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The Dow Jones average suffered its worst beating since October 2020 on Friday, capping a fourth straight weekly decline, as mostly positive earnings reports failed to ease worries about rising inflation or the near-certainty that the Federal Reserve will raise interest rates by at least a half point at its meeting next month. Friday’s nearly 1,000 point drop in the Dow followed a speech by Fed Chairman Jerome Powell on Thursday that signaled support for a 50-basis point rate hike is very much on the table since taming inflation is “absolutely essential.” Rates jumped on Powell’s remarks before the benchmark 10-year yield eased slightly on Friday to about 2.9%. Next week will see earnings reports from the four biggest U.S. companies by market cap: Apple, Microsoft, Amazon and Google parent Alphabet. In the week just concluded, the Dow finished down 1.9% in its ninth losing week of the last 11, while the S&P 500 fell 2.8% and the Nasdaq sank 3.8%.
75 basis points
Seventy-five basis points is the new 50 basis points. A relentlessly hawkish Federal Reserve is ramping up market expectations for big interest rate hikes that would have been considered unthinkable (and market crippling) just two months ago.
Nomura says that the FOMC will hike the fed funds rate by 75 basis points in June and July after a 50-basis point rise in May. That would bring the rate up to 2.25%, a phenomenal amount of tightening given that the Fed was still easing by buying assets as recently as March.
The shift in market expectations for even more tightening came after Fed Chairman Jerome Powell said at an IMF debate Thursday that a 50-basis-point hike in March was “on the table.” Perhaps even more pertinent to the markets, he said there was some merit in front-loading tightening with the current upside risks to inflation and a historically tight labor market.
Traders quickly priced in more aggressive hiking as Powell spoke, with CME FedWatch now pricing in an 85% chance the benchmark rate will rise to a range of 1.5%-1.75% after the June meeting. That would mean a 75-basis point hike in June if May gets the expected half-point boost.
Chatter of a hike of as much as 75 basis points started last week when St. Louis Fed President James Bullard said that he wouldn’t rule one out. Before Powell spoke yesterday, San Francisco President Mary Daly added some fuel to the fire, saying she would be talking to colleagues about whether a hike of 25, 50 or 75 basis points was needed.
In fed funds futures, the market is now pricing in about 270 basis points of tightening for 2022, topping the 250 seen in 1994, with expectations now for the rate to hit 3% by March 2023, according to Deutsche Bank.
Deutsche Bank’s chief economist said yesterday that the Fed could hike rates to as high as 5% by the time it’s done tightening, a level not seen since 2006.
Quotes: “Our U.S. team has changed their Fed call,” Rob Subbaraman, Nomura head of global markets research, wrote in an email seen by Bloomberg. “They now expect the FOMC to be even more front-loaded with rate hikes, in order to get the funds rate back to neutral as expeditiously as possible to avoid a wage-price spiral.”
“We recognize Fedspeak has not outright endorsed a 75 basis point hike yet, but in this high inflation regime we believe the nature of Fed forward guidance has changed – it has become more data dependent and nimble,” he said.
“We are in a new environment, dancing to a new tune, and the incremental mean reversing way of thinking about inflation and rates is likely to be misleading,” Deutsche Bank chief economist David Folkerts-Landau said. “Inflation is seeping into expectations, and labor markets are historically tight.”
What this means for stocks and bonds: The selloff in Treasury bonds accelerated as expectations for even more hawkish policy rose.
The 10-year Treasury yield (TBT) (TLT) hit 2.95% at the high of the day Thursday. The 2s10s curve flattened.
Stocks started Thursday with a rally, but the big rise in rates (especially real rates) reversed the trend and the S&P (SP500) (SPY) fell 1.5%, while the Nasdaq 100 (NDX) (QQQ) lost 2%.
Worries will increase in the equities market if the Fed slams on the brakes as Nomura predicts.
Investors “are in a new investing world,” eToro strategist Ben Laidler said. “The sharp and never-ending repricing of Fed interest expectations and high-for-longer inflation has driven bond volatility twice that of equities, and a tightening US financial conditions index.”
“This drives lower valuation and a Growth to Value rotation,” he added. “Equities are being stress-tested by surging bond yields. But there is a limit to how high yields will go. The Fed has more yield control now with its huge balance sheet runoff, whilst high debt levels, and wide yield gap with global markets are constraints.”
