U.S. stocks remain stuck in one of the tightest trading ranges in nearly two years, according to market experts, and they may not work their way out of the current sideways funk until Washington reaches a conclusion on its partisan debt ceiling standoff.
Despite a modestly better-than-expected first-quarter earnings season; a broadening consensus from Federal Reserve watchers that the central bank has made its last rate hike of the current tightening cycle; and the isolation of regional-bank-balance-sheet risks to a small number of stocks, the S&P 500 has been unable to reclaim the year-to-date highs it achieved in early February.
In fact, the market's recent movements have been so lifeless that last week's trading range -- even amid a potentially game-changing inflation report that was paired with a surprising leap in new unemployment applications -- was the narrowest since August 2021.
"It’s fair to ask whether this low volatility suggests the market is too complacent about the possibility of debt-ceiling turmoil," said Chris Larkin, managing director for trading and investing at E-Trade From Morgan Stanley.
"A debt default may not be the most likely scenario, but any prolonged debate or unexpected development has the potential to trigger higher volatility."
"Meanwhile, this week’s retail sales report -- and retail earnings -- may provide some insight into how the consumer is feeling about the economy, as well as the market," he added.
Potentially, at least.
The wind-down of first-quarter-earnings season definitely puts this week's trio of big retail earnings -- Walmart, Home Depot and Target will all report over the next three days -- in sharp focus.
But the broader post-earnings performance for the S&P 500 has been muted, despite the stronger-than-expected results.
Solid, Not Spectacular S&P 500 Profits
Collective S&P 500 profits are likely to have fallen 0.6% from a year earlier to a share-weighted $438.5 billion, according to Refinitiv data. That would confirm a so-called earnings recession following the 3.2% decline recorded over the three months ended in December.
At the same time, around 76.6% of reporting companies have topped Wall Street forecasts. And that produced one of the strongest beat rates in years, eclipsing not only the recent four-quarter average of 73.5% but also the long-term average of 66.3%.
A long string of slowing inflation readings, last exemplified by a March CPI reading that fell below the 5% level for the first time in two years, has also put the chance of a final Fed rate hike at just 25%, according to CME Group's FedWatch.
In fact, traders are pricing in a near 60% chance of a rate cut at the Fed's September meeting.
That may seem a bit aggressive, given that inflation is still running at more than twice the Fed's preferred 2% target and the economy is currently growing at a 2.7% clip (according to the most recent data from the Atlanta Fed's GDPNow forecasting tool).
But the tone does reflect the fact that the market has at the very least neutralized the Fed's near-term influence on stock prices.
So why hasn't that precipitated a breakout for the S&P 500? The index typically rallies hard in the wake of a Fed rate pause but begins to turn lower as the Fed moves to cutting, given the implications that has for economic growth.
"Investors are anxious for a debt ceiling solution. Over the short-term, the stock market is stuck until we reach a debt ceiling resolution and until we see more clarity from the regional banking sector," said Brad Bernstein, managing director at UBS Wealth Management in Philadelphia.
Biden 'Optimistic' a Debt-Ceiling Deal Can Be Reached
President Joe Biden, who is slated to meet with Republican lawmakers in Washington on Tuesday, told reporters over the weekend that he's "optimistic" a deal can be reached, and he hasn't changed his plans to attend the G-7 leaders' summit in Japan later this week.
"We expect volatility as we move closer to the June 1 debt ceiling [deadline. And] while we expect a deal to be reached at the 11th hour, we view any near-term pullbacks as buying opportunities," Bernstein added. He noted that during the previous major debt-ceiling negotiation in 2011, "the market declined, but rebounded very quickly."
The main difference between then and now, however, could be the manner in which the debt ceiling standoff is ultimately brokered.
The spending cuts demanded by Republican lawmakers, which total around $4.8 trillion over the next 10 years, could choke off growth prospects just as the U.S. consumer begins to retrench in the face of rising layoffs and still-high inflation rates.
"A Treasury default is unlikely, but markets could still experience volatility due to 'X date' concerns or the prospect of austerity," said Jason Pride, chief of investment strategy at Glenmede. "All else equal, a tightening of the purse strings reduces aggregate demand in the economy and is a headwind for profits."
Ian Shepherdson at Pantheon Macroeconomics notes that spending concessions agreed by President Barack Obama in 2011 as part of the debt-ceiling agreement nearly tipped the economy into recession. He argues that Democrats are unlikely to take a similar risk as growth prospects dim heading into next year's election cycle.
"That means Speaker McCarthy will have to take his chances with the extreme right Freedom Caucus, calling their bluff with a deal which will include some cuts, but nothing like as much as the House bill," Shepherdson said.
"Our base case is that both sides blink in time, but not before the clock has almost run out and markets have become very nervous."
Some of those nerves are evident in the bond market, where the yield on one-month Treasury bills has spiked to 5.59% -- some 43 basis points (0.43 percentage point) above six-month bills -- to compensate for any default risk that may occur after the June 1 deadline that Treasury Secretary Janet Yellen has declared.
But foreign investors continue to bid impressive amounts for new U.S. paper, including an astonishing 86% of last week's $21 billion sale of 30-year bonds.
The Stock Bulls Are Getting Antsy
Bernstein of UBS, meanwhile, thinks stocks are getting "closer to the beginning of the next bull market," even with the prevailing headwinds of weaking economic growth.
"We will most likely have a shallow recession towards the end of 2023 that will not surprise anyone," he said. "Any recession would put pressure on the Fed to cut rates sooner than later, which would most likely be bullish for stocks."
A second-half earnings recovery is also likely to provide another chance for stocks to break out of their current torpor, according to Glenmede's Pride.
"Next quarter’s earnings growth decline is forecasted to be primarily driven by the energy sector, as oil prices continue to fall from their ’22 highs, and the materials sector, as higher rates and a slowing economy weigh on demand," he said.
His remarks echo Refinitiv data suggesting collective profits that don't include the energy sector will fall by just 0.3% compared with a year-earlier last year.
"Earnings growth is expected to rebound in the second half of 2023, with a consensus calendar-year earnings growth rate of 1%," he added.
We'll see whether that does the trick.
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