Washington Watch Continues As Debt Ceiling Talks, Powell Remarks Overhang Recent Rally

(Friday market open) Stocks are on pace for their best week since March, but Fed Chairman Jerome Powell and the debt battle in Washington, D.C., hang over Wall Street as the weekend approaches.

Optimism abounded on Wall Street Thursday amid hopes that the debt ceiling standoff would end soon and the Federal Reserve would pause rate hikes. Neither of these scenarios is guaranteed, especially the rate pause, so investors might want to proceed carefully with major indexes at or near their 2023 highs. Chances of a pause in June—seen as almost certain by the futures market until recently—don’t look as sure anymore.

Powell is scheduled to appear today at 11 a.m. ET along with former Fed Chair Ben Bernanke in a panel discussion. This is well worth watching (it’s available on the Fed’s site) and could potentially have a market impact. It seems unlikely Powell would discuss future Fed policy, though.

The S&P 500® index (SPX) ended Thursday just below 4,200, a level it hasn’t closed above since last August. The Nasdaq® 100 (NDX) cleared 13,800 for the first time in more than a year. Both were carried by their heavy exposure to mega-cap info tech and communication services shares. They’re up again in premarket trading but shares of Foot Locker (FL) got stomped on, down 25% after earnings data missed analysts’ expectations.

Morning rush

• The 10-year Treasury note yield (TNX) rose one basis point to 3.66%.
• The U.S. Dollar Index ($DXY) fell slightly to 103.22 but remains near two-month highs.
• The Cboe Volatility Index® (VIX) futures slipped to 15.95, not far above the 2023 low of 15.53.
• WTI Crude Oil (/CL) has climbed steadily this week and recently traded at $73.10 per barrel.

Just as stocks hit nine-month highs, along came bond yields to possibly spoil the party. The 10-year Treasury note yield reached a two-month peak above 3.65%. The 2-year Treasury note yield, which was under 4% last week, is now above 4.2%. High yields were one factor in squelching last summer’s stock market rally, as you may remember.

Typically, higher yields hurt more interest-rate sensitive sectors like info tech. That wasn’t the case yesterday but can’t be ruled out if this yield advance continues.

With 9% gains so far this year, the SPX is rapidly putting last year’s dramatic bellyflop in the memory hole. That said, the S&P 500 equal-weight index (SPXEW) is up barely 1% year-to-date. The major difference is that the SPEXEW weighs all stocks equally instead of by market-capitalization. If you’re only watching the SPX, you’re not getting the full story. The mega-caps now form about 25% of the SPX’s value, meaning approximately six stocks speak for 500.

Also, volume remains lower than average this week, perhaps a signal that not everyone has bought in on this rally. Breadth was relatively strong yesterday, however, with advancers easily outnumbering decliners and seven of the 11 S&P sectors rising, led by, what else, info tech. “Defensive” sectors like utilities and staples keep lagging.

Just In

FL shares plummeted 25% ahead of the opening bell after the company missed Wall Street’s expectations on both earnings per share and revenue. A 9.1% drop in same-store sales also painted a disappointing picture for the sports apparel retailer, which cited macroeconomic headwinds. Shares of FL competitor Nike (NKE), which is expected to report next month, fell 2% in premarket trading, likely hurt by the FL earnings miss and what it might say about demand in the sportswear market.

Things ran a bit smoother over at Deere (DE), which also reported earnings this morning and enjoyed a light boost in shares. DE’s earnings and revenue beat Wall Street’s estimates, and the farm equipment company raised guidance, though management warned that supply chain constraints remain an issue.

Eye on the Fed

Chances of the Fed pausing rate hikes in June stood at just under 60% as of this morning, according to the CME FedWatch tool. That’s down from above 80% a week ago. Odds of a pause keep receding amid relatively resilient economic data. On Thursday, Dallas Fed President Lorie Logan said current economic data doesn’t justify a pause in rates, CNBC reported.

Powell and other speakers will be part of a panel today called “Perspectives on Monetary Policy.” While it’s extremely doubtful that Powell would comment on future policy moves, he could very well make observations about how policy to date has affected the economy. In general, it offers another chance to glean how he thinks.

Stocks in the Spotlight

We’re far from done with retail earnings after this week’s troika of Home Depot (HD), Walmart (WMT), and Target (TGT). Next week brings expected results from Lowe’s (LOW), Dick’s Sporting Goods (DKS), Best Buy (BBY), and Dollar Tree (DLTR).

One possible lesson from this week’s retail results: Discount stores are performing best thanks mainly to a cautious consumer who’s spending less on so-called “discretionary” items.