Streaming Sea Change
Netflix (NFLX) lost more than a third of its value this week, shedding more than $50B in market capitalization. The day after earnings, shares tumbled 35%. The last time the stock fell like that was nearly 18 years ago, on Oct. 15, 2004. Netflix stock slipped nearly 41% that day, all the way to a split-adjusted $1.47 from $2.49 the session before. It’s a staggering loss for a company that is an original FAANG stock, considered a bedrock of growth stocks.
Netflix lost a net 200,000 subscribers for the quarter and forecast that it would shed 2M more in the current quarter. That’s launched talk of whether the company is saturating its total addressable market. On the earnings call the company seemed ready to throw a kitchen sink at the problem (including monetizing free-riding viewers and creating an ad-supported tier).
Quote: The results were a “sea change quarter” that “essentially conceded to every key point of the bear thesis,” J.P. Morgan analyst Doug Anmuth said.
“The bigger factor is management’s acknowledgment of relatively high household penetration when including account sharing, increased competition, and COVID pull-forward giving way to fundamental weakness,” Anmuth wrote in a note to clients. “We’re moving to the sidelines as we look for greater confidence in restoring subscriber growth & reaccelerating revenue, while also increasing development velocity in account sharing and advertising,”
Go deeper into the changing landscape: The stumble in the long-time dominant force in streaming may open the door for competitors to take the lead. But Wall Street is cautious, with other major streaming stocks all tumbling yesterday.
Walt Disney (DIS), HBO Max parent Warner Bros. Discovery (WBD) and Paramount (PARA) all fell more than 5% yesterday. There was also downward pressure for some smaller streamers often named in merger and acquisition chatter, with Lions Gate Entertainment (LGF.A), AMC Networks (AMCX) and fuboTV (FUBO) sliding.
There have been three chapters in the Netflix saga, according to Rameez Tase, co-founder of Antenna Data, which tracks the subscription economy. In Chapter 1 Netflix disrupted TV, in Chapter 2 TV fought back and clawed back market share and in Chapter 3 TV eats its own profits because hurting Netflix isn’t a business model, Tase tweeted.
“Yes, they weakened Netflix … but at what cost?” he said. “Each of Netflix’s competitors now faces 2 existential challenges: retention and monetization. Will they be able to prevent churn? Will they be able to charge more?”
“The implications? Get ready to see an all-out war for retention and monetization, prices are going up, up, up, (but) will consumers bear it? Wall Street shifts from Subscribers to Customer Lifetime Value (and) Growth Marketers are the new saviors of TV.”
Elon Musk stoked “420” excitement among his supporters on April 20 with another cryptic tweet that indicated he may make a tender offer for Twitter (TWTR).
Musk tweeted “_______ is the Night.”
On Thursday, Musk said he will explore a potential tender offer for Twitter, having secured $46.5B committed financing for the deal. Musk’s filing says entities related to him have received commitment letters committing to about $46.5B to finance the offer.
Twitter has adopted a poison pill to thwart Musk’s hostile bid of $43B for the company.
Musk is said to be in talks with private-equity firm Thoma Bravo about partnering on a potential Twitter takeover bid.
Thoma Bravo executives are said to be mixed on a potential partnership due to Musk’s behavior and controversial politics, according to a New York Post report.
Also on 4/20, Tesla (TSLA) powered through supply chain issues and late-quarter disruption in Shanghai to comfortably top estimates with its Q1 earnings report.
The company generated $3.3B in GAAP net income during the quarter and $3.7B in non-GAAP net income. The automaker reports it produced 305,407 vehicles in Q1 (+69% Y/Y) and delivered 310,048 vehicles (+68%).
Operating margin shot up to 19.2% of sales to improve from last quarter’s mark of 14.7%. Automotive gross margin excluding regulatory credits was 30.0% vs. 27.7% consensus and 29.2% last quarter.
Housing inflection point
Demand for homes is strong, with many properties for sale going for well above asking price. But with a hawkish Fed and the Treasury yields jumping, the 30-year fixed-rate mortgage just topped 5% for the first time in a decade.
“Rising rates are starting to show up in housing data,” Schwab’s Kathy Jones tweeted. That could further dent demand, although “housing starts have historically been unresponsive to changes in mortgage rates in a supply-constrained environment, likely because homebuilders are able to continue building with little fear that homes will sit vacant after completion,” Goldman Sachs said.
Yesterday, the NAHB Housing Market Index fell to a seven-month low of 77 for April. “The housing market faces an inflection point as an unexpectedly quick rise in interest rates, rising home prices and escalating material costs have significantly decreased housing affordability conditions, particularly in the crucial entry-level market,” NAHB Chief Economist Robert Dietz said.
