The summer tranquility for stock investors is over. This week, a convergence of risk events, including the Federal Reserve's interest rate decision, a flurry of earnings reports from tech giants, and oil prices surging past $100, is set to create a bumpy ride for markets.
Microsoft and Meta Platforms will report their results on Wednesday, followed by Apple and Amazon on Thursday. Simultaneously, the Federal Reserve and the Bank of England will announce their rate decisions, while European inflation data and China's PMI readings are also due for release. Goldman Sachs partner Richard Privorotsky noted that all of this is occurring against a backdrop of Brent crude briefly breaking above $100 per barrel, elevated global bond yields, and two consecutive weeks of decline in the stock market.
In terms of market pricing, the swaps market has fully priced in a rate hike by the Fed in September and implies the possibility of another increase later this year. JPMorgan's market intelligence unit warns that if the 10-year Treasury yield breaks above 4.8%, interest-rate-sensitive stocks will face even greater pressure.
Volatility Heats Up, Systemic Investor Positions Are Vulnerable
Geopolitical tensions have already raised volatility, and this week's earnings and economic data have the potential to trigger even larger market swings. Historically, Goldman Sachs data shows that in US midterm election years, index-level volatility typically begins to rise in August and continues to climb through October. Richard Privorotsky believes that VIX call options are a good tail-risk hedge and suggests the market is more likely to remain in a choppy range, as implied correlation remains near its lowest levels in decades, with dispersion suppressing overall market volatility.
Technical levels are also noteworthy. The MSCI World Index faces significant resistance around the 4,885-point level. Deutsche Bank strategist Parag Thatte and his team point out that the positioning of systematic investors is at the 70th percentile, which is considered elevated. This positioning becomes vulnerable if volatility rises or the equity market breaks out of its range to the downside.
Additionally, active investors have engaged in significant deleveraging over the past week, with their risk exposure falling back to the 17th percentile near the lows from early April. This is well below the levels implied by current earnings and macroeconomic growth.
Valuation of 'Magnificent Seven' Falls to Historic Lows, Divergence Intensifies
Big Tech earnings are the central focus of this week's market. The "Magnificent Seven" stocks have been a source of funding for AI beneficiary trades and the semiconductor trade for months, but they have not benefited from the recent wave of profit-taking in related sectors. According to Deutsche Bank strategists, the repositioning of large-cap tech stocks is about three-quarters complete, with positions having notably declined from elevated levels.
However, a noteworthy signal has appeared on the valuation front. The forward price-to-earnings ratio for the "Magnificent Seven" has dropped to the bottom of its seven-year range, both in absolute and relative terms. Deutsche Bank believes this valuation compression has been driven primarily by falling share prices rather than downward earnings revisions, which could present a buying opportunity.
Concerns over AI capital expenditure continue to simmer, reinforced by Alphabet's recent announcement, which has dampened investor enthusiasm for re-entering these positions. Nonetheless, Morgan Stanley analysts Stephen Byrd and Michelle Weaver hold a different view. They remain optimistic about the "smart superhighway" theme, recommending positions in fuel cell and energy storage companies, computing infrastructure manufacturing ecosystem players, and hyperscale cloud operators that can benefit from scale and AI capital expenditure returns. They specifically name Meta Platforms, Alphabet, Microsoft, and Amazon.
"Given the recent market pullback that has swept through a range of AI infrastructure stocks, we believe the current period represents a rare and attractive buying opportunity," the Morgan Stanley team wrote. "We fundamentally believe in the pace of AI capability improvement, the benefits from AI applications, and the associated capital expenditure."
Fed's Stance is a Key Variable, Bond Yields Influence Stock Sentiment
Beyond tech earnings, central bank actions pose the biggest threat to market calm this week. The swaps market has fully priced in a Fed rate hike for September and implies the possibility of a second increase later this year. Any statement from Fed Chair Kevin Warsh will be closely scrutinized by the market.
Warsh is known to be skeptical of forward guidance, meaning that rate hike expectations will be more data-dependent. A further easing of tensions in the Middle East, which could lead to lower oil prices, would help the central bank in its policy mission.
JPMorgan's market intelligence unit emphasizes that the speed of interest rate changes is more critical to the stock market than the absolute level. The unit notes that the 10-year Treasury yield has already broken above its May high of 4.67%, and the next key level to watch is the January 2025 high of 4.79%. "If subsequent data or Fed rhetoric supports a further break above 4.8%, interest-rate-sensitive stocks will begin to feel more pressure."
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