The stock market comeback stumbles: the Fed means business

This week has been a rollercoaster ride for equity traders. The massive sell off in US stocks on Tuesday was a truly rare event. The 4% + decline in the S&P 500 was the sharpest sell off in 2-years. To put this move into some context, this sell off is 4 standard deviations from the mean daily performance of the S&P 500. This type of move usually preludes a crisis. In all my years of working in financial markets, I have not seen the market react like this to one economic data report. Every single stock on the Nasdaq fell at one stage on Tuesday, and since then US stocks have failed to gain traction. After wavering on Thursday, US stock markets turned lower in the afternoon, with the S&P 500 closing down more than 1.2%, while the Nasdaq Composite index was down nearly 2% and the Dow Jones closed at its lowest level for two months. The selloff was broad based, Treasury yields jumped (bonds sold off), the 2-year Treasury yield rose 8 basis points on Thursday, which caps off a bad week for bond market bulls, the 2-year yield has jumped some 35 basis points this week, and the yield curve (10-year Treasury yield – 2-year Treasury yield) has fallen further into inversion territory.

How to interpret market moves

The most basic description is that the Fed is focused on bringing inflation back to the 2% target rate, which will mean tighter monetary policy for longer. The market was also wrong in assuming that the Fed would 1, accept higher inflation and 2, pivot away from aggressive rate hikes. While we think that the market overreacted to the August inflation report, the prospect of a Fed pivot to a more dovish stance is starting to look like a 2024 event, not a 2023 event.

When expectations and reality collide

As John Authors said earlier this week in his Opinion article for Bloomberg, “selloffs happen when expectations and reality collide” – never a truer word spoken! The problem for the US economy right now is that CPI likely hasn’t peaked in the US yet, and risk factors are building for higher inflation later this year. For example, the US will start building back up their strategic petroleum reserves later this year, which could put upward pressure on the oil price in time for winter, service sector inflation is still rising – the St Louis Fed’s sticky CPI index for the US reached its highest level since 1982 this week. Added to this, there are oil supply/ demand imbalances and the threat of an Opec production cut. Data on Thursday did not help bring any clarity for financial traders, for example, initial job claims were weaker than expected, dropping to 213k for last week. Added to that, import inflation did not fall as much as expected, and retail sales excluding autos fell 0.3% in August. Thus, the US consumer is weakening at the same time as inflation remains high, and the labour market is strong, which means the Fed will remain in hawkish mode.

Adobe’s M&A woes

This fundamental analysis translates to weaker retail, tech and communications sectors, while defensive sectors remain bid, such as healthcare, which was the top performing sector on the S&P 500 on Thursday, closely followed by financials, which are benefitting from the talk of a higher terminal Fed Funds rate. The worst performing sector was tech, after Adobe fell more than 16% on Thursday after it announced a $20bn deal to buy Figma, the interface design web application firm. This is an interesting reaction to a deal that could benefit Adobe in the long term. The sharp selloff suggests that the market does not like M&A in the current environment, as the cost of financing goes up, the selloff is also a sign that the market is worried about the economic future, and thus the prospect that Figma will deliver for Adobe. Thus, other M&A announcements in the coming days and weeks could elicit a similar reaction to Adobe’s.

Oil price decline

Markets are on a war footing and are bracing themselves for a recession, even though the US has been in a technical recession since June. This fear is also evident in the commodity market. Brent oil prices tumbled more than 4% on Thursday and this dragged down the oil majors, with BP falling 2% during the US session. As we have mentioned before, we believe that $80 per barrel could be a floor for Brent crude, after it fell through the key $90 support level on Thursday. While we think that there could be more downside for oil and stocks, ultimately, we believe that the oil price could recover when the Biden administration in the US starts to re-fill the strategic petroleum reserve early in November and when the dollar finally starts to weaken.

FX: dollar dips after strong week

Overall, it’s hard to see how sentiment will pick up before the end of the week, especially as we wait for next week’s Fed meeting. On the FX front, the dollar has lost some of its momentum from earlier this week, USD/JPY has backed away from 145, while EUR/USD hovers close to parity. GBP/USD fell to a fresh multi decade low earlier, after the announcement of the UK mini-budget for next Friday. We don’t like the prospects for the pound as fiscal plans and more government spending will require a weaker currency to attract buyers of gilts. Thus, we believe that future periods of pound strength could be sold into. Only the Fed can halt the slide in stocks and weigh on the dollar at this stage, so the focus is squarely on next week’s meeting.