Week ahead: US in focus as risk sentiment dips

Risky assets sold off at the end of last week, with the S&P 500 and the Nasdaq closing lower on Friday after some concerning US consumer sentiment data. May has been a flat month for stocks, and the S&P 500 is up a measly 0.6% in the last 4-weeks. There are plenty of reasons to sell stocks now: recession fears, a US regional banking crisis that threatens a credit crunch down the line and bonds that are giving equity-like returns. However, there has been one reason why stocks haven’t fallen off a cliff – the better-than-expected earnings season. However, with more than 90% of companies listed on the S&P 500 already having reported earnings, could this pillar of support for US stocks start to give way?

Traders ignore the good news on earnings

It's worth noting that analyst expectations for earnings-per-share growth was dismal, and the bar was low. Even so, for all the challenges facing corporations right now, Q1 has surprised on the upside. There have been some notable outperformers, including Meta and Microsoft, and 78% of the 92% of companies listed on the S&P 500 who have reported earnings have beaten EPS estimates. Added to this, on aggregate, earnings have exceeded estimates by 6.8%, which is above the 10-year average of 6.4%. It is also the highest surprise percentage since Q4 2021. So, why haven’t stocks benefitted more from the positive earnings story? According to data from FactSet, companies that have beaten EPS expectations, have seen average price increases of 0.3% from two days before the release to 2 days after the release. This is well below the 5-year average change in stock price, which is 1%. Interestingly, 48% of companies that have reported higher than expected EPS for Q1, have seen their share prices decline. It could be worse, for those companies that have reported results below expectations, their stock price decline has been larger than average. For example, Tyson Foods reported a weaker than expected EPS for Q1, and its share price fell more than 24% in the four days before the earnings release and the two days after. Markets are not in the mood for corporate earnings misses

Why the lack of enthusiasm?

This is a difficult one to answer, especially since earnings outlooks for Q2 2023 provided by companies and analysts have been less negative overall compared to recent averages. Thus, is the market overly pessimistic? Will the market calm down if the Fed does indeed pause and could we see a rally later in the summer? News flow could be impacting market sentiment and causing the market to ignore the positive earnings news. The US appears to be hurtling towards a debt ceiling crisis, with meetings between the White House and Congress pushed back to next week. The US equivalent of the Office for Budget Responsibility has said that the Federal Government is on track to run out of money by the second week of June, after a notable decline in tax receipts so far this year. Thus, market sentiment is likely to remain flaky and sensitive to any new flow about this issue in the coming days.

US: Long term inflation expectations becoming de-anchored

The other factor worth watching is US interest rate expectations. The University of Michigan US consumer sentiment survey for May saw a sharp decline in consumer sentiment compared to April. The decline was driven by a rise in fears about the trajectory of the economy, and the debt-crisis stand-off. One can assume that sentiment could bounce back if Washington lifts the debt limit, and a crisis is averted. What will be less easy to deal with is the rise in long term inflation expectations. Long run inflation expectations rose from 3% to 3.2%, the highest reading since 2011. This is some way off the Fed’s 2% target inflation rate and suggests that sticky inflation could be here to stay. This is the Fed’s worst nightmare, keeping long term inflation expectations well anchored is something they have wanted to achieve. Thus, Fed speakers this week, including Jerome Powell on Friday, are worth watching closely. After this data, we should expect them to talk down the chances of rate cuts, and instead remain committed to their mission to bring down inflation. The markets remain in a tight spot, and any tough talk from the Fed could weigh heavily on stocks, and tech stocks in particular. The market has already upped the chances of another US rate hike next month, with a 15.5% chance of a 25-bps rate hike to 5.25-5.5% at next month’s meeting. This is up from 8% last week. Overall, we think that the Fed will pause rate hikes, however, the prospect of rate cuts look unlikely in our view, and we think that the risk is high that the 1% of rate cuts priced in by the market between September and January 2024, are too much, and these cuts could be reversed in the coming weeks. There has already been a slight decline in expectations for the first rate cut that is expected in September. There was a 51% probability of rates being cut by 25bps last week, that is now 48%. We will be watching these probabilities closely, if they continue to decline, then it could propel a further leg higher in the dollar rally. The dollar index is already up more than 1.2% in the last month, and it looks comfortable above 102.00, which could signal further gains are afoot.

Looking ahead, the market will focus on UK jobs and wages data out this week, along with Japanese producer prices, Eurozone industrial data and the NY Fed Empire Manufacturing Survey. US retail sales, German ZEW and the Eurozone Q1 GDP reading will also keep the market busy.