A bad week for markets, can PCE save the day?

After a sharp sell off in markets, led by the US tech sector, are there reasons to be cheerful? As we progress through the European session, there are signs that risk appetite is returning. The major European stock indices are mostly higher, US stock index futures are sharply higher, and the dollar is stabilizing. USD/JPY, which has sold off sharply in the last two weeks, is also finding its feet just below 154.00. Although there has been some headline grabbing bad news about earnings, notably Tesla and the global car sector, the news is not all bad, even though the price action is skewed to the downside.

Is the market overreacting to earnings reports?

For example, on aggregate, so far, the Eurostoxx 600 index has reported positive earnings surprises, beating analyst estimates by more than 3%. This has been led by communications, healthcare, and utilities. Early indicators suggest that consumer discretionary is also surprising to the upside, even with some notable misses including LVMH. The weakness in US and European earnings so far seems to stem from companies that rely on overseas orders, EV makers or those heavily invested in the AI boom. Domestic banking in Europe seems to be in decent health.

On Friday, NatWest reported earnings. They boosted their full year revenue guidance – full year income is now expected at £14bn, up from £13-13.5bn previously. This has been boosted by decent fee income and higher than expected net interest income. NatWest is mostly a domestic UK lender, its results are a reflection on the UK economy, and they are a sign that the UK economy remains resilient even in the face of high interest rates. These results also suggests that mid-level UK banks are in ruder health than some mid-level US banks that are burdened by losses on corporate real estate portfolios. Thus, while there are some big trends that might unravel in the coming weeks – especially the momentum trade in big tech, there are some reasons to be cheerful in other parts of the market and the world.

The sell off is not in correction territory

Although the selloff in stocks in the last two weeks has been brutal, and stocks in the US and Europe are expected to register their second week of losses, the actual declines so far have been moderate. So far in July, the S&P 500 is down 1.2% and the Nasdaq is down by 3.1%. The Eurostoxx 50 index is down by less than 1%, and the FTSE 100 is up by 1.1%, or more than 2% on a currency adjusted basis. Thus, the sell off has been bruising for pockets of the market, and daily sell offs have been very large, specifically for the Nasdaq, but the selling is not indiscriminate. Added to this, the mid-cap rally has been impressively resilient during this sell off, as the prospect of falling bond yields boosts cyclical stocks. In the past month, the S&P 500 equal-weighted index is outperforming the S&P 500 index, which suggests that value stocks have outperformed growth. Other factors that are positive for value stocks including a robust US economy, which expanded by 2.8% in Q2, and growing world trade in Asia, that could benefit value stocks later in the year if it is a sign that the economy in China is picking up.

What to watch today: Core PCE and USD/JPY

A key US inflation indicator is released later today. The core PCE reading for June is released at 1330 BST today. This is the Fed’s preferred inflation measure, and because the Fed is focused on data-watching, that means that investors need to watch this indicator closely. Economists are expecting a 0.1% gain MoM, and for the annual index to moderate to 2.4% from 2.6% in May. The risk is to the upside after stronger than expected US Q2 GDP and a stronger than anticipated Q2 core PCE reading, which may have fallen to 2.9% from 3.7% in Q1, however, this was stronger than the 2.7% expected.

Core PCE and the 10-year Treasury yield

If we get a reading either side of expectations, watch the US 10-year yield as its reaction could determine how FX and stocks perform on the back of this data release this afternoon. The US 10-year yield is down 24 basis points since reaching a peak on the 1st July, as risk aversion has taken hold. A stronger than expected reading for core PCE could put upward pressure on the 10-year yield and push it back towards the 4.49% high from 1st July. This would be bad news for risk sentiment in our view, as it may threaten the prospect of a September rate cut from the Fed. Although the market has fully priced in the first rate cut from the Fed for September, the Fed has remained faithfully data dependent, so if they do not see a good enough improvement in the June core PCE, then doubts might start to creep in about the potential for rate cuts this autumn.

Can the yen rally continue?

It is also worth watching USD/JPY, which faces some key tests in the coming week. The Fed and the BOJ both meet on Wednesday next week, can the yen, which has jumped nearly 5% vs. the USD since the start of July, continue to rally at this pace if the BOJ rolls back on rate cut expectations, or does not cut asset purchases by as much as expected? Tokyo CPI for July was weaker than expected, with core price growth falling to 1.5% from 1.8% in June. Weak inflation readings like this could leave the BOJ with little choice but to delay interest rate normalization and a reduction in bond purchases to further in the future. This could damage the yen rally, and even send USD/JPY into reverse.