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MARKETS

The S&P 500 rebounded after a two-day slide following a hawkish FOMC meeting, which left rates unanchored and heightened market sensitivity to even tier-2 economic data.

This increased attentiveness underscores the market's propensity to react to even minor shifts in US economic data.

Indeed, positive activity readings and the most significant two-week decline in initial jobless claims since September dominated the narrative during an otherwise slow news week, paring rate cut bets and skewering investor sentiment.

However, a glimmer of rate cut optimism appeared on Friday following the release of a sombre University of Michigan sentiment survey. According to the final report, the survey indicated a significant drop of over 10% in May, reaching a six-month low.

The drop in the University of Michigan sentiment index is statistically significant, pushing the headline gauge to its lowest in five months. Survey director Joanne Hsu highlighted multiple consumer spending risks, particularly concerning the labour market. Americans expect rising unemployment rates and slowing income growth, a troubling combination of fewer jobs and slower pay growth on Main Street.

On the bright side, waning demand might help reduce inflation, alleviating consumers' worries about higher rates, which were also evident in Friday’s update. Year-ahead inflation expectations were revised to 3.3% in the final May reading, down from the preliminary 3.5%. This revision provided a modest boost to sentiment and lowered near-term inflation expectations.

This release hit the sweet spot in a market eager for positive inflation news and negative economic prints. Lower inflation expectations and weakening consumer sentiment could prompt the Federal Reserve to lower rates, potentially boosting already high US benchmark index prices. This scenario aligns with the modern-day stock operator's playbook, where lower rates are vital to pushing stocks higher.

The Nasdaq closed Friday at a fresh record high, propelled by gains in chipmaker Nvidia, which overshadowed concerns about a prolonged period of higher rates from the Federal Reserve. Meanwhile, the S&P 500 erased its midweek losses, ending the week with a marginal gain. This demonstrates the market's resilience and the pivotal role of tech stocks, particularly those like Nvidia (NVDA), in driving broader market sentiment despite ongoing monetary policy uncertainties.

But this isn’t just a one-trick pony show. The market has broadened significantly in recent months. While tech giants like Nvidia continue to play a crucial role, other sectors have also shown resilience and growth. This diversification indicates a healthier and more robust market environment, where gains are not solely reliant on a few significant players but are supported by a broader range of industries contributing to the overall market momentum.

Utility stocks finished in the green, continuing a hot streak for a sector that has emerged as an unexpected beneficiary of the AI boom. According to sector analysts, AI data centers could account for 10.9% of US electricity demand by 2030, up from 4.5% today. Suppose power needs to grow as much as anticipated. In that case, this will necessitate more power plants, transmission lines, and other infrastructure investments, leading to increased returns for the companies that build them. This projected growth highlights the critical intersection of AI technology and the utility sector, presenting significant opportunities for investors and infrastructure developers. Indeed, the AI ripple effect keeps going on and on, just like the Energizer Bunny.

The recent surge in utility stocks marks a significant turnaround from the previous year when the Federal Reserve's interest-rate hikes created an environment ripe with high-yield investment opportunities. This shift has turned traditionally risk-free Treasurys into attractive cash machines, diverting investors' attention away from utilities and their historically reliable dividends. However, the recent success of utility stocks signals a renewed confidence in the sector, hinting at the potential for future growth and stability.

While Nvidia has stood out as that hardware store on the prospecting hill -- the modern-day Levi Strauss. The build phase may also benefit the 'shovel providers' of this AI' gold rush' -- the companies that provide the computing power and tools necessary to build the models needed to compete.

FOREX MARKETS

FX markets continue to be range-bound as the argument for divergence is not convincing, and economic data fails to present a convincing case for a full-blown easing cycle among the majors.

The hawkish undertone of the Federal Reserve minutes prompted a moderate dollar strengthening across the board, essentially reversing most of the greenback's losses post-CPI.

In the Eurozone, the latest run of economic data has largely supported a less dovish stance from the European Central Bank (ECB). Strong PMI results have indicated ongoing growth momentum, while negotiated wages unexpectedly rose from 4.5% to 4.7% year-on-year in the first quarter. However, recent ECB communications have made a June rate hike almost certain. Nevertheless, the possibility of a hawkish cut could limit the Euro's decline.

In Japan, headline inflation has held up better than anticipated, but predicting tops in USD/JPY remains challenging. Forex traders anticipate a resurgence in consumer inflation for May, primarily driven by elevated utility prices. This expectation is likely to be confirmed by Tokyo's upcoming inflation data, which is scheduled for release this Friday. Despite anticipated fluctuations in inflation due to various government initiatives, this temporary deceleration isn't expected to alter the Bank of Japan's stance on policy normalization.

Despite these factors, FX traders continue to display a bullish bias on USD/JPY, driven by a carry-oriented approach. With only a 25 basis point increase anticipated by year-end and US rate cuts being scaled back, traders are expected to continue testing the limits of Japan’s FX intervention tolerance. A move towards 158.0 seems increasingly plausible in the coming days. This combination of modest rate hike expectations in Japan and a strengthening US dollar sets the stage for another challenge to the Bank of Japan's intervention policies.

OIL MARKETS

Crude oil futures rebounded from three-month lows on Friday, albeit with weekly losses, as the Memorial Day holiday marked the start of the summer driving season.

WTI touched an intraday low of $76.15 during London trading, its lowest level since February 26th. Similarly, Brent crude's global benchmark dropped to $80.65, marking its lowest point since February 8th.

Although both benchmarks recovered later in the session, they still ended the week with losses of 2.9% for U.S. crude oil and 2.2% for Brent crude.

