Market update: It’s time to take a breather, but what comes next?

Fundamentals in focus, but key risks remain

US stock and bond markets are closed at the start of the week for the Juneteenth national holiday, which comes at a good time as markets have been on a rollercoaster ride in recent days. US equities finished mostly higher on Friday, however, that came after some steep losses post Wednesday’s Federal Reserve meeting, where the US central bank hiked interest rates by 75bps and revised down its growth forecasts for this year and next. The markets have been spooked ever since the May report for US inflation was released, which showed prices rising at a faster pace than expected. Combined with a Fed in an aggressive tightening mode and this has caused risk appetite to nose-dive. The bulk of the selling last week was in the growth and pro-cyclical sectors of the economy, such as tech and the travel sector, however, the move lower was broad-based as the Vix index, Wall Street’s fear gauge, rose to its highest level since early May. In a recent note, we pointed out that historically bear markets can last up to 9 months’, thus, since the current sell off started in January, we may still have 3-4 months’ left before the bulls regain control of the market narrative. 

Why calm may pervade this week 

We should caveat the above remark by saying that the market may not fall in a straight line, and we do not necessarily expect the ferocity of last week’s sell off to continue indefinitely. Instead, we expect further declines in risk assets, we predict the nadir for the S&P 500 to be around the 3,100 mark, punctuated by a few sharp sell offs in the coming months. The same drivers are likely to continue to weigh on the markets: stubbornly high inflation, recession concerns and fears that the Fed and other global central banks are not only behind the curve but are limited in what they can do when supply-side factors are driving price growth. These are the key fundamental factors that have the potential to drive markets lower, but what about this week? We think that the sell-off will stall somewhat this week for a few reasons, although any respite will be temporary. 

1. The US markets are closed on Monday for a public holiday. This will give markets time to pause. A lot of selling took place last week, while there is still more out there in our view, we will need another major driver to push key risky asset prices below levels that are starting to look oversold. 

2. A lot of recession risk has already been priced in, that is why stocks and other risky assets sold off so sharply last week. The US yield curve backed away from zero at the end of last week, however, it remains incredibly close to inversion territory at +8bps. This comes even though the US economy is not in an actual recession. Of course, the signs look bad: inventories are building up at a rapid rate and the consumer is pulling back, as evinced by the 0.3% dip in US retail sales last month. However, even if we get more negative economic data coming out of the US, this is now expected by the market. Thus, this week’s housing data, which is expected to moderate further for May, may not lead to a major sell off, and the market may also take the expected decline in US consumer sentiment in its stride. Likewise, even Fed President Jerome Powell’s two days of testimony to the US Congress on Wednesday and Thursday this week is unlikely to spook markets since we doubt that he will stray too far from his message at last week’s Fed meeting. Over the weekend, Fed Governor Waller said that he would support another 75bp rate hike at the July meeting, he also added that the Fed is “all-in” on re-establishing price stability. His most telling remarks came when he said that the Fed made a mistake by not hiking sooner after the pandemic as that made the Fed less flexible to adjust to the changing economic situation in 2021. If Chairman Powell hints that the Fed is basically impotent when it comes to tackling inflation when he addresses Congress this week, then it could trigger another market sell off. If Powell wants to lower market volatility, then his message should be that the Fed has everything under control, even if they started hiking rates a little late, and that the US economy remains resilient. 

3. Technical factors could also prop up some risky asset prices this week. The S&P 500 is approaching a key level at 3,500, which many analysts are treating as key support. While we don’t think that this level will mark the end of the sell-off in US blue-chips, we respect this level as it is both a Fibonacci and a Point and Figure support level. Some are also arguing that the new moon on 28^th June, which also roughly corresponds with the end of the second quarter for trading on 30^th June, are also signs that the selloff could be coming to an end, as sometimes markets can change direction during a new lunar cycle or at the end/ beginning of the year or quarter. Obviously, take this with a pinch of salt, but in these unusual market times, anything goes. 

Fundamentals are in focus 

Overall, we think that markets will want to sit and take stock this week. It is a time to digest plenty of economic data including UK CPI data, which is expected to rise a notch to 9.1% from 9% in May. While this would be a smaller monthly rise compared to April, UK inflation is unlikely to peak until October, when the energy price cap will be lifted once again, and inflation is expected to be pushed into double digits. If UK inflation data follows the US and jumps by more than expected last month then the pound and other UK asset prices could come under pressure. 

Watch out for the preliminary PMI reports that are also due for release in the major economies this week. These reports have been over-estimating economic strength in recent months and have diverged from the global economic data. However, look closely at new sales and at the latest inventory figures, as these could tell us how bad the global economic situation really is. Also, for those who track the FTSE 100 closely, the oil price sold off last week alongside risky assets as recession fears took hold. This weighed heavily on UK-listed oil companies such as BP, which dropped 6% on Friday. This was the first time the oil price had fallen so consistently for several weeks, and producers felt the hit. However, the Brent crude oil price has opened higher late on Sunday, which could see the oil producers follow suit. Thus, the FTSE 100 may be a beneficiary of calmer markets at the start of this week.