SUMMARY: China cut travel quarantine requirements, is on track to issue a record amount of local bonds, and officials are promising timely policy measures to cope with economic challenges. All that contributes to the easing of supply-related inflation, which, as we mentioned yesterday, accounts for ~half of PCE growth. The news will help a risk-on, narrative driven, short-term Cyclical and re-risking rally, which we also covered in more depth yesterday.
Implied vol is elevated but has moved lower across the curve. That’s a better environment for returns and is positive for risk if implied vol continues to move lower, but PCE is at the end of the week and employment data the following week. Although the incoming data is unlikely to fundamentally change the policy outlook, relevant macro data that has the potential to change narratives about the Fed and could keep equity vol elevated above normal.
Bond vol should improve if we are right about 10yr yields peaking and rate path expectations stabilizing. Lower bond vol would help ease equity vol too, but Treasury volatility is MUCH higher than the VIX. Bond vol can narrow even if equity vol remains steady.
2Q earnings reporting season will start in a few weeks, and Fed inflation fighting implicitly means pushing corporate pricing power lower and is a headwind to profitability. Declines in margin sentiment, measured using the Amenity natural language processing tool, are broad-based with nearly all sector margin commentary (expectations) lower y/y. Earnings expectations at the index level are still dependent on HIGHER profitability in the back half of 2022, setting the stage for negative revisions over the coming quarters. Much of that risk may be discounted given the growing chorus of negative revision commentary.
At the sector level, investor sentiment toward market leaders has deteriorated. Downside protection for Defensives and Energy is unusually expensive relative to upside potential. Simultaneously, upside is more expensive for Tech and Comm Services, recent losers. Investors are positioned for a short-term Cyclical reversal.
Companies with the worst credit ratings underperformed during the leg down on the market but haven’t yet recovered in the rally. We expect the re-riskers will catch up in an extended rally, especially as inflation narratives improve and sentiment about poorly rated names improves. S&P 500 high yield Cyclicals are listed here. Extremely negative sentiment can setup bear market rallies, but a sustainable rebound is unlikely until there is enough data for investors to form a reasonable expectation of how much the economy needs to slow to reduce inflation.
MARKET VIEWS: Nike’s inventory buildup was elevated last quarter, but the company blamed items stuck in transit, not demand. An inventory glut still does not appear to be a macro problem. China reopening would help, and we did get better news out of China overnight. China cut the travel quarantine time, is on track to issue a record amount of local bonds, and officials are promising timely policy measures to cope with economic challenges. All of it contributes to the easing of supply-related inflation, which, as we mentioned yesterday, accounts for ½ of PCE growth currently. The news will help a risk-on narrative drive short-term Cyclical leadership and re-risking in a rally, which we also covered in more depth yesterday (see here).
Implied vol has moved lower across the curve. That’s a better environment for returns and is positive for risk if implied vol continues to move lower, but PCE is at the end of the week and employment data follows next week. Although the incoming data is unlikely to fundamentally change the outlook, relevant macro data that has the potential to change narratives about the Fed can keep vol elevated above normal.
Implied bond vol is significantly higher than equity vol. Bond vol should improve if we are right about 10yr yields peaking and rate path expectations stabilizing. Lower bond vol may help eased equity vol, but bond vol needs to come in substantially for the spread to normalize.
2Q earnings reporting season will start in a few weeks, and the risks of negative results/revisions have increased. Fighting inflation implicitly means pushing corporate pricing power lower, and tight labor wage pressures are headwinds to profitability when combined with peaking price levels. Consumer spending is strong but slowing and management sentiment toward demand and margin expectations have declined over the past few quarters.
The declines in margin sentiment are broad-based with nearly all sector level margin commentary (expectations) lower at the end of 2Q22 versus a year ago. Earnings expectations at the index level are still dependent on HIGHER profitability in the back half of 2022, setting the stage for negative revisions over the coming quarters. Earnings misses combined with negative revisions/guidance could be a catalyst for higher volatility, though much of that risk may be discounted given the growing chorus of negative revision commentary. The degree of revisions matters, and this reporting season will provide important hard data.
Working against high volatility is that Investor sentiment is terrible – the moving average and latest reading are both in their 1st percentiles. Typically, poor sentiment can be a positive setup for risk assets, but current sentiment is not a catalyst because the breadth of economic data is falling. How sentiment compares to data is more important than sentiment alone. Extremely negative sentiment can setup bear market rallies, but a sustainable rebound is unlikely until there is enough data for investors to form a reasonable expectation of how much the economy will slow.
At the sector level, sentiment is worst for the relative winners this year. Downside protection for Defensives and Energy is unusually expensive relative to upside potential. Simultaneously, upside is more expensive for Tech and Comm Services, recent losers. Options pricing suggest investors are positioned for a short-term reversal.
In-line with the lackluster performance of Cyclicals relative to Defensives and Earnings Turbulence relative to Low Vol during the latest market rally, companies with the worst credit ratings underperformed during the leg down on the market but haven’t yet recovered. We expect the re-riskers will catch up in an extended rally, especially as inflation narratives improve and sentiment about poorly rated names improves. S&P 500 high yield Cyclicals are listed here.
