Q1 Comes to a Calm Close, Turbulence Ahead

US equity markets have managed to maintain a modestly constructive bias this week in large part due to quarter-end window dressing and Federal Reserve Chair Janet Yellen’s talk, given at the Economic Club of New York on Tuesday. For the week, thus far, the S&P 500 has notched a gain of 1.39%, the Nasdaq has gained 2.15% and the Dow Industrials have ticked 1.03% higher. In all three cases there has been a refreshing lack of both pricing turmoil and volatility. Relative tranquility in energy markets, a calming/dovish voice on the interest rates landscape and a lack of earnings season drama have all contributed to the rather calm waters investors have been treated to ahead of Q1 earnings season. In fact, so calm has the investing terrain become in recent days that the volatility index has traded to lows not seen since August of last year. On August 14th, the VIX closed at 13.02. Over the subsequent 5 trading days, it climbed to 40.74 or 312%. I am not suggesting that we see a repeat performance of that trade this time around, as many of the drivers for that ferocious selloff are not in play. I am only suggesting that if recent history is any indication, volatility is cheap as we close out Q1.

Thus far this week, the 10-yr yield has barely moved, shedding 6 bps to close yesterday with a yield of 1.83%. Clearly markets and investors have been well positioned this week for Chair Yellen’s dovish guidance, confirmation of the FOMC’s latest announcement, and her lean in to the increasingly central role and impact that global geopolitical and economic themes have on US monetary policy. As the Fed continues to take a path of forbearance that is predicated upon caution and deliberation, with an eye on the global stage, investors increasingly edge further out on the risk ledge. As I have suggested in recent contributions, and here in Kenny’s Commentary, the Fed’s hands are somewhat tied in as far as their aspirations for tightening are concerned given the global construct that has yet to yield much in the way of demand over the past several years. As a result, markets are going to need a degree of reinforcement from a different catalyst if investors hope to see our recent rebound off from February lows remain in tact.

That is where earnings season comes in. Last week we received corporate profitability data for Q4 and it wasn’t pretty. As I have discussed, in the final quarter of 2015, corporate profits dropped by 11.5% when adjusted for inventory valuations and capital consumption. That decline follows an unexpectedly large 5.1% contraction in the previous quarter. I expect that corporate profits, long considered a leading indicator of US economic health, will continue to provide a cautious overhang to the market and to this earnings season. Though corporate profits don’t tell the full story, they do provide meaningful insight into what stage of the economic cycle we find ourselves in.

With that as a backdrop and with S&P 500 earnings projections and revenue growth for Q1 at multi-year lows, I would suggest that we may run into some further turbulence in the days, weeks and months ahead in Q2. That turbulence is likely to bring a downshift in pricing with it.


Flickr photo: RoiseTulips