Stock investors are fastening their seatbelts, preparing for a turbulent week driven by a series of risk events, with no thoughts of a "summer lull." While geopolitical factors have already stirred up volatility, earnings reports and macroeconomic news are likely to trigger even sharper swings. Microsoft and Meta are set to report earnings on Wednesday, followed by Apple and Amazon on Thursday. The Federal Reserve and the Bank of England are poised to make interest rate decisions this week, and among a deluge of economic data, European inflation rates are also a key focus.
Richard Privorotsky, a partner at Goldman Sachs Group, noted, "All of this is happening against a backdrop where Brent crude briefly surged past $100, global bond yields are high, and the market is still digesting two consecutive weeks of equity weakness." He believes buying VIX call options is a good hedge against tail risks. "I think we're still in a phase of significant chop, with implied correlations near multi-decade lows, and stock-specific dispersion is suppressing overall market volatility."
The rationale for buying VIX call options is supported by historical data. According to Goldman Sachs, during US midterm election years, index-level volatility typically rises in August and continues to climb through October. More broadly, single-stock volatility remains elevated, and the divergence in returns has been a key theme this year. These extreme indicators now appear more likely to reverse than persist, potentially amplifying volatility.
Technical analysis may help explain the path forward. The MSCI World Index seems to be capped around the 4885 level. Meanwhile, strategists at Deutsche Bank, including Parag Thatte, indicate that systematic investors' elevated positions are at the 70th percentile, "which could become vulnerable if volatility rises or equities break down from their range."
Looking at other positioning data, Deutsche Bank strategists note that last week saw another significant wave of deleveraging, with discretionary investors cutting their risk exposure to levels seen in early April (the 17th percentile). This is well below what earnings and macroeconomic growth would suggest. They add that the rotation out of mega-cap tech stocks is about three-quarters complete, as positions have receded from their highs.
In the mega-cap tech earnings arena, all eyes are on the "Magnificent Seven." For months, this group has been funding the AI beneficiaries and semiconductor trades, but they haven't benefited from the recent profit-taking in these stocks. Investors appear cautious about re-entering, especially after Alphabet's statement last week stoked concerns about capital expenditure commitments. Despite this, valuations for the "Magnificent Seven" are now at historical lows. Both on an absolute and relative basis, their forward P/E ratios have fallen to the bottom of their seven-year range. As this valuation compression is driven by both falling stock prices and rising earnings expectations, it may present a buying opportunity.
While concerns about massive AI investment are a focus, some are convinced that at least some hyperscale cloud providers will be the ultimate winners. Analysts at Morgan Stanley, including Stephen Byrd and Michelle Weaver, hold this view, betting on the "intelligent superhighway." They recommend holding shares in fuel cell and energy storage companies, computing manufacturing ecosystem firms, and hyperscale cloud providers that can achieve scale and generate attractive returns on their AI capital expenditures. They cite Meta, Alphabet, Microsoft, and Amazon. The Morgan Stanley team wrote, "Given the recent market pullback impacting a range of AI infrastructure stocks, we believe the current moment represents an extraordinary and attractive buying opportunity. Fundamentally, we are very bullish on the pace of AI capability improvement, the dividends from AI application, and the associated capital expenditure."
Beyond tech earnings, the biggest threat to market calm this week comes from central banks. The swaps market has fully priced in a rate cut by the Fed in September, and possibly a second one by year-end. Any significant shift in this pricing could impact equities, so Fed Chair Powell's comments will be scrutinized intensely. A further easing of tensions in the Middle East, pushing oil prices lower, would help the central bank's mission, and Powell's opposition to forward guidance means rate cut expectations will be more data-dependent. According to the JPMorgan market intelligence team, "For equities, the pace of rate changes is more important than their absolute level." They note that the 10-year US Treasury yield broke above the May high of 4.67% last week, with the next key level being the January 2025 high of 4.79%. "If upcoming data or Fed rhetoric supports a further break above 4.8%, we will begin to see increased pressure on rate-sensitive stocks."
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