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U.S. STOCKS GET BRAINED, BUT DEFENSIVES LOOK SMART (1605 EDT/2005 GMT)
Wall Street’s main indexes to a knock to the head on Tuesday, as weakness in tech and other growth stocks weighed, after comments from Federal Reserve Governor Lael Brainard spooked investors about potential aggressive actions by the central bank to control inflation. .N
Brainard said she expects a combination of interest rate increases and a rapid balance sheet runoff to bring U.S. monetary policy to a “more neutral position” later this year, with further tightening to follow as needed.
Indeed, modest early strength in the S&P 500 .SPX evaporated a little more than 30 minutes into the trading day, essentially coinciding with when the Brainard remarks hit the wire.
It was pretty much all downhill after that, as the U.S. 10-Year Treasury yield US10YT=RR spiked to 2.5670%, a fresh high back to May 2019.
With this, growth names suffered the brunt of the selling. The NYSE FANG+TM index .NYFANG slid more than 3%, while the Phil chip index .SOX collapsed 4.5%.
Value .IVX significantly outperformed growth .IGX. However, both indexes ended red.
Nevertheless, there were some pockets of strength. Defensive sectors, including utilities .SPLRCU, healthcare .SPXHC, staples .SPLRCS and real estate .SPLRCR all ended in positive territory.
Here is Tuesday’s closing snapshot:
RECESSION FEARS LIKELY TO BECOME REALITY – DEUTSCHE BANK (1440 EDT/1840 GMT)
The double-whammy of already heightened inflation and Russia’s war on Ukraine have prompted some analysts to downgrade their global economic forecasts and adjust their projected likelihood of near-term recession.
Deutsche Bank (DB) now expects “the U.S. economy to be in outright recession by late next year, and the euro area in a growth recession in 2024,” according to a research note released on Tuesday.
The widespread scarcity of materials and commodities responsible for sky-rocketing prices will be exacerbated by the situation in Ukraine, which “is unlikely to end any time soon,” and has caused “upheavals in markets for energy, food grains, and key materials, that have in turn further disrupted global supply chains,” writes David Folkerts-Landau, group chief economist at DB.
Characterizing the U.S. Federal Reserve as “well behind the curve” in its efforts to tighten its monetary policy to combat multi-decade high inflation, which Folkerts-Landau believes will remain well above the Fed’s target unless demand is meaningfully dented.”
The investment bank now sees Fed hiking the key Fed funds target rate by 50 basis points at its next three meetings, in May, June, and July, and peaking at 3.6% next summer, “with balance sheet rundown adding at least another 75bp-equivalent in rate hikes,” the note says.
Even with these aggressive actions, Deutsche Bank sees 2022 headline and core CPI of 7.2% and 5.6%, respectively.
And, taking additional signals from the Treasury yield curve and consumer sentiment, “beyond the near term,” Folkerts-Laundau writes, “a recession is our base case.”
The bank now expects negative GDP in the last three months of 2023 and the first quarter of 2024.
GICS RESHUFFLE COULD CHANGE SOME BIG ETFs (1340 EDT/1740 GMT)
Some popular exchange-traded funds may be up for big changes after the MSCI and S&P Dow Jones Indices’ review of its Global Industry Classification Standard, or GICS.
The GICS framework is one of the dominant frameworks for classifying stock sectors, and as such, is the top way of creating sector and industry-based ETFs, which make up about $725 billion in total assets in the U.S., according to CFRA.
A preliminary analysis by CFRA indicates big retailers including Target TGT.N, Dollar Tree DLTR.O and Dollar General DG.N could be reshuffled from the consumer discretionary sector .SPLRCD to consumer staples .SPLRCS.
That would prompt them to be dropped from ETFs including the Consumer Discretionary Select Sector SPDR Fund XLY.P and added to funds tracking the consumer staples sector such as the Consumer Staples Select Sector SPDR Fund XLP.P.
However, the broader SPDR S&P Retail ETF XRT.P, the largest fund tracking the retail industry, should be relatively unchanged, according to CFRA.
The potential removal of payment processors like Visa V.N from the information technology sector means they could be reshuffled into ETFs tracking the financial sector such as the Financial Select Sector SPDR Fund XLF.P.
Visa is currently one of the Technology Select Sector SPDR Fund XLK.P‘s top holdings, making up 3.71% of its portfolio, while Mastercard MA.N holds a 3.1% weighting and PayPal PYPL.O 1.4%.
Stocks previously classified under the thrift and mortgage finance sub-industries may also be added to the SPDR S&P Regional Banking ETF KRE.P following the GICS review, CFRA says.
Interestingly, while State Street and Vanguard’s sector and industry ETFs follow GICS classifications, Blackrock’s iShares U.S. sector-based funds do not.
