Pre Asia Open: For US Equities, The Higher For Longer Rate Bell Tolls

Photo by Kittitep Khotchalee on Unsplash
Photo by Kittitep Khotchalee on Unsplash

Last week, equity markets continued their downward correction despite solid economic data. This correction was driven by the realization that rate cuts are not imminent or as aggressive as previously anticipated. The S&P 500 experienced a 3.2% decline by late Friday, with notable sectors such as technology, consumer discretionary, and communication services posting significant losses. The steep selloffs from mega-cap high-tech players further compounded this downturn.

Friday's market meltdown was heavily influenced by significant declines in the tech sector, with Super Micro Computer and Nvidia taking notable hits. Super Micro, an equipment provider for artificial intelligence tasks, experienced a sharp 23% decline, marking its most significant drop since August and closing at its lowest level in over two months. Chipmaker Nvidia also witnessed a substantial 10% decline, marking its most significant single-session plunge since the onset of the pandemic in March 2020.

Expectations for rate cuts have been consistently scaled back, with Fed Chair Powell indicating that the probability of near-term easing is diminishing. This shift follows robust labour market data and a persistently sluggish improvement in underlying inflation metrics. As Powell articulated last week, "the recent data have clearly not given us greater confidence, and instead indicate that it's likely to take longer than expected to achieve that confidence."

Initially, the market was highly optimistic about rate cuts at the beginning of the year, with approximately 125 basis points of easing priced in. However, the current sentiment has shifted significantly, with the market pricing in only 40 basis points of cuts and the first full 25 basis point cut not anticipated until November.

Equities initially shrugged off this year's consistent rise in bond yields and diminishing Fed expectations, relying on solid economic growth to support earnings, with the assumption that the Fed would eventually ease. However, recent days have seen murmurs questioning whether rates are restrictive enough to rein in the economy and inflation, transitioning from the fringe to the mainstream media. Consequently, stocks are now showing signs of strain.

This month, the correlation between the seemingly impervious US equities and the repricing of rates and geopolitical tensions has reached its limit. The S&P 500 cracked on Friday for its most significant decline since Jerome Powell's pivot on October 19.

The straightforward interpretation suggests that prolonged high or higher rates will necessitate an unwinding of the valuation expansion that fueled one of the most remarkable five-month equity rallies in recent memory. However, there's a secondary concern: The Fed has presently elevated the risk of a "hard landing" by endorsing or tolerating a "soft landing" scenario too early in the cycle.

The Fed inadvertently exacerbated the situation by prematurely easing financial conditions through the "insurance cuts" approach before inflation was fully contained. Coupled with continued government fiscal generosity, this has increased market-implied probabilities of transitioning into an economically unstable "no landing" scenario in recent weeks.

It's not just monetary policy that's facing scrutiny. Fiscal policy has also failed to alleviate the inflationary challenge, which could eventually pose a greater risk for the global economy. Additionally, oil prices have posed a significant obstacle this year, surging over 20% from $70 to above $86 before moderating slightly this week to around $83. Gasoline prices have followed suit, climbing over 30% since January at the wholesale level, albeit showing some moderation last week

Simultaneously, the escalating frequency of war-related headline bombshells is likely contributing to a developing shift in the equity volatility complex, causing some disruption in the systematic realms.

To say last week was a bad week for Wall Street could be the understatement of the year. Suffice it to say that it’s unlikely investors are enamoured with the current mix, which is parchment wrapped with elevated geopolitical risk amid hawkish-fed rhetoric where the idea of delaying cuts until 2025 and the possibility of rate hikes entered the conversation. Hence, for US equities, the higher for longer rate bell tolls

Big Tech earnings are set to arrive this week, hopefully in a timely manner. After enduring its most challenging week in over a year, investors are seeking a potential artificial intelligence-driven windfall to lift the downtrodden S&P 500 Index.

The bar is indeed set quite high. The question looming is whether we've reached a juncture where only a powerful earnings performance will propel stocks further upwards.

Last quarter, corporate America knocked it out of the park, with aggregate earnings per share (EPS) growth reaching a solid 8%. That's more than double the pace predicted by bottom-up company analysts.

Consensus forecasts point towards a 3% aggregate EPS growth for Q1 earnings. While this would mark a slowdown from the pace seen in Q4, it's worth noting that the pre-season bar is the highest it’s been in nearly two years.

While occasional dips in mega-cap performance may occur, very few quarters can be objectively classified as poor. The perception of a "bad" quarter often hinges on analyst’s relative or subjective measures rather than absolute balance sheet shortcomings.

If you're not exactly jumping for joy, you're not alone. As a macro trader, earnings season is nothing more than a distraction. But hey, who can resist the excitement of seeing how companies maneuvered their way to better-than-expected profits over the last quarter? It's like a high-stakes game where anything can happen, and everyone's trying to come out on top.


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