The equity market’s month-long pullback continued last week as yet another inflation indicator, the Core PCE Price Index, came in hotter than expected. 

Since peaking on February 2nd at +8.5% for the year, the S&P 500 has since fallen 5% and now sits at +3% year-to-date. 

While the market’s previous rate of ascent was unsustainable—and a pullback was expected—the intensity of this pullback calls into question whether uptrend from the October lows will resume or fade away. 

Indeed, the notion of a “soft landing”–an outcome the smart money positioned for in October when it seemed inconceivable, but which had recently gained mainstream acceptance–is now being called into question once again. 

The change in perception is on account of stronger than expected growth and hotter than expected inflation, which has caused the market to change its views on how high the Fed will raise rates and how long it will keep them there. 

This repricing of Fed rate hikes has caused the dollar and interest rates to surge (they have risen almost every day so far in February), which has put renewed pressure on equities. 

So, where do we go from here? 

As of Friday, the financial markets were approaching an important crossroads. 

The dollar is nearing a level that acted as support on its way to its September top and has acted as resistance during its recent swoon. This level is also the measured move target (i.e., the expected destination) of the dollar’s recent “bull flag” technical pattern. Further, the dollar is the most overbought since its September high. 

US Dollar Index Futures | Source: Investing.com

Conversely, the S&P 500 (futures) is now in the thick of a cluster of support levels–the uptrend line from the lows (~4000), the 200-day moving average (~3950), and the downtrend line from the all-time highs (~3925). It is oversold and institutions are still more relatively bullish than retail traders (the last data we have of institutional positioning shows that they were still scooping up equities in early February, while retail was selling). 

Thus, with the dollar approaching ample resistance while being overbought and the S&P 500 in a support zone with institutions still more bullish than retail traders, we would expect at least a temporary reversal of February’s trends. 

I.e., we would expect the dollar to pull back and equities to bounce. Whether these reversals have legs and the dollar’s downtrend and equities’ uptrend resume in full force, however, remains to be seen. 

One factor that may play a deciding role is the trajectory of commodities. 

If you recall in Q4 2022, the market switched its focus from inflation (which was coming down nicely) and began focusing on growth, which it perceived to be slowing. 

But then growth numbers started to pick up and the soft-landing narrative went mainstream. 

However, as inflation has started coming in hotter, the market finds itself once again focusing on inflation and ignoring growth concerns. 

But commodities seem to be telling us the opposite story–we should be focusing on slowing growth and not worrying about inflation. 

Why? 

1. Commodities are now (just) below their level from one year ago (when Russia invaded Ukraine)—one whole year of sideways price action. 

2. The Goldman Sachs Commodities Index, a measure of broad commodities prices, is tracing out a “descending triangle” pattern. These patterns are considered bearish and such a pattern suggests commodities may have substantially further to fall.

3. Retail sentiment in commodities is now in a zone that suggests slowing growth, recession, and/or deflation (a zone that tends to be a headwind for equities).

4. Crude oil inventories have skyrocketed recently–increasing by 58.4 million barrels in only 7 weeks, a rate exceeded only once before in history, during the COVID panic when the whole world was shut down. Rising crude inventories suggests growth is not nearly as robust as the headline economic numbers would have us believe. 

5. China’s reopening appears to have fallen flat–shipping rates are down, the yuan is down, and as mentioned above, crude inventories are surging. 

Thus, commodities are screaming that we should be worried about growth and not inflation. Consequently, we may start to hear renewed concerns about growth in the financial media. 

iShares S&P GSCI Commodity-Indexed Trust | Source: Investing.com

Although relative sentiment in assets sensitive to economic growth is still bullish, without refreshed buying interest from the smart money, that bullishness will expire in mid-March. 

The Bull Case

The bull case for equities is that the Fed is trapped. It can’t raise rates much further without achieving decidedly worse outcomes than accepting 4% inflation–outcomes that the political establishment will want to avoid as we move into the 2024 election cycle. 

If growth slows, the dollar and rates should move lower, which should support equites. If growth does not slow, a trapped Fed would cause real interest rates to fall, which again should support equities. 

The Bear Case

The bear case is that the market wakes up to the disconnect between where interest rates are and where equities are. When rates were last this high, equities (particularly tech stocks) were much lower. 

To that point, the most historically accurate valuation indicators suggest fair value on the S&P 500 is around 3000 (25% below its current value). Slowing growth could cause earnings to recede, which would give the market impetus to fall. 

And should the market begin to fall, trend-followers, who recently bought as the market rose, would be forced to sell again–which would add additional downside pressure. 

Our Opinion

Which case will play out? We’re leaning toward the bull case, at least for the next several months. While we don’t expect the market to rise sharply, we do expect it to grind higher. We don’t believe the Fed will be (or can afford to be) as hawkish as the market currently expects. The smart money still seems to be solidly bullish equities and bearish the dollar–that’s not the type of behavior we would expect if the equity rally were set to end. 

That said, relative sentiment has turned bearish in certain assets related to the tightening or easing of financial conditions that have particular significance for non-U.S. equities, energy and materials stocks, small caps, and high-yield bonds. 

Thus, if the broad U.S. market were to rise from here, we might expect to see those sectors lag (notably, non-U.S. stocks, which strongly outperformed from the October lows, have recently started to lag U.S. equities).

We have adjusted our forecasts for commodities, energy stocks, emerging and developed markets accordingly. 

In summary, over the next week we will be watching for a near-term bounce in equities and a pullback in the dollar, along with a potential change in the market narrative from resilient growth to slowing growth.

Let’s see what happens.