S&P Dow Jones Indices said it would provide the names of the largest companies to be affected by June 30, with a full list shared by Dec. 15. The changes would go into effect in March 2023.
BANKS, NO SLAM DUNK BUT STILL IN THE GAME (1303 EDT/1703 GMT)
Between yield curve inversion, economic concerns, geopolitics and Fed tightening uncertainties, banks have had a wobbly start to 2022. But while KBW managing director Christopher McGratty says KBW’s bullish September “buy the banks” call is less of a slam dunk now, he’s still hopeful.
“We still think the revenue development will be very good over the next several quarters. And we think valuations are inexpensive, but the challenge is that the macro factors are really just dominating headlines and that’s leading to low levels of conviction from investors,” McGratty said adding that “there are more risks in the market today than there were three months ago.”
KBW’s bias is for small and mid-cap banks over bigger banks, but still McGratty is eyeing a bounce in bigger bank stocks.
McGratty sees smaller bank valuations below trough multiples from 2015-2018. He also prefers shorter-term lenders levered to the front-end of the yield curve and those with meaningful excess cash to mitigate risks of elevated deposit costs.
However, KBW is not recommending bank stocks with “outsized unsecured consumer credit is downgrading Citizens Financial group CFG.N to market perform from outperform, and not recommending banks with “buy now, pay later” loan exposure so it sees Truist Financial TFC.N and Regions Financial RF.N underperforming.
McGratty also points to risks, given that sharp moves higher in rates drive large negative swings in accumulated other comprehensive income (AOCI) such as the reduction of the value of bonds on bank balance sheets, thus reducing tangible book value (TBV/shr by a median of 4%.
Investors are now more focused on price/earnings ratios than TBV, but McGratty is still wary of banks with higher AOCI risk, higher trading premiums and less excess cash to reinvest – Glacier Bancorp GBCI.N, Flushing Finanical Corp FFIC.O, and Truist.
He’s forecasting a challenging Q1 2022 with a 36% year-over-year decline in investment banking and an 18% drop in trading revenue for bigger banks. But the group’s recent decline to a multiple of 10.23 x his 2023 earnings estimate “provides a good set up for a relief bounce” after earnings reports. He prefers JPMorgan JPM.N, due to underperformance on commodity concerns and expectations for an improved net interest income (NII) outlook. But he is most cautious on Citigroup’s C.N Russia exposure and buyback uncertainty. Besides JPM and C, McGratty’s preference order is Bank of America BAC.N, then Morgan Stanley MS.N and then Goldman Sachs GS.N.
Ahead of earnings season, which kicks off next week he recommends overweight positions in Wintrust Financial WTFC.O, FNB Corp FNB.N, Pinnacle Financial PNFP.O, Metropolitan Bank MCB.N, Peapack-Gladstone Financial PGC.O, and an underweight positions in US Bancorp USB.N, Bank of New York Mellon BK.N, CFG, and BOK Financial BOKF.O.
Trading in the S&P 500 banks index .SPXBK has been volatile, last down 0.9% on the day and off ~10% year-to-date. In comparison the KBW Regional bank index .KRX, down 0.3% on the day, is down ~4% YTD.
DOES TREASURY YIELD CURVE SIGNAL A RECESSION? NOT IN REAL RATES (1208 EDT/1608 GMT)
The yield curve in inflation-linked U.S. Treasury debt does not signal an impending recession, even as handwringing increases that inversions in nominal Treasuries make an economic downturn likely, according to Barclays.
The closely watched yield curve between two-year and 10-year notes US2US10=RR inverted last week, which is seen as a reliable signal that a recession may follow in one-to-two years.
However, “notwithstanding the question of whether curves are accurate predictors of recessions, we believe a simple dissection of nominal rates into forward real and breakeven inflation rates from TIPS (Treasury Inflation-Protected Securities) does not support a view that markets are signaling a recession in the coming few years,” Barclays analysts Michael Pond and Jonathan Hill said in a report.
If the market were pricing for an upcoming recession the real curve, which reflects yields after expected inflation, should invert as markets price in a need for monetary policy to be stimulative, Barclays said.
This was the case in August 2019, which was also the last time that the two-year, 10-year Treasury curve inverted, just before the Fed began its last easing cycle, which was amplified by the pandemic, the analysts said.
“Instead, the current market is priced for real policy rates to return to about neutral within the next year or so, and stay there for the next four years,” they said.
The neutral rate is seen as the level that neither speeds up or slows down the economy, which the Fed estimates is 2.4%.
