Equities Q2 Fundamental Outlook: Who is Right About SVB, the Fed or Markets?
Nasdaq 100, S&P 500, Dow Jones – Equities Second Quarter Fundamental Forecast
- Tech-heavy Nasdaq 100 outperformed the Dow Jones in Q1
- SVB’s collapse threw a hard curveball for the Fed and hikes
- As it stands, the markets foresee rate cuts but Powell does not
Equities First Quarter Recap – SVB Collapse Throws a Curveball for the Fed
There was an internal divergence in how Wall Street performed during the first quarter of 2023. The tech-heavy Nasdaq 100 pulled ahead while the blue-chip-oriented Dow Jones underperformed. The Nasdaq/Dow ratio surged, touching the highest point since August.
The collapse of Silicon Valley Bank in early March overshadowed what was the growing theme of a rebound in US economic activity. On the chart below, you can see the Nasdaq peaking in February after January’s blowout non-farm payrolls report crossed the wires.
What followed was a period of increasingly hawkish Federal Reserve policy expectations that pushed up the 2-year Treasury yield as the Nasdaq fell. Not long after, SVB collapsed. That sent front-end government bond yields tumbling as markets aggressively priced in Fed rate cuts later this year.
The government stepped in to protect SVB’s depositors and that seemed to quell market volatility. The VIX market “fear gauge” remained restrained. But, Fed dovish expectations held, allowing the rate-hike-sensitive tech sector to enjoy the prospect of potentially lower borrowing costs in the future.
Nasdaq 100 First Quarter Timeline
Chart Created in TradingView
The Damage Done to Policy Tightening Expectations
In March, the Federal Reserve proceeded with tightening. Interest rates were raised by 25 basis points, bringing the target range to 4.75% - 5.00%. Chair Jerome Powell then conducted the usual press conference and showed that policymakers did not see the case for interest rate cuts this year. That put the central bank on a divergent path from markets.
Looking at the next chart below, we can see what the median FOMC dot plot projection looked like compared to market pricing. Long story short, while the Fed sees no change to interest rates this year, overnight index swaps are pricing in close to 100 basis points in cuts by the end of this year. This is setting up equities for an interesting second quarter.
How Has SVB Impacted Fed Policy Bets?
All Eyes on Economic Data
The stark divergence between the Fed and markets means that at the end of the day, one of these two will be wrong. If the market is wrong, the Nasdaq (and equities broadly) will be very much vulnerable going forward as rate-cut bets are priced out. On the other hand, if the Fed is wrong, could stocks be poised to keep rallying?
If the Fed is wrong, the economy is likely heading for trouble. Based on a study I conducted, historically, the S&P 500 has declined about 7% on average during the first 3 months of US recessions since 1969. Every recession is different of course.
With that in mind, only ongoing data will tell how the US economy absorbs the aftermath of SVB’s collapse. That is what the second quarter is going to be about. For now, we can look at how inflation expectations have evolved after SVB.
On the last chart below are the 2-year and 5-year breakeven rates (a gauge of inflation expectations) weekly. You can see how these evolved at the onset of the 2020 global pandemic. As the world economy shut down, markets started pricing in a deflationary spiral, which is a consequence of recessions.
A similar drop in breakeven rates after SVB’s collapse did not transpire by March’s Fed rate decision, but there have been cautious losses. That might support the Fed’s confidence for the time being. A further deceleration in medium-term CPI expectations would likely be an increasing sign of economic troubles ahead, however.
How Has SVB Impacted Inflation Expectations?
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