Downside risks continue to rise but the earnings season may still set the course

If equities had a bad first quarter, it was far worse with the bond markets. With cash and bonds offering negative real yields, ‘buy the dips’ strategy seem to be providing the floor for global equities, despite deteriorating fundamentals. Equities have rebounded strongly in March. The benchmark gauges have retraced over half the losses since Jan 1 ’22, in record time from the initial shock of the war and the havoc it’s wreaked on global commodity supplies.

The markets have been resilient to the regular bouts of the covid variant over the past 2 years. Fast forward now, with twin risk pillars of Fed tightening and the war uncertainty, the equity markets are defying the trend again. They have come back from many other crises over the past few decades, this time may be no different.

On Friday, a closely watched measure of the yield curve - the yield on the 2-year note again moved above the 10-year yield. The equity market, rightfully so, seems to have taken the yield inversion in its stride. The inversion, a good indicator of the future strength of the economy, hasn’t been reliable one for equity market timing.

The case for stock market skepticism remains strong – the war in Ukraine, inflation data reinforcing a faster Fed tightening, earnings expected to slow down, supply chain disruptions, and not to ignore the covid related restrictions in China’s biggest cities. There is no doubt that the risks are climbing every day as inflationary shock through imported prices and prolonged supply bottlenecks squeezes demand, slower economic growth and the Fed and ECB keen to accelerate the end of excessively loose monetary policy.

There is evidence to believe that the recent rally has some support – economic outlook may indicate slower growth and not a recession, strong employment numbers in the U.S., consumers’ savings cushion, solid corporate balance sheets and limited alternative investment options. With valuations, although off their peak, are still at an elevated level and may limit any upside. Whether the Fed may engineer a not so hard landing, or the supply chain logjam starts to unlock, the earnings season starting now become all the more important.