Meanwhile, the forward one-year real yield curve is inverted beyond the five-year point, which “may be pointing to the eventual need for accommodative policy, but it also is likely reflecting uncertainty in the long-term outlook for growth and the neutral policy rate,” Barclays said.
Barclays concludes that the inversion in the nominal yield curve is coming predominately from the curve of breakeven rates, which indicate expected inflation. And rather than pointing to a recession, real rates are pointing to a return to neutral, while forward one-year breakevens are consistent with a normalization of inflation back to the Fed’s 2% PCE (Personal Consumption Expenditures) target, from currently elevated levels, rather than a persistent undershoot, as was the case in August 2019, they said.
SMALL CAPS AND INVERSIONS (1131 EDT/1531 GMT)
As equities have struggled to start the year, small caps as measured by the Russell 2000 .RUT have lagged their larger cap brethren, and the recent yield-curve inversions represent a new risk, according to Bank of America Merrill Lynch equity and quant strategist Jill Carey Hall.
According to Hall, small caps typically outperform during bear flatteners, when shorter-term rates are rising faster than longer-term ones, but an inverted curve presents a risk.
Hall notes that while small caps are generally higher in the three months after an inversion of the 2-year U.S. Treasury yield and the 10-year U.S. Treasury yield US2US10=RR, which happened on March 29.
However, returns are usually negative after six months as well as over the full period of inversion, with small caps trailing large caps 70% of the time during the inversion, said Hall.
While the inversion has led Hall to stay favorable on small caps in the near-term versus large caps, thanks to tailwinds from domestically-exposed stocks, services recovery beneficiaries and capex beneficiaries, as well as better pricing power, Hall believes a more cautious stance could be needed “in future months if more indicators roll.”
Hall notes that not all yield curves have inverted yet to flash a recession signal, while the yield curve may be a less reliable signal today thanks to ultra-low yields outside the U.S. and supply chain issues that have distorted the slope given expectations for high inflation near-term.
In addition, small cap valuations have been pricing in more risks compared to prior inversions, with the relative PE of small caps to large caps cheaper than any other inversion and by 20% on average.
THE SERVICES TRADE: PMI, TRADE BALANCE (1105 EDT/1505 GMT)
The customer-facing services sector, which accounts for about three-quarters of total U.S. employment and trades at a surplus with our overseas peers, is enjoying the continued relaxation of measures to combat COVID-19.
To begin with, the services sector’s expansion accelerated last month.
The Institute for Supply Management’s (ISM) non-manufacturing purchasing managers’ index (PMI) USNPMI=ECI rose 1.8 points to 58.3, landing just a rounding error below analyst expectations. nN9N2TD019
A PMI print above 50 signifies monthly expansion.
The good news: employment bounced back from contraction and new orders jumped a robust 4 points. The bad news: the prices paid component rose further into the stratosphere, rising to 83.8 from 83.1, implying that the rude guest, inflation, isn’t going anywhere soon and cementing expectations for aggressive Fed tightening.
But despite the headline number’s uptick, “respondents have indicated that they continue to be impacted by capacity constraints, logistical challenges and inflation,” writes Anthony Nieves, Chair of ISM’s Services Business Survey Committee, who adds that “geopolitical concerns — particularly the Russia/Ukraine war, which has impacted material costs, most notably fuel and chemical prices — have created uncertainty for many businesses.”
These sentiments are echoed by the survey’s respondents.
“Supply chain challenges continue,” and “labor and inflation continue to push costs higher across the board,” and “pricing pressures are stronger than ever” were common refrains.
Below is a comparison of ISM’s services and manufacturing PMI indexes, both of which have been expanding since June 2020:
Global financial information firm HIS Markit also released its take on services PMI USMPSF=ECI, showing a 1.5 point uptick to 58 March, lower than the 58.9 reading in its initial “flash” take on the data.
“Business activity in the vast service sector enjoyed a boost from the relaxation of virus-fighting restrictions in March,” says Chris Williamson, Chief Business Economist at S&P Global. “The downside is further upward pressure on prices as demand exceeds supply …Consumer price inflation therefore looks likely to accelerate further as we head into the spring.”
Markit and ISM PMIs differ in the weight they apply to their various components (new orders, employment, etc). The graphic below shows the extent to which the two indexes agree (or not):
The gap between the value of goods and services imported to, versus exported from, the United States USTBAL=ECI narrowed a bit in February to $89.2 billion, hovering close to January’s record high.
Consensus called for the Commerce Department’s report to show a more significant deficit reduction, to $88.5 billion.
International trade has been a net drag on the U.S. economy for a year-and-a-half, a trend that this data suggests is likely to continue.