Another sector in focus next week is semiconductors, which skyrocketed this week in what Nathan Peterson, director of derivatives analysis at the Schwab Center for Financial Research, called a “melt-up” for the PHLX Semiconductor Index (SOX). The index is now up 27% year to date and nearing a test of its late-March high.

Back then, the tech sector drew most of its fuel from investors seeking well-capitalized stocks during banking industry turmoil that appeared to potentially threaten the economy. With the bank turmoil receding a bit this week as Western Alliance (WAL) reported a climb in deposits, tech’s rally appears to be more about what investors sometimes call “animal spirits” that can pervade Wall Street when optimism is widespread. The tech-heavy NDX is up nearly 30% for the year.

What to Watch

Next week brings the government’s second reading on Q1 Gross Domestic Product (GDP), which was sluggish at 1.1% in its first reading. Looking to the present rather than the past, the Atlanta Fed’s GDPNow indicator estimates Q2 GDP growth at a much more solid 2.9%. But that’s well above most analysts’ projections. The next GDPNow update is scheduled for Friday, May 26.

We’ll have to wait until next Friday for the coming week’s biggest data in the form of April Personal Consumption Expenditures (PCE) prices. That’s the Fed’s preferred inflation barometer. March saw PCE prices rise 0.1%, with the slow pace helped by weaker oil prices that month. Core PCE, which didn’t include energy or food, climbed 0.3%, still above the pace the Fed likely wants to see.

Talking technicals: The 4,200 level has been a barrier for the SPX the last nine months, and 4,290 is a level to consider above that if the SPX keeps climbing. That would represent the start of a new bull market, a 20% rise from last October’ lows.

CHART OF THE DAY: RISK EMBRACE. Both the PHLX Semiconductor Index (SOX—candlesticks) and the Utility Select Sector Index (IXU—purple line) have had their ups and downs this year. At this point, the more risk-intense SOX is on the upswing while defensive utilities stocks are losing ground. Data sources: Nasdaq, S&P Dow Jones Indices. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Thinking cap

Ideas to mull as you trade or invest

Earnings speed bump: Though Q1 earnings season has generally been better than expected, overall results are still down from a year ago by around 3% (analysts had generally expected a 6% drop going in). It doesn’t necessarily improve now that we’re in Q2. Quarterly EPS is likely to be negative for the third quarter in a row, falling more than 6%, according to FactSet; after that, analysts anticipate 0.7% EPS growth in Q3 and 8.1% in Q4, leading to overall 2023 EPS growth of 1%. If that proves too optimistic and starts getting rolled back, the current SPX forward price-earnings ratio of 18 might start expanding even without any rally in the stock market. That’s when investors might be reminded that falling “E” often leads to falling “P.” Look today for possible updated quarterly outlooks from FactSet.

Marginal gains: Why are earnings in a rut? It’s partly explained by inflation, interest rates, and generally slow economic growth. There’s another key element: net profit margins, which are down from a year ago but appear to be flattening somewhat near 11.5%. The average net S&P 500 profit margin topped 12% in Q1 last year, according to FactSet. On the positive side, far more companies reported improved profit margin in Q1 versus companies reporting a decrease, which may bode well for the future and suggests margins may be near a bottom. The caveat there is that energy is the sector seeing the greatest percentage of companies reporting margin improvement, which could mainly reflect volatile crude oil and natural gas prices rather than the economy as a whole.

Where’s the profit? If S&P net margin remains at the current 11.5%, that would arrest a six-quarter streak of falling margins through Q4 2022, according to FactSet data. Higher costs—reflected in the Producer Price Index (PPI) over the last two years—played a large role in compressing profits, but PPI has been flat to lower in four of the last five months, perhaps reducing wholesale-driven pressure on companies. Which stock market sector might get the most margin support from easing PPI? The only data point in PPI that’s declined each of the last three months is “processed goods for intermediate demand,” which according to the Labor Department covers everything from construction materials to  sedatives for hospitals and yarn for shirts. Another way to track which companies suffer most and least from wholesale inflation is to check the percentage of firms citing “inflation” in their earnings calls by sector. Luckily, FactSet does that. In Q1 the companies that mentioned that word most were in the materials, staples, energy, and financials sectors. The companies mentioning inflation the least were in communication services and info tech.

Calendar

May 22: No major earnings or data expected.

May 23: April New Home Sales and expected earnings from AutoZone (AZO), and Dick’s Sporting Goods (DKS).

May 24: No major earnings or data expected.

May 25: Q1 GDP second estimate, April Pending Home Sales, and expected earnings from Dollar Tree (DLTR) and Best Buy (BBY).

May 26: April Personal Consumption Expenditures (PCE) prices, April Personal Income and Personal Spending, April Durable Orders, Final May University of Michigan Consumer Sentiment.

TD Ameritrade® commentary for educational purposes only. Member SIPC.

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