Redfin reported last week that home sales fell 4% in March as buying costs shot up. “We expect the combination of surging mortgage rates and record-high home prices to cause more homebuyers to drop out of the market,” Redfin chief economist Daryl Fairweather said. “Unfortunately, homeowners are turning their back on the market too. Instead of being motivated to list before prices weaken, potential home sellers may be choosing to wait-out the impending market cooldown.”
Stock impact: The “inexorable rise in back end rates is having a meaningful impact on interest rate sensitive areas of the economy and market, like housing,” Morgan Stanley equity strategist Mike Wilson said.
The SPDR Homebuilders ETF (XHB) is down nearly 30% year to date and off 15% from its near-term peak in mid-March. The sector is also vulnerable to the risk of the Fed orchestrating a hard landing with its rate hike, possibly leading to a recession. But Citi says that a replay of 2008 isn’t in the cards.
“We believe the housing risk is much less severe than occurred during the Great Financial Crisis since credit quality is healthy, home equity levels are high, and there is higher structural demand for the home than pre-pandemic,” analyst Steve Zaccone wrote in a note.
The Goldman Sachs economics team says that there is now a 35% chance of a U.S recession over the next two years, with the labor market a particular problem for the Federal Reserve. The large gap between jobs and workers, which keeps wage growth elevated, has historically only declined during periods of economic contraction, chief economist Jan Hatzius and team wrote in a note out on Sunday. Predictions for a recession have been growing as the Fed tries to negotiate a soft landing for the economy at a time when inflation is at a level not seen in four decades.
Deutsche Bank was the first big Wall Street bank to forecast a recession, saying in the first week of April a recession in late 2023 is now their base case.
Quotes: “Taken at face value, these historical patterns suggest the Fed faces a hard path to a soft landing,” Hatzius said, according to Bloomberg. But other strategists are more cautious.
Wells Fargo stock strategist Chris Harvey said in a note last week that despite “daily calls for a recession from anyone with a megaphone, we do not expect one of the next 12 months. Rather, stagflation (high inflation/slower growth) likely will prevail.”
Credit Suisse says it is not underweight equities because: “i) equities are fair value (not overvalued) with equities being an inflation hedge compared to bonds; ii) monetary conditions are very loose; iii) we only tend to get recessions 9 months after 3-month money inverts relative to 10-year.”
Go deeper on yields: The Fed’s hawkish signaling, with 50-basis-point rate hikes expected over the next few meetings has sent Treasury yields sharply higher. An inversion in the 2-year and 10-year Treasury yield curve was pointed to as a signal of an upcoming recession. But the inversion was short-lived and that curve has started steepening again.
“Despite the embarrassing panic about the wrong yield curve measures flattening/inverting earlier this year, the curves that actually forecast recessions remain steep and have been steepening,” MKM’s Michael Darda said in a note.
“The long Treasury rate (or 10-year Treasury yield) minus the 3-month Treasury bill yield has inverted before every recession since the mid-1950s.” That spread is now around 200 basis points. Still, traders see little respite from the bond selloff in the near term. “We’re coming out of one of the worst quarters in history … and the big bear market in bonds continues,” Thanos Bardas, global co-head of investment grade at Neuberger Berman, told The Wall Street Journal.
Dow -1.9% to 33,811. S&P 500 -2.8% to 4,272. Nasdaq -3.8% to 12,839. Russell 2000 -3.2% to 1,941. CBOE Volatility Index +24.3% to 28.21.
S&P 500 Sectors
Consumer Staples +2.1%. Utilities +0.9%. Financials +2.6%. Telecom -2.2%. Healthcare +1.1%. Industrials +2.%. Information Technology +2.%. Materials +1.7%. Energy +1.%. Consumer Discretionary +1.9%.
London -1.2% to 7,522. France -0.1% to 6,581. Germany -0.2% to 14,142. Japan +0.% to 27,105. China -3.9% to 3,087. Hong Kong -4.1% to 20,639. India -2.% to 57,197.
Commodities and Bonds
Crude Oil WTI -5.8% to $100.75/bbl. Gold -2.2% to $1,932.5/oz. Natural Gas -11.4% to 6.465. Ten-Year Treasury Yield +2.7% to 2.91.
Forex and Cryptos
EUR/USD -0.11%. USD/JPY +1.76%. GBP/USD -1.68%. Bitcoin -2.4%. Litecoin -4.6%. Ethereum -2.6%. XRP -8.4%.
Where will the markets be headed next week? Current trends and ideas? Add your thoughts to the comments section.
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