Traders are adapting to the increasing likelihood that interest rates will remain elevated for an extended period as inflationary pressures persist. Fed officials have indicated a cautious approach to easing monetary policy, signalling patience before considering a reduction in the federal funds rate. The federal funds rate is within a target range of 5.25% to 5.5%.

The confluence of elevated interest rates and persistent inflation is poised to impede economic growth, a trend already evident in U.S. manufacturing activity, which continues to contract. This dual pressure on consumer purchasing power and demand could further exacerbate the slowdown.

However, whether these economic headwinds will deter drive-happy Americans remains uncertain. Despite the economic challenges, Americans are not shying away from hitting the highways this weekend. As the Memorial Day holiday weekend unfolds, today marks the second day of festivities. AAA anticipates a record number of travellers venturing more than 50 miles over the holiday weekend, projecting 38.4 million holiday travellers. This figure reflects a 4% increase from the previous year and is 1.9% higher than the pre-COVID Memorial Day weekend in 2019.

We aren't consistently bearish on oil, and with WTI trading below our year-end target of $80, we actually initiated long oil contracts for the first time in months on Friday. We closed our short positions and reversed our stance, reflecting a more neutral to slightly positive outlook on oil prices.

Where Do We Go From Here?

Equity markets remained relatively stable this week, with the S&P 500 essentially flat. Stocks are holding near record highs in North America, even as expectations of Fed easing are being scaled back and longer-term Treasury yields are trending higher. With valuations already stretched—a topic worthy of discussion—the market increasingly relies on the premise that earnings will remain solid.

With about 470 S&P 500 companies having reported Q1 results, 78% have exceeded earnings expectations, according to Refinitiv. The average earnings surprise is around 8%, consistent with typical earnings-season norms. The technology and health sectors have led the way, nearly 90% of companies beating expectations. This strong performance has pushed overall S&P 500 earnings growth to 8% year-over-year, compared to the 5% growth anticipated at the start of April. While these results aren't a significant upside surprise, they have been good enough to keep bearish sentiment at bay.

The market, always forward-looking, seems untroubled by near-term prospects, focusing instead on the next six to twelve months. Several macroeconomic factors historically influence earnings growth, and the current outlook is mixed:

Yield Curve: The deeply inverted yield curve, which has been a significant concern for investors, traditionally predicts economic growth and impacts sectors like banking. Despite some steepening in the latter half of 2023, progress has stalled, with the 10s/2s curve remaining around -40 bps. While rate cuts could help steepen the curve, persistent core inflation makes that unlikely in the short term.

Economic Growth: U.S. growth appears to moderate, with real GDP expanding at an annual rate of 1.6% in Q1 and forecasted to remain below potential for the rest of the year. This is a notable shift from the 3.1% year-over-year growth seen through Q4 2023. Some might argue that the 10% correction in the S&P 500 from last July to October has already priced in this slowdown, with the recent rally reflecting optimism for a re-acceleration in late 2024. Indicators such as ISM new orders have stabilized in modest growth territory, while payroll growth has cooled.

The Big Dollar: A strong U.S. dollar typically dampens domestic corporate earnings by reducing export demand and the value of foreign earnings. The dollar's pullback in 2023 has likely supported growth, but its decline has stalled as expectations for Fed easing are delayed while other central banks are on the verge of easing. We anticipate that eventual Fed rate cuts will exert downward pressure on the dollar through 2025.

Profit Margins: Corporate profit margins remain robust, defying the steep contraction typically seen at the onset of a recession or bear market. Firms have successfully passed higher costs onto consumers, maintaining healthy margins.

In summary, while not an unequivocally bullish environment for earnings, the macroeconomic conditions suggest stability. The market appears to concur, maintaining a cautious yet optimistic stance. ( BMO)

What’s The Key Takeaway From Last Week

It seems like nobody emerged from this week with any significant new insights.

By Friday afternoon in the US, the S&P was poised to close mostly flat for the week, contradicting a consistently hawkish message from Fed officials and another exceptional report from Nvidia. In essence, it wasn’t necessarily a “quiet” week. Instead, things just ended up staying “unchanged.”

Looking ahead to next week, there may not be any definitive developments either. The second estimate of Q1 US GDP and an update on the Fed’s preferred price gauges are scheduled, but these releases will unlikely alter the Committee’s “higher for longer” bias. Any potential narrative shift will likely have to wait until the first week of June when NFP hits

It appears that the Federal Reserve's actions are increasingly having less impact on equities (and risk assets in general), or perhaps the market has acknowledged that rates will remain somewhat elevated indefinitely. It's becoming evident that current policy settings are not truly restrictive. In fact, many serious observers are beginning to recognize that higher rates may actually contribute to the growth momentum in the US, as interest income fuels spending at the household and corporate levels. So, why should stocks be concerned?

Some bearish investors have either thrown in the towel or, to put it more mildly, have acknowledged the slim chances of a significant market downturn that would validate aggressively bearish year-end SPX targets. For instance, Mike Wilson revised his 12-month forecast higher this week. However, Marko Kolanovic remains steadfast in his stance.

CHART OF THE WEEK

" Our Risk Appetite Indicator reached a new high since 2021 on Friday,” analysts including Andrea Ferrario and Christian Mueller-Glissmann wrote in the Banks ( Goldman Sachs) Commentary this week.

So when everyone is on the "risk on" wagon, it usually means investor positioning; hence, markets are overly susceptible to even mildly bad news. If this is not intuitive, do not quit your day job. 

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