calendar - Above, under Earnings Section

US Economic Calendar in Eastern Time (Source: Trading Economics)

None of the above is Investment Advice. I may or may not have positions in any of the stocks or asset classes mentioned. I have no affiliation with any of the companies other than explicitly mentioned.