Why did markets rally, and can it be sustained?

Last week was a big one for both risky and defensive assets: US equities rose more than 5% from the previous Friday’s close and US Treasury yields fell around 35 basis points (bps),¹ with almost all of that coming in the few hours after Thursday’s US inflation reading.

Annual consumer price growth came in at 7.7%, marginally undershooting the 8% expected by economists. Why the euphoria in response to such a small miss?

The market is often described as a tussle between fear and greed. I’d argue two equally powerful emotions were in the driving seat this week: relief and hope.

Investors dare to dream

Relief because US core CPI has come in above market expectations on eight out of 12 previous occasions. Markets had become accustomed to constantly pushing back the timeline over which inflation would start its long march back towards the Federal Reserve’s target. We’d become used to hearing various reasons why inflation was transitory.

In summary, we’d become accustomed to disappointment, so even a small downside miss is a big relief.

Which brings me to hope. The last 12 months have been unusually bruising for investors in almost any asset class. Cash really has been king in an environment of rising bond yields and tumbling equity markets. With a weaker CPI print now behind us, investors can dare to hope that the worst is over as we near the end of the rate hiking cycle.

We think we’re now approaching that inflection point. But that doesn’t mean we’re embracing risk in a dash for the end of the year. As everyone knows, it’s the hope that kills you.

Can it last?

We think the market reaction in government bond yields is likely to prove more durable than the reaction in equities: the stumble towards recession will reinforce the notion that we’ve seen the peak in yields, but also raise concerns about the corporate outlook. Even with discount rates lower, the bar for ongoing equity strength is high.

The earnings season is all but finished, but the salami slicing of earnings estimates continues.

Bottom-up consensus forecasts are falling, and downward momentum is picking up. Estimates for earnings over the next 12 months were down 0.8% after the Q2 earnings season. But after this earnings season, they have already been cut by 2.5% and are still falling. That takes our 2023 growth estimates to 4%.

Looking more specifically at Q4 earnings estimates, forecasts are down 5% since the start of October.

That’s a fair bit worse than the normal downgrades for Q4 this time of year. That still leaves you with very slightly positive growth expected for Q4, but is roughly in line with our expectations earlier this year that earnings growth would grind to a halt by the end of 2022.

The view from the top

Things look similar on top-down forecasts. Representative of sell-side strategists, Goldman Sachs trimmed their US earnings forecasts this week, this time from +3% to 0% for 2023. So just a bit below bottom-up analyst consensus. That forecast, though, is still some way above their own mild recession scenario of -11%, which in turn is above our recession scenario estimate.

Another thing to highlight is that the misses on Q3 results have been pretty broad-based. Big tech got most of the headlines on earnings disappointment, but things didn’t look any better in most sectors.

Looking at the revisions after results, we’ve had 12-15% downward revisions to Q3 estimates in tech, financials, discretionary and industrials. Only estimates for non-cyclicals remained roughly flat, while energy’s were increased a lot. Q4 forecasts were trimmed in 71% of companies.

The earnings weakness that is creeping into results is too broad-based to be idiosyncratic – it’s more likely to be driven by macro conditions.

1. Source: Bloomberg, as at 11 November 2022