Inside Markets — Orderly Decline

Yesterday’s orderly decline in equity markets suggests the broad macro outlook remains relatively benign.  The decline will be far less orderly when the macro environment changes.  For now, markets are giving the ‘January Effect’ on CPI the benefit of the doubt.  There are some minor inflation reports still due this week that could influence the message on inflation and Fed policy, but markets will likely wait at least until the release of January core PCE on 2/29.  Core PCE, which is running much closer to target is the Fed’s preferred inflation measure but the divergence between it and CPI will remain a source of concern for the Fed.  And the most likely risk to the outlook remains a Fed-induced recession.

Yesterday’s hotter-than-expected CPI should be enough to keep equity buyers on the sidelines for the time being. However, we see investors adding more equity exposure once bond yields peak. Yesterday, 10-year Treasury yields backed up until they reached the 100-day moving average near 4.33%. Ten-year yields are lower to 4.25% today and a peak would be confirmed once they close below ~2.19%.  Note that we could first see a bit more backup in 10-year yields into the 4.40%-4.45% range. The break below ~2.19% could come on tomorrow’s retail sales number, but it’s more likely to occur after the 2/29 core PCE print or 3/12 CPI report.

Simply put, equity markets rise and fall on earnings estimate revisions. The CQ4 earnings season continues with mid-single digit upside in estimates thus far. That’s a pretty good outcome in an environment where real yields remain highly restrictive, but it’s well below consensus expectations for 10%+ earnings growth next year.  The biggest upside estimate revisions are hitting the largest 10-20 stocks, while the rest of the index struggles.  Narrow leadership is a bearish internal signal that usually occurs in a maturing market cycle.  We’ve been hoping to see the leadership broaden out, but the data on estimate revisions suggests otherwise.  The RTY is the index to follow with sustained closing levels north of ~2070 helping to diminish the bearish internal threat of narrow leadership and performance concentration.