“Horses, with their supernatural ability to use their limbic nervous systems to discern truth and congruency, do not base their choice of the leader of their herd on strength or intellectual wisdom. Nor is their choice based on which member might keep the herd safe from a predator wolf. They choose the one who feels the group best and who cares the most. They choose the horse—usually a mare—who is most capable of holding that care in a way that calms the whole group.
— Jerry Colonna
The View from 30,000 feet
As if the dynamics for U.S. Treasuries weren’t bad enough, last week’s ousting of McCarthy as Speaker of the House further shook already eroding confidence in U.S. politics and the fiscal picture. Last week Bank of America published a research piece noting that the last three years represents the worst rout in the history of the U.S. bond market (236 years), with the cumulative losses in the $25t Treasury market now close to -25%. Losses in the bond market are being compared to the wipeout in equity experienced by holders of technology in the dot-com era. With that as the context and backdrop of the markets, it’s surprising there has not been even more disruption to the equity markets, with the S&P500 only off about -6% from its recent high set in July. The end of last week marked an interesting turn, as good news in demand for workers (claims and unemployment) mixed with evidence of a continued trend down in wage pressures (average hourly earnings), providing hope for investors that Goldilocks is alive and well. Skeptics of Goldilocks seem well justified, given multi-decade highs in borrowing cost, but the fact is, evidence of a material slowdown in the economy has yet to appear. With this in mind, all eyes will turn to Q3 earning season, which kicks off in earnest this week, as investors look for clues of either continued momentum or signs that the Fed’s efforts to curb growth are taking a toll. Further complicating the cross currents in the markets, was the weekend attack by Hamas of Israel. Early week action is likely to provide a stark reminder that geopolitics and human lives are what matter most to both markets and humanity.
- Q3 Earnings preview
- Energy quietly shifting from an inflationary headwind to a disinflationary tailwind
- Shake up in Congress brings nothing but bad news for the U.S
- The most Frequently Asked Question from clients this week: What’s the downside to the S&P500 in a recession?
Q3 Earnings preview
- Q3 is projected to be the fourth straight quarter of year-over-year declining earnings for the S&P500, with year-over-year earning for the quarter now expected to fall -0.3%. However, it should be noted that Q3 is projected to be the smallest year-over-year decline of the last four quarters.
- Some good news:
- Q3 earnings estimates only decreased -0.3% since the end of Q2. This is an extremely small decline. Historically, earnings estimates are marked down between -3.5% and -4.5%, in the quarter leading up to earnings announcements.
- Historically, companies have had the tendency to beat earnings estimates by 3% to 5%. If this is the case in Q3, actual earnings will turn positive on a year-over-year basis.
- A total of 116 companies have issued earnings guidance for Q3, outpacing the number of companies issuing guidance at any time over the last five years. The increase has been led by Technology, which had a 25% increase in companies issuing guidance. One possible way to interpret this is that companies have more certainty in their internal forecasts.
- Q4 is expected to mark the return of year-over-year earnings growth, with the S&P500 expected to grow earnings by 8.3% year-over-year. It also marks easier comps, making it more manageable for companies to increase annual growth.
- Valuations are not cheap, with the Forward P/E now at 17.5x, but not wildly expensive either as compared to the five-year average of 18.7x and 10-year average of 17.5x.
- We’ve found that sequential quarterly earnings provides more valuable information on earnings momentum than looking at year-over-year. On that note, Q3 is projected to be sequentially higher than Q2 and will mark the third consecutive quarterly increase.
Q3 marks a trough based on annual growth and momentum based on quarterly growth
Energy quietly shifting from an inflationary headwind to a disinflationary tailwind
- WTI Brent rose from 67.12 om June to 93.68 in September, a staggering 40% increase. As painful as that sounds, the average American consumer didn’t feel the pain at the pump, with the Daily National Average Gasoline Price only increasing by about 10%.
- Unfortunately, the increase in gasoline prices was enough to cause headline inflation to surge 0.6 for the month, spooking the Fed and instigating the current “higher for longer” narrative that helped to ignite bond yields.
- The good news is that as of the close on Friday, WTI was down -12% since the September high, with gasoline prices down -4%.
- Even better news for prices is that wholesale gasoline prices are down over -20% from their September highs, and Crack Spreads are down -48%, their steepest fall since June of 2022.
