Pressure Descends On Market Despite Impressive Outing From Morgan Stanley

Key Takeaways:

• Morgan Stanley becomes latest big bank to impress with earnings, but stock falls
• China’s GDP comes in below expectations, but retail sales, industrial production strong
• Powell back on Capitol Hill today for a second day of testimony

Big banks continue to hold up their end of the bargain, but the rest of the market doesn’t seem too impressed this morning. Major indices declined overnight amid worries about the Chinese economy, while slipping U.S. bond yields put a little pressure on things, too.

Morgan Stanley (MS) became the latest and final Wall Street banking giant to surpass analysts’ estimates with a nice earnings report, wrapping up the start of earnings season. All six of the largest U.S. banks reported profits that beat Street projections, and MS accomplished that through strong performance in both equity trading and investment banking, though overall trading results weren’t as great.

In general, it’s impressive that the banks did so well in Q2 considering the headwinds they faced including declining bond yields and a slowdown in trading from Covid peaks. Having said that, shares of many fell as investors wondered what they could do for an encore. MS is no exception, as shares dropped more than 1% in pre-market trading. What we might have here is a case of “buy the rumor, sell the fact.”

In other earnings news, health insurer UnitedHealth (UNH) beat every metric out there thanks in part to the fact that with Covid people aren’t going back to the doctor as they would in normal times. That means the company had less to pay out. They raised guidance, too.

Weekly initial jobless claims came in at 360,000, in line with Wall Street’s consensus.

China’s Economy Under Microscope

Pressure early Thursday could reflect a weaker than expected read on China’s economic growth, along with falling crude prices that could suggest a drop in demand. Gross domestic product in China rose 7.9% year over year in Q2, which sounds great but is a bit below the consensus view. It was down sharply from growth of more than 18% in Q1, suggesting growth is starting to slow in the world’s second biggest economy.

The GDP figure got balanced out a bit by stronger than expected retail sales and industrial production for June, however. Chinese stocks actually climbed Thursday, but most of Asia and Europe fell. Some of the softness overseas could stem from Covid fears amid the Delta variant outbreak.

Investors probably have their eyes on the bond market this morning, where the 10-year Treasury yield continues to lose ground. It fell to 1.32% this morning, down around 10 basis points from recent peaks and back near five-month lows. Falling yields can be a sign of worries about economic growth. There was a defensive tone in the market yesterday despite a pretty good performance from the Tech sector, but that in and of itself could be part of the problem, as we’ll discuss below.

For now, it’s really all about earnings, with major indices just below all-time highs. People may wring their hands, but it’s just normal trading. We go up and we go down, and there’s no major trend to the downside based on this morning’s weakness. The yo-yo game continues, if you will.

New Records, But Worries, Too, as Tech Dominates

Energy stocks got crushed yesterday as OPEC+ (OPEC plus Russia) found a way to settle its family spat. This could mean more crude starting to hit the market by later this year, perhaps as soon as September. Crude retreated back toward its weekly lows and is down again this morning after a surprise build in gasoline supplies reported by the U.S. government yesterday. The crude market has been volatile ever since the OPEC+ meeting ended.

Aside from Energy softness, the market performed pretty well again Wednesday as the S&P 500 Index (SPX) hit a new all-time high just under 4400 before giving up most of its gains by the end of the day. A new record sounds impressive, and it is, but with a few caveats.

First of all, more of the SPX strength lately has come from the “mega-cap” Tech stocks like Apple (AAPL) and Microsoft (MSFT). Both of those are trading at new peaks as investors found fundamental things to like including JP Morgan Chase (JPM) raising its price target for AAPL and MSFT announcing a cloud-based version of its Windows operating system called Windows 365.

A Bloomberg report of possible production increases for the iPhone also appeared to boost AAPL shares. JPM cited chances of improved smartphone market share in its AAPL price target boost.

However (and you knew that was coming), when more of the SPX strength is crowded into these $2 trillion behemoths, it can disguise problems lower down. Mainly, we’ve seen the Tech sector zoom up more than 7% over the last month while no other sector has gained more than 5% and most have been up just a bit or even down. Energy and Financials, which pointed the way throughout the first few months of the year, are solidly in the red since mid-June.

Having just a few heavyweights carrying most of the load for the broader market could make the SPX more vulnerable if anything goes wrong for the FAANGs and their cousins like MSFT or chip stocks. An ugly earnings result from any of the FAANG stocks or MSFT could mean a swift kick in the pants for the entire SPX if one of them gets pushed around, simply because their weight has a much bigger impact than a bad day from, say, a 90-pound weakling $100 billion company.

Inflation, Weak Volume Raise Concern

Another caveat is relatively low volume in recent weeks, which according to analysts could mean less conviction behind the rally. While summer doldrums are a known entity on Wall Street most years, volume has been thin for a while now, going back to before the warm weather.