A silver lining can be detected in the fact that while both exports and imports increased, exports saw the bigger spurt – 1.8% versus the 1.3% growth in imports – suggesting overseas demand recovery could be starting to catch up with the United States, which is particularly heartening considering the steady increase in the dollar’s value since the beginning of the year.
Harkening back to ISM, while U.S. services have long traded at a surplus, that surplus inched down to $18.3 billion, 5.6%smaller than the previous month.
The closely watched goods trade deficit with China dropped by 15.7% to $30.7 billion.
“Looking ahead, trade flows are likely to be disrupted by the war in Ukraine and lockdowns in China,” says Rubeela Farooqi, chief U.S. economist at High Frequency Economics. “There is also additional downside risk from a potential softening in demand in Europe and China.”
Investors were in a selling mood in late morning trading, with all three major U.S. stock indexes loitering in negative territory.
FAANGS weighed heaviest, and sentiment skewed away from growth .IGX.
WILL THE FED KILL THE ECONOMY? INVERSIONS SAY ‘YES’ (1028 EDT/1428 GMT)
The Fed may be paving the way for deflation by quickly hiking interest rates in the battle to curb inflation, says Steven Ricchiuto, U.S. chief economist at Mizuho Securities.
Put another way, the yield curve inversions show markets are assuming the Fed will be successful at killing the economy in order to keep inflation from becoming persistent, he says.
The aggressive approach to demand management poses a risk if the constraints on aggregate supply prove to be less long-lasting than the Fed assumes, Ricchiuto says in a note on Tuesday.
“Today’s inflation pressures could quickly be replaced by deflation pressures,” he says.
“Ignoring this risk while commodity constraints are clearly depressing global economic activity and overseas investors continue to grab yield in the dollar markets could be big problem for the world’s largest net debtor nation,” he says.
Household savings rose and debt was paid down with the aid of Covid-19 related transfer payments, he says. But these positives are being eroded by higher inflation, increased financing costs and companies controlling compensation cost by reducing their contribution to employee benefits, he says.
The rise in mortgage, auto and consumer financing rates clearly suggests policy already is significantly affecting the U.S. economy and ensures a hard landing later this year even as many other economists call for a recession in 2023, he says.
“Although there is no visible evidence that a credit-induced recession is in the cards, a hard landing would feel like a recession for all but upper-income households,” Ricchiuto says.
WITH A DEFENSIVE TILT, U.S. STOCKS LEAN HEAVY (1007 EDT/1407 GMT)
Wall Street’s main indexes started out mixed, but have turned heavy in early trade as the prospect of fresh sanctions on Russia is keeping investors on edge, while megacap growth stocks retreat after strong gains a day earlier. .N
Indeed, after handily outperforming on Monday with a more than 4% rally, the NYSE FANG+TM Index .NYFANG, is among Tuesday’s laggards, giving back around 2%. Chips .SOX are even weaker, down over 3%.
With this, the S&P 500 growth index .IGX/S&P 500 value index .IVX is turning down from the more than two-month high hit Monday as value shares and defensive groups show some resilience.
Here is where markets stand early in Tuesday’s regular session:
NASDAQ COMPOSITE: 100-DMA THROWS ITS WEIGHT AROUND (0900 EDT/1300 GMT)
With a 17% surge off its March 14 intraday low into its March 29 high, the Nasdaq Composite .IXIC staged an impressive snap back over just 11 trading days.
So far, however, the tech-laden index’s recovery has hit a wall in the form of the descending 100-day moving average (DMA):
Since breaking below the 100-DMA on January 6, the Composite has now registered 62-straight closes below this closely-watched moving average. That’s its longest such streak since an 80-day run of closes below the 100-DMA in late 2018.
Of note, in the wake of the early-January break, a sharp two-day rally of around 5%, stalled as the IXIC then battled the 100-DMA. A resumption of weakness then carried the index to fresh lows.
Since coming within two points of the 100-DMA last Tuesday, the Composite stumbled again. Monday’s strength brought the index to a level just shy of the moving average which ended at 14,585. But with 100-DMA pressing down, and CME e-mini Nasdaq 100 futures NQcv1 quoted down slightly in premarket trade on Tuesday, the Composite appears poised to once again back off from the 100-DMA at the open.
In any event, the Composite now has support at Friday’s low of 14,131. A more important level resides at the March 3 high at 13,837. This is also backed up by the now rising 30-DMA, which ended Monday around 13,650.
The 30-DMA also acted as an important resistance hurdle in mid-February and again in early-March, so since it has been reclaimed, traders will now want to see it act as support.
Meanwhile, additional hurdles on the upside are the 200-DMA, which ended Monday around 14,735, and the resistance line from the November peak, now around 15,075.
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(Terence Gabriel is a Reuters market analyst. The views expressed are his own)