How earnings and a potential US-China trade deal are driving markets

Key Concepts

• Corporate Profits: Net profit margins for S&P 500 companies are exceeding their 5-year average.
• Earnings Season: Financials and industrials have reported solid earnings, with AI infrastructure demand being a key driver for industrials. Tech earnings are anticipated to be a major market driver this week.
• Market Expectations: High expectations exist for China trade developments, Federal Reserve rate cuts, and tech earnings.
• AI Hype: Continued announcements and demand for AI infrastructure are fueling market sentiment.
• Market Volatility: Despite solid earnings, some stocks have experienced significant intraday swings, potentially driven by options positioning.
• US-China Trade Relations: A potential deal framework between the US and China is providing market relief, removing an overhang.
• Economic Data: Reliance on private data and corporate commentary due to limited government data availability.
• Labor Market: Cautious hiring but no mass layoffs are observed.
• Consumer Spending: A "K-shaped" recovery is noted, with higher-income consumers holding up well, while lower-income consumers struggle with inflation.
• Federal Reserve Policy: A 25 basis point rate cut is largely priced in. Expectations for the end of Quantitative Tightening (QT) are increasing. Markets are pricing in further rate cuts, potentially starting in January.
• Inflation: Shelter costs are starting to offset inflationary pressures in other categories.

Corporate Earnings and Market Sentiment

Fresh data from Faxet indicates that corporate profits are remaining stable. Specifically, net profit margins for S&P 500 companies have surpassed their 5-year average for six consecutive quarters, with analysts projecting this trend to continue into the following year. Michael Ryan King, a senior market strategist, notes that despite significant macroeconomic headlines, earnings season has been robust.

Financial Sector Performance

The financial sector kicked off earnings season strongly, with money center banks benefiting from trading and investment banking activities.

Industrial Sector Drivers

More recently, industrial companies have reported solid earnings, largely driven by strong demand for AI infrastructure.

Regional Banks and Credit Concerns

Regional banks did not perform as strongly, following a brief credit scare a few weeks prior.

Anticipation of Tech Earnings

This week is expected to see a significant market impact from tech earnings, which are considered the primary driver for the market.

Market Expectations and AI Demand

The market is currently characterized by high expectations across several fronts: China trade developments, Federal Reserve rate cuts, and tech earnings. King highlights the challenge of sustaining the "AI hype" despite a continuous stream of deal announcements. While solid earnings are anticipated, the market's reaction to these results remains a key question. There is no indication of a slowdown in capital expenditure (capex) spending; instead, companies are reporting increased investment.

Market Reaction to Earnings

An interesting market reaction was observed with companies like GE Vernova and Verdivive. Despite reporting strong earnings and gapping up at the open, their stocks sold off sharply during the session, only to recover their gains over a two to three-day period. This volatility is attributed, in part, to options positioning at both the single-stock and index levels.

US-China Trade Relations and Market Overhang

Positive headlines from Asia regarding a potential US-China trade deal framework have provided market relief. Treasury Secretary Besson expressed confidence in this framework, which, even if provisional, has been sufficient to support market sentiment. The potential removal or deferral of tariffs, such as those on fentanyl, and the prospect of increased soybean purchases are key aspects of this development.

Removal of Trade Overhang

The removal or pushing back of this trade overhang allows markets to continue their upward trajectory, focusing on other catalysts. This is evident in the market's rapid recovery from a significant drawdown experienced around October 10th, which was the largest since the trade war discussions in April. This event reset market positioning, as a scramble for protection quickly unwound, leading to a push towards fresh highs. Consequently, investors can now concentrate on earnings and other economic factors rather than trade-related anxieties.

Economic Outlook and Federal Reserve Policy

The expectation for strong earnings growth into next year, potentially double-digit, is a positive sign. There is hope that investments in the US economy will translate into improved corporate earnings and economic data.

Federal Reserve and Interest Rate Cuts

The Federal Reserve's upcoming meeting is another significant event, with an interest rate cut widely expected. The absence of government data, except for CPI, has led to a reliance on private data sources and corporate commentary to gauge economic movement.

Labor Market and Consumer Behavior

Corporate commentary suggests a cautious hiring environment but no widespread layoffs. The labor market remains relatively stable. The consumer economy is described as a "K-shaped" recovery, with higher-income consumers performing well. However, lower-income consumers are struggling with the cumulative effects of inflation. Overall, the economy is holding up reasonably well.

Fed Catalyst and Market Pricing

The market has largely priced in a 25 basis point rate cut. There is also increasing speculation about the end of Quantitative Tightening (QT) at this meeting or the next. While Federal Reserve Chair Jerome Powell is expected to maintain flexibility, market sentiment strongly suggests further rate cuts are imminent. The recent CPI data, which did not show significant upside surprises and saw shelter costs begin to offset other inflationary pressures, supports the Federal Reserve's ability to proceed with rate cuts. Markets are now pricing in a third cut, with a slightly better than coin-flip probability for January, indicating a continued upward shift in rate cut expectations.