From earnings to recession fears—making sense of market volatility
And just like that, volatility made a dramatic return in the past week. While not entirely unexpected, it still sent chills throughout the markets.
A perfect storm denting market sentiment
Investors’ nerves were already frayed going into the weekend, having contended with a set of less-than-perfect tech earnings from market heavyweights, a rapidly strengthening Japanese yen that could potentially cut off an important source of market funding, and a weaker-than-expected U.S. July jobs report.
Then came news that Berkshire Hathaway, led by Warren Buffett, had halved its stake in Apple and boosted the firm’s cash holdings to a record $277 billion—a development that’s widely interpreted as signs that stock valuation has gotten too high and that the U.S. economic outlook has weakened.
This confluence of factors has, unsurprisingly, dented investor sentiment and translated into a sharp market sell-off.
Q2 U.S. earnings: meeting lofty expectations proved challenging
Nearly three-quarters of S&P 500 Index companies have handed in their report cards as of August 2 and, of those, 78% came in above expectations. On a year-over-year basis, earnings growth for the quarter is tracking at around 11.8% while revenue growth may settle at around the 5.5% mark.1 In absolute terms, these numbers aren’t bad—but context is important.
Given the impressive run-up in U.S. stock prices coming into this earnings season, anything less than perfect—meaning a beat on the top line, bottom line, and earnings guidance—might be considered a miss. Crucially, the magnitude of the beats has been weaker.1
Digging a little deeper, we see that Q2 earnings growth is coming in roughly 4.5% above estimates (not bad), but this is below the 5-year average of 8.6%. The picture on the revenue side isn’t too different: At 1.1%, the magnitude of the upside surprise is below the 5-year average of 2.0%.1
Signs of weakness in the macro picture
July’s Federal Open Market Committee (FOMC) meeting yielded no surprise: The U.S. Federal Reserve (Fed) kept rates on hold and adopted a slightly more dovish tone. July’s U.S. jobs report, however, gave investors pause: Only 114,000 jobs were created during the month, some 60,000 below estimates, and the unemployment rate rose to 4.3% while the average work week declined.2
When viewed in tandem with July’s manufacturing Purchasing Managers’ Index, which came in below expectations and hit an eight-month low, it isn’t unreasonable to wonder if the Fed may have a more difficult time engineering a soft landing in the United States than expected. It’s plausible that the Fed may now have to lower interest rates to avoid a sharper contraction in economic activity instead of cutting rates on a maintenance basis (i.e., on the back of falling inflation).
In our view, the sudden change in market sentiment could help focus minds at the Fed: The bond market has priced in a 22% chance of a 50 basis point cut at September’s FOMC meeting.2 It’s worth noting that the Fed typically lowers rates by a total of 4.25% in an average rate-cutting cycle. During that period, the 10-year U.S. Treasury yield falls—on average—by 2.65%.2
Implications for investors
At the point of writing, U.S. Treasuries are working as portfolio diversifiers—they’ve rallied over the past few days on the back of the risk-off backdrop.3 That said, the concern here is that credit markets aren’t priced for a liquidity event. With spreads under 4%, we may see further deterioration. This is why we continue to advocate defensive positioning with a modest overweight in bonds and higher-quality bonds specifically.
On the equity side, we continue to suggest an underweight stance on riskier parts of equities such as nonprofitable small caps, growth at any price, or momentum trading. Instead, it might make sense to lean into the quality-at-a-reasonable-price theme and begin emphasizing more defensive areas of the market such as utilities and infrastructure-related assets.
We may have come to the end of the longest late-cycle period in history and could soon be moving to a recession. Markets typically herald a recession’s arrival, not the other way around. We’d look to high-yield spreads cheapening to attractive levels and changes to Fed policy before looking to add risk, and we’re keeping our eyes on U.S. small- and mid-cap stocks, U.S. credit, and non-U.S. equities. For now, though, we’re choosing to be patient.
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