Besides the good news from AAPL and MSFT, Tech as a whole might be doing well because investors think “growth stocks” tend to be a little less affected by inflation than companies that make typical products people buy day-in and day-out. The earnings season could offer investors a chance to see just how big an issue inflation is for many of the folks running S&P 500 companies without the advantage of $2 trillion market capitalizations.

Consider watching and listening closely to what executives say about pricing pressure, especially considering the hot producer price index (PPI) data for June issued yesterday. Traditionally when PPI stays high, companies either can start to feel rising costs bite at the heels of their margins, or pass along the costs to consumers. If they choose option two, as some already have, that can sap consumer demand and eat into economic growth.

Delta (DAL) basically chose option two. Higher fuel costs created challenges for the airline, and it’s planning to boost fares and add fewer flights. This is exactly how inflation can bite companies and their customers at times like these. We’ll see if other airlines have similar plans when they report over the next week or two. It would be ironic to see airline travel numbers decline due to price pressure just as Covid eases.

Price pressure was probably on a lot of minds when Fed Chairman Jerome Powell spoke to Congress yesterday. He takes the podium again today, but if it’s like yesterday there’s not a lot to buy tickets for, if you will. Basically, he kept to the script and said the Fed isn’t changing plans around stimulus yet, and that inflation may be elevated for a while before moderating. Some analysts interpreted this to mean current high inflation might last through Labor Day or even into the holiday season.

Yield Pressure Continues as Powell Reassures Market

Even with that in mind, investors squeezed yields a little harder as the week continued. The 10-year Treasury yield fell back to 1.32% this morning after hitting 1.4% earlier in the week, apparently soothed by Powell’s testimony.

If you take Powell at his word, the inflation we’re seeing now has more to do with supply chain issues coming out of the Covid reopening and should partially reverse as bottlenecks unwind. “You wouldn’t react to something that’s going away,” he told the House Financial Services Committee.

Bonds have been going up with stocks, but yesterday saw a defensive tone continue. While Tech kept rising, so did Real Estate, Utilities, and Staples. All of these tend to do better when investors are worried about the economy.

Taming of the Inflation Shrew Questioned: With this week’s inflation data front and center, some economists have begun to question if the days of taking low inflation for granted might be over. After inflation surged in the late 1960s and 1970s, it started moving lower after 1980 and really softened in the 1990s. With a few short exceptions, it hasn’t come back in a big way until this year. Some of the trends that led to soft inflation over the last 40 years—including globalization, large populations of adults in their peak productive years, and the revolution of e-commerce—may have had their peak impacts and we now could be on the wrong side of the curve, a Wall Street Journal article said this week.

Online prices have started to rise, the populations of the U.S. and China are aging—meaning more consumer spending growth but less growth in goods production, an inflationary situation—and recent tariff battles muted the impact of global supply chains that helped keep prices low, economists told the newspaper. This could mean higher inflation in the years ahead or the Fed having to keep monetary policy tighter than it otherwise would to meet its 2% inflation target.

Let’s Talk Q3 Earnings: It’s very unlikely earnings growth like the 60% or better many analysts expect in Q2 can be repeated, because it’s coming off comparisons to a year ago when Covid was on the rampage. That’s why you might be hearing talk out there about “peak earnings.” However, as we noted yesterday, it’s not peak earnings, necessarily; just the possible peak of earnings growth. A more useful perspective is to note that Wall Street’s estimates for Q2 earnings per share rose into earnings season, which implies things got better as the quarter progressed.

Eventually, that could start to spill into estimates for earnings in the Q3 we’re now in. While comparisons to a year ago get tougher in Q3, pay attention to where the average analyst estimate is now vs. when the quarter ends on Sept. 30. Analysts project very healthy Q3 earnings growth of 23.7% and Q4 growth of 18.3%, according to FactSet. If those keep rising (and we’ll update you throughout the quarter), peak earnings growth may be here but peak earnings might not be anywhere close.

Retail Sales, Sentiment Readings Still Ahead this Week: This week looks like a snake that’s eaten a few rabbits. There was a big bulge of stuff in the middle but a bit less to see on either end. After today’s MS earnings and jobless claims, the earnings calendar dries up until we return next week to a deluge of company reports.

Data-wise, all that’s really left after this morning is June retail sales tomorrow, along with University of Michigan sentiment. Retail sales is the biggie, with analysts expecting a moderate drop of 0.6% month over month from May, according to consensus from Briefing.com. Having said that, analysts actually expect a 0.3% rise in core retail sales once you subtract the volatile automobile market.

Retail sales surged earlier this year but then fell off in May, hurt by huge drops in building materials, autos and auto parts, and furniture. To some, this could suggest the peak post-Covid consumer demand period is slowing, but tomorrow’s data may help people get a better read on that. Keep an eye on those categories. Also, keep in mind that year-over-year retail sales actually rose more than 28% in May from a year earlier when some of the economy was locked down. It’s the month-to-month levels that could be more of an apples-to-apples comparison for the meantime.

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