May 3, 2023
Two of the three most likely Fed scenarios would likely result in upside for the S&P 500. Though the probability is something under ~5%, the ‘no hike and pause’ scenario would probably result in initial SPX upside of ~1.5%. The ‘hike and pause’ scenario has a ~55% probability with expected upside of 0.50%-1%. We assign a ~40% probability to the ‘hike and continue’ scenario, which would likely result in immediate downside of ~1%-1.25%. A hike and pause outcome would make the Fed data dependent on MoM core CPI. The next two CPI reports hit before the June Fed meeting with officials looking for deceleration from last month’s +0.384% print.
In our opinion, 10-year Treasury yields need to break below 3.20% to confirm a longer-term peak in nominal yields. Applying historical moves based on US sovereign credit rating downgrade would get us pretty close. Thus far, the 3.21%-3.32% range has contained rallies. Ultimately, we expect a break to lower levels, but it may not happen as soon as we’d like. Ten-year real yields have a strong negative correlation with the performance of the Tech sector. Ten-year real yields currently sit at +120bps, and a break below +108bp would confirm a top. A confirmed top in real yields would lead to multiple expansion and outperformance for the Tech sector. Real yields are calculated by subtracting inflation expectations from nominal yields. Getting 10-year real yields below 108bp requires nominal yields to fall faster than inflation breakeven yields. But a correction in equity markets would increase the probability for inflation breakeven yields to trade below support at 209bp. The bottom line is that Tech multiple expansion requires a more prolonged disinflationary cycle, which seems unlikely in the near term.
Narrow upside equity leadership and weak market breadth are often characteristics seen in the later stages of a bear market rally. For context, consider that the top 9 holdings in the SPX are responsible for 80% of the gains this year.
History shows that monetary tightening works with a lag, and sustained equity rallies require the Fed to first end its hiking cycle. History also shows that the Fed won’t end its hiking cycle until a recession has already started. Economic recessions from the past share a negative feedback loop between lower consumer spending, falling corporate profits and rising unemployment, which feeds back to lower consumer spending. All those components of the economy appear ok, but recessions tend to come on fast. Consumer spending was strong in January and February, but bank card spending data from March and April slowed considerably. Consumer excess savings have eroded, money supply is contracting and bank lending standards are tightening. Q1 earnings prints have come in better than expected, but aggregate full-year guidance has remained unchanged as a rising cost of capital leads to a peak in profit margins. Labor markets have remained strong in Q1, but labor markets are a lagging indicator and the recent rise in jobless claims deserves attention.