While The Dollar Grows Stronger, Investors Weigh The Health Of The Service Sector

(Wednesday Market Open) The U.S. dollar is moving higher once again this morning and pushing towards another 52-week high. As I’ve mentioned many times before, a strong dollar could be a drag on multinational companies.

Potential Market Movers

Equity index futures were pointing to a lower open this morning in reaction to the higher U.S. currency, but investors are also awaiting several economic reports. After the market open, the market will get a good look at the service side of the economy with the latest releases for S&P U.S. Services PMI and the ISM Services Index. Based on consumer spending, the service economy has been solid in the last few months. Analysts are hoping that it continues to boost the economy and offset any slowing in goods consumption.

The JOLTS job openings report also arrives after the open and should provide insights to the overall strength of the economy as well as Friday’s June Employment Situation report.

Finally, the June FOMC Meeting Minutes will come out this afternoon giving analysts a chance to parse the discussion among Fed officials and their views on inflation, expectations for raising rates and the overall strength of the economy.  

WTI crude futures were up about 1% this morning, providing a small bounce after yesterday’s sell-off. A debate around commodities is rising. One side sees falling commodity prices as a reaction to the increasing likelihood of recession—the other sees rising rates having strengthened the dollar, and that’s helping curb inflation and bring commodity prices lower.

This is one of these arguments where one doesn’t cancel the other—both sides are probably right.  

The discussion over commodities leads to a broader debate around rates and yields. Some argue that yields are coming down because commodities prices are coming down. The other side thinks yields are being pushed lower as recession-fearing investors move toward bonds as a safe haven. Again, the answer is likely both.

The Federal Reserve’s choice to raise the Fed funds rate and start unloading its balance sheet are already having the intended effect of slowing inflation. Whether that will be reflected in the Consumer Price Index (CPI) numbers next week is difficult to say, but the pullback in commodities is a good start.

However, raising rates will slow the economy and the Fed has warned it would continue on this path. The Fed is still attempting to orchestrate a “soft landing,” a tough task under current conditions and the primary reason recession fears are rising.

There’s another influence on the commodity debate: uncertainty around China. A week ago, investors were excited that China appeared to be reopening and that many pandemic measures were finally behind them. However, Beijing’s mass testing this week is fueling fears that China could be locking down again. That could reduce the supply of many products, particularly technology.

The Shanghai Composite fell 1.43% overnight while the Hang Seng dropped 1.22%. 

Reviewing the Market Minutes

Stocks started the day lower as concerns about recession weighed down stocks at the open. However, the major indexes recovered with the Nasdaq Composite ($COMP) closing 1.75% higher after being down 1.9% earlier in the day. The S&P 500 (SPX) was also able to mount a comeback from a loss of 2.2% to a gain of 0.16%. The Dow Jones Industrial Average ($DJI) rallied off its low after being down 2.4% to a loss of just 0.42%.

With the U.S. Dollar Index ($DXY) rocketing 1.29% on the day, a trajectory that’s been difficult for multinational companies, the rally in stocks could be a result of short covering instead of a change in investor sentiment.

In fact, the rally wasn’t very broad as NYSE decliners edged out advancers. Additionally, only the consumer discretionary and technology sectors finished the day in the green.

Another sign of recession emerged during the trading day. The 10-year Treasury yield (TNX) fell eight basis points to 2.8% while the 2-year Treasury yield was only slightly lower, closing at 2.82%. This means the 2s10s yield spread that is often used as a proxy for the yield curve has inverted once again. An inverted yield curve is seen by many investors as a reliable indicator of recession.

The fear of recession also appears to be driving oil prices lower. The WTI crude futures settled 8.1% lower on the day, falling below $100 per barrel. While lower energy prices should help to bring some reprieve from inflation, there’s no telling how much it will cost in economic growth. 

CHART OF THE DAY: HOME ON THE RANGE. The S&P 500 (SPX—candlesticks) appears to be bouncing between a range of price levels going back to the end of 2020 to the beginning of 2021. However, the downtrend appears to be intact as the SPX continues to make lower highs and lows. Data Sources: ICE, S&P Dow Jones Indices. Chart source: The thinkorswim® platformFor illustrative purposes only. Past performance does not guarantee future results.

Three Things to Watch

Aiming Lower: Data collected by FactSet found that the majority of analysts are now projecting that the S&P 500 (SPX) will finish below 5,000 for the year. The new target is 7% lower from the peak estimate of 5,344.26 set back on January 20, 2022. With the benchmark index currently trading below the 3,900 level, the average analyst price target of 4,987.28 would make for a decent rally in the second half of the year. However, finishing the year at a new all-time high could be a bit of a stretch for stocks.

One reason for the bullishness is that analysts are projecting big rallies from the communications (+42.6%), consumer discretionary (+40.2%), and information technology (+36.5%) sectors. The S&P 500 would need these kinds of rallies to reach the target.

The data also showed that analysts are maintaining a high number of buy ratings with 57% of the stocks in the S&P 500 rated ‘buy.’ That’s above the five-year average of 53.3% and higher than the previous month’s 55%.

Analysis Paralysis: With Q2 earnings season a week away, analysts are keeping earnings estimates at a relatively positive level too. While it’s true, according to FactSet, that analysts have lowered earnings estimates over the last three months, the margin by which analysts have reduced their expectations is smaller than the historical average. Additionally, analysts have increased their earnings projections for the full year.

The findings are a bit surprising in the wake of rising rates, higher inflation, a worsening bear market and a slowing economy appearing to be heading for recession. While analysts remain positive towards energy, materials, industrials, and real estate for Q2, they’re also adding financials and utilities to the positive growth column for the calendar year.

However, these earnings growth expectations don’t seem to match up with performance growth many analysts are hoping for from the communications, consumer discretionary, and technology sectors. That’s because each of those sectors are still projected to have negative earnings growth for the year. Consumer discretionary and communications have the worst outlooks at -13.5% and -4.5% respectively. Either something’s got to give, or several analysts are going to look foolish.

Bear Market Strategies: A study by Factor Research has found that all but one bear market strategy, including defensive and diversifying strategies, have resulted in negative returns so far this year. The study found that too many strategies were highly correlated with the equity markets. However, most strategies outperformed the S&P 500 (SPX) by not losing as much as the index. The “quality stocks” strategy was the only defensive strategy to underperform the SPX while bitcoin was the worst in the diversifying group. A big exception came among the diversifying group where the “managed futures” strategy returned about 30% for the year.

These results are likely frustrating for active investors trying to find a tactical approach to investing by looking for a bull market somewhere else. But long-term investors are likely to hang on to a well-diversified portfolio of quality stocks and wait out the downswings. 

Notable Calendar Items

July 7: ADP National Employment Report and earnings from Levi Straus LEVI, WD-40 WDFC, and PriceSmart PSMT

July 8: June Employment Situation Report and May consumer credit

July 12: Earnings from PepsiCo PEP

July 13: June Consumer Price Index (CPI) and earnings from Progressive PGR, Fastenal FAST, and Delta Air Lines DAL

July 14: Producer Price Index (PPI) and earnings from Taiwan Semiconductor TSM, JPMorgan Chase JPM, Morgan Stanley MS, Cintas CTAS, and ConAgra CAG

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

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