- Empirically, Headline CPI has been leading Core CPI since the pandemic. The spike in oil and gasoline prices in the last CPI report raised red flags. However, the recent weakness in oil and gasoline, combined with the sharp fall off in wholesale gasoline and crack spread, provides visibility that energy should play a less role in inflationary pressures in the coming months, with a wildcard being thrown in based on impacts of hostilities in the Middle East over the weekend.
The spike in August Headline CPI driven by Energy not likely to repeat in September
Shakeup in Congress brings nothing but bad news for the U.S.
- Last week’s ousting of McCarthy is bad news for the U.S. on a number of fronts:
- The current funding of the U.S. government is set to run out on November 17th. With a leadership vacuum, it becomes unlikely that a deal will be reached to fund the government without a shutdown. It’s estimated that a shutdown will detract between 0.1 and 0.2 from GDP each week the government is shutdown.
- The likely candidates are Scalise(R-LA) and Jim Jordan (R-OH), bothrepresentmoves totherightfrom McCarthy and willlikelycreatefrictionin reachingfuture compromises.
- The chaos in Washington weakens chances of continued aid to Ukraine. There is a large contingent of Republicans opposed to Biden’s $40b request for funding. This will embolden Putin and the enemies of the West, flaming further hostilities.
- The word is that Democrats pulled support for McCarthy because he backed down from his criticism regarding the January 6th insurrection and aligned himself with the Biden impeachment contingent. The tit-for-tat mentality in Congress is causing Americans to believe that infighting is more of a priority than governing.
- Possibly the largest issue that McCarthy’s dismissal creates is it creates a gap in creditability for Congress. The U.S. electorate and its allies recognize the weakness, as do enemies of the State. It means Ukraine can no longer rely on the U.S. for economic or military support. The world is calling into question the fiscal responsibility of the leaders of the U.S. Enemies see less consequence in launching hostilities because they perceive the U.S. is playing with a weak hand and unable to unite against with its allies, perhaps emboldening organizations like Hamas.
Partisan fighting has taken over U.S. politics, raising questions about financial stability
FAQ: What’s the downside to the S&P500 in a recession?
- The Fed’s most recent shift to “higher for longer” means higher real rates and an increase of restrictive policy for 2024, which increases the probability of a hard land (recession).
- Although Q3 earnings are expected mark the end of year-over-year earnings declines for the S&P500, investors should not be complacent because in an average recession earnings fall by 5% to 15%.
- Current 2024 S&P500 earnings estimates are 247.52, which is up from 2023’s estimate of 221.17. This would represent a 10.6% increase in earnings, if it were to transpire.
- If there was to be a recession, and that recession brought with it a normal downdraft in earnings, that would mean earnings would be somewhere in the range of 235 to 210.
- A mild recession, would likely bring with it selling that might take the S&P down to as low as 14x. Although, the recession scare in 2022 only took the S&P500 down to 16x. Let’s say the downside range is somewhere between 14x and 16x, keeping in mind that during the GFC, the Forward P/E’s briefly broke below 10x, so there is some scope for a range lower.
- If we use the earnings range of 235 to 210, on a Forward P/E range of 14x to 16x. This gives a range for the S&P500 in a recession scenario of 2,940 to 3,760, which would be -32% to -13% lower than Friday’s close.
- Given that there is no reason at this time to believe that we would be looking at a severe recession, the most likely downside is a -15% to -20% selloff that quickly reverses, as the Fed aggressively cuts rates.
Interest rates are restrictive, and base on Fed rhetoric set to get more restrictive, risking recession
Putting it all together
- The markets ended last week with positive action likely driven by selling exhaustion coupled with a positive spin on the recent jobs data that indicated that job growth was robust and wage pressures were easing.
- Based on our market internals calculations, the equity markets did not reach sufficiently oversold levels to indicate the current wave of selling is quite done.
- To further complicate matters, the Hamas attack of Israel over the weekend introduces another wave of uncertainty into market conditions that will likely drive a risk-off move and simultaneously create a bid for save haven assets such as Treasuries and Gold.
- The macro environment has dominated market action over the last month, driven by energy prices and questions about the fiscal responsibility and ability to govern of U.S. law makers. We can now add increased geopolitical tensions to the list of macro drivers.
- At least one of these pressures looks to be easing with energy prices experiencing wholesale price weakness, but turmoil in the middle east may change that picture.
- Regardless, the Fed is likely to view increased uncertainty and the associated tightening of financial conditions attached to the uncertainty as positive regarding their fight against inflation, which reduces the probability that the Fed will continue to raise rates, and may even set in motion easing faster than the market is currently pricing.
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