The Week Behind

While equities experienced a strong, late-day bounce to close last week, all major indices finished in the red. The DOW was the relative outperformer, down only 1.28%. The S&P lost 2.21%. The interest-rate sensitive NASDAQ, despite retreating Treasury yields, was the worst of the bunch, dropping 4.13% as semiconductors in the index averaged ~10% losses. 

Highlights

• Headline PCE for May came in at 6.3%. Identical to last month’s print; 0.3% below this year’s peak of 6.6%.
• Core PCE came in at 4.7%, continuing a steady downtrend.
• The Atlanta Fed revised projected 2Q GDP to -1%, implying the U.S. will enter a technical recession (consecutive quarters of negative GDP).
• Micron (MU) revised guidance downward. The stock reacted poorly.
• US2YR and US10YR closed the week below 3% for the first time in a month. 

Ramifications of Micron

In the trailing twelve months (TTM), semiconductors have been the first to rally and the first to sell-off. MU’s report should not have been a shock, but the fact it continued to trade lower illustrates negativity surrounding the sector was yet to be fully-priced in. Perhaps, it is now. The SMH, a highly-traded semiconductor ETF, shed another 10% last week. However, it is ominous that semiconductors did not participate in Friday’s late-day rally despite month-to-date lows for treasury yields. That does not bode well for the direction of the market as we begin July, a seasonally strong month for stocks. 

While equities perform better in lower interest rates environments, when a cyclical sector, like semiconductors, falls with yields, it signals recessionary positioning: buying bonds with a guaranteed return in a “flight to safety” while simultaneously selling cyclical semiconductors with performance tied to economic activity ahead of a potential recession. Further validating this recessionary repositioning are the sectors that ended the week in the green – energy, utilities, consumer staples, and healthcare – all historically defensive and recession-resistant. 

It is nice to see some green on the screen to start the month, but, make no mistake, what’s rallying right now suggests managers have decided to rebalance for recession. However, given the volatility and fragility of this market, we could see the trade unwind rapidly if any economic indicator suggests the risk or severity of recession is overblown.

The Week Ahead

From a technical standpoint, the major indices will be at inflection points to start the shortened week. In combination with the earnings vacuum, stocks will be at the mercy of perceived recessionary risk. Economic indicators provide updates on the state of the economy. The reports below are most likely to influence interest rates and commodity prices, which I suspect are in the driver’s seat this week.

Tuesday:

• Factory Order MoM (May)

Wednesday:

• ISM Non-Manufacturing PMI (June)
• JOLTs (Job Openings, May)
• FOMC Minutes
• API Crude Oil Stock Change (weekly change in crude oil supply)

Thursday:

• ADP Employment
• Balance of Trade (U.S. Exports and Imports, May)
• EIA Gasoline and Oil Stock Change (weekly)

Friday:

• Non Farm Payroll, Unemployment, Wages (June)
• Wholesale Inventories (MoM)

Overall, bulls are looking for data indicating the FED is succeeding in slowing the economy without crashing it: numbers that are incrementally bad without warranting panic. Holding all else equal, no surprises to the upside or downside, I think we’ll trade slightly lower given the weakness in the semiconductor complex. 

What Got Us Here? What Will Bring Us Out?

We are at the point where “everyone” knows the stock market is going down. The same way in 2021 “everyone” knew the stock market was going up. In both instances, “everyone” was certain of the direction but less certain of the underlying causes.

In 2021, SPACs were cash printers, Bitcoin hit $60,000, GME broke $400, stocks were valued on FWD P/S, stocks were untouchable. You bought every dip you could. Under the hood, the U.S. government was providing trillions in stimulus, interest rates were 0%, the FED was buying bonds. The money supply was at all time highs.  

In 2022, SPACs are guaranteed losers, Bitcoin is struggling to hold $20,000, GME is back ~$100, stocks are valued on FWD P/E, many stocks are uninvestable. You sell every rip you can. Under the hood, the U.S. government (outside of California) is not providing stimulus, interest rates are rising, the FED is selling bonds. The money supply is tightening. 

With the benefit of hindsight, I think 2021’s uptrend rolled over coincidently with the forces behind it. Using that same logic, I do not think 2022’s downtrend can roll over until the forces behind it do. I argue the primary force in each case is monetary policy as decided by the FED. It is my view that we rallied in 2021 until we reached peak quantitative easing (QE – adding money to the economy). In 2022, we will continue to sell-off until we reach peak quantitative tightening (QT – taking money out of the economy)

Assuming inflation behaves and the labor market cools without collapsing, the earliest we could have solid evidence of peak QT is at September’s FOMC meeting. A favorable macro could permit a 25bp hike instead of 50-75bp. This would have a meaningful impact on the outlook for stocks and, perhaps, more importantly, the sentiment surrounding the asset class as a whole. However, the trajectory of inflation and the labor market is still widely uncertain and until they become more certain, expect trade to remain choppy, favoring the downside.