Earnings, Sentiment, And Positioning Supportive, But Headwinds Remain
August 2022
Improving investor sentiment, better than feared earnings expectations, and commodity prices falling alongside U.S. Treasury yields provided a tailwind for stocks in July, propelling the S&P 500 to a 9.2% monthly gain - the index’s best calendar month since November of 2020. The American Association of Individual Investor (AAII) sentiment survey improved each week in July and respondents ‘bullish’ on stocks over the next six months rose to 30.6% at the start of August from 19.4% on July 6. With the percentage of ‘bullish’ respondents still below the 38.0% historical average dating back to 1987, a fear of missing out on additional gains could lead investors to shift from the ‘bearish’ or ‘neutral’ camp to ‘bullish’ as they chase stocks higher. Improved investor sentiment is a positive, but a CBOE Volatility Index (VIX) hovering around 22 and put/call ratios back to March levels are two worrisome signs that complacency is on the rise as well.
Commodities weakened throughout July, driven by falling demand and U.S. dollar strength. Downward pressure on commodity prices generated debate over whether the U.S. was at ‘peak inflation’ and a rotation out of cyclical value sectors such as energy and materials and back into secular growth names in the consumer discretionary and information technology sectors. U.S. Treasury yields peaked in mid-June and trended lower throughout July as market participants wagered that falling commodity prices would allow the Federal Open Market Committee (FOMC) to pivot and return to their dovish roots. FOMC Chair Jerome Powell did little to push back against this idea when he stated that the Committee would be data driven and no longer provide the market with forward guidance. Global equites rallied and Treasury yields fell into month-end as expectations for future rate hikes were ratcheted lower. However, the market’s response to bid up stocks and bonds while selling the U.S. dollar on the FOMC’s perceived pivot was based on a misread of the FOMC’s policy stance and leaves equity and credit markets susceptible to a pullback leading up to the Committee’s September meeting as a more hawkish reality sets in.
Developed and emerging market stocks abroad participated in July’s rebound, but the MSCI ACWI ex. U.S. and MSCI EM trailed the S&P 500 and Russell 2000 by a wide margin. Euro area equity markets were resilient during the month despite persistent upward pressure on natural gas prices which have led to public rifts between European Union (EU) member states. While political dysfunction continent is hardly new, pushback on natural gas rationing and the resignation of Italy’s prime minister comes at a time when the euro area is already teetering on the brink of recession, with additional upward pressure on energy prices likely into the winter months as Russia looks to inflict pain on Europe by curbing natural gas supplies. The economic and political backdrop on the continent is a tenuous one and we remain underweight international developed market stocks as a result.
We were struck by the lackluster response out of the MSCI Emerging Markets (EM) index to falling commodity prices and a modestly weaker U.S. dollar over the back-half of July as shifts in these two variables would have historically spurred inflows into the MSCI EM. Investor indifference toward emerging markets is largely a function of persistent economic and regulatory uncertainty out of China, which accounts for 32% of the MSCI EM index. China aligned itself with Russia on the heels of its invasion of Ukraine, drawing the ire of the U.S., and as House Speaker Nancy Pelosi visited Taiwan in early August, a stop China viewed as a provocation and violation of the “One China” policy, tensions flared yet again. China responded with cyberattacks on government websites in Taiwan and could block supplies of semiconductors and other goods to the U.S. via the Taiwan Strait as a retaliatory measure. Should China press its position on Taiwan, sentiment surrounding Chinese stocks could sour further and weigh on the MSCI EM index, a dynamic that leaves us cautiously neutral on emerging market stocks.
Improving investor sentiment could be supportive of additional equity gains in August, as investors appear eager to look past geopolitical and monetary policy headwinds that continue to build. Below the surface, trading volume has been lackluster and market breadth remained narrow as just three sectors – consumer discretionary, information technology, and industrials -- outpaced the S&P 500 during July’s rally. While July’s rebound is encouraging, persistent uncertainty on many fronts calls into question the durability of the bounce and we remain neutral on stocks relative to our strategic allocation and favor quality U.S. large-cap stocks. The time to add ‘risk’ will come, but now is not that time, in our view.
Source: Bloomberg, Factset
