This chart shows why stock futures are down this morning

By David Nelson, CFA

Last week’s modest pull back in U.S. stocks was surprising given the current headwinds and challenges for risk assets. 2-year treasury yields are the highest since last November. Short duration fixed income and cash instruments are offering a competitive alternative to stocks.

This morning futures reflect that reality with most markets looking at a soft open.

Terminal Rate

Clearly investors saw something beyond the challenges most strategists and talking heads have been warning about for months. The yield curve screams recession but with employment still robust and the Atlanta Fed raising its estimate for 1st quarter GDP up to 2.5% the argument for a soft landing still has believers.

Bloomberg Data

Multiple expansion can only take you so far. The current earning’s season delivered the usual beats but on lowered expectations as analysts scrambled to cut estimates. Add a nearly dysfunctional Washington careening toward a debt ceiling battle, the overall stock performance is nothing less than heroic.

Bloomberg Data

Coming into this week markets had priced in a terminal rate (fed funds target) above 5%. Gone are the rate cuts investors had expected at the start of the year and a likely catalyst for the risk-on backdrop that had investors buying back everything they sold in the last few months.

Bloomberg Data

However, the challenge as we start this holiday shortened week is a terminal rate once again on the march higher. The recent CPI and PPI releases show we are making progress but maybe not at a pace quick enough to keep the Fed from pushing up fed funds higher than most expect. Each stair step higher in rates makes the alternative to stocks that much more attractive.

Asset allocators have to look at all choices when they put capital to work. You start with a risk-free rate and then look for risk assets that can beat it with a healthy margin, at least enough to get paid for the risk you are taking.


Bloomberg Data

The playbook I laid out in my State of the Markets podcast two weeks ago still makes the most sense.  In the long run stocks follow earnings. Estimates for the S&P 500 are at best flat coming in around $222 for this year. The good news is that by summer investors will start to shift their focus to 2024. The 12 month look ahead should provide about 10% earnings growth.

None of that will matter if the terminal rate keeps rising. Higher for longer is now the prevailing theory but before the Fed can take their foot of the brakes they need to see clear evidence employment is coming back into balance and that headline inflation is on a path to their 2% target.

The final hurdle is the debt ceiling which should come to a head in early June. Yes, they will raise the debt limit but if history is any guide it won’t be until markets force an end to the debate and a final agreement on spending.