Negative guidance from the Fruit on demand for the new iPhone 14 pro has reinforced the already bearish prevailing bias in equities. From our perch, this should not be a surprise to investors. However, the way price is responding to news suggests that many market participants are still too optimistic on the outlook for earnings in consumer discretionary and the equity market more broadly. As discussed in our recent notes, the best leading indicators of future earnings like the rate of change in financial conditions and the ISM new orders to inventory ratio are consistent with minus 15 to 25% off current earnings (recall that was our fear when the global risk proxy was rallying through the northern hemisphere summer). On the positive side, the guidance from the Fruit is a sign of the capitulation in beliefs that we have been looking for to become more bullish on equities. On the negative side, the near term capitulation phase (and associated surge in volatility) could still be rather brutal.
As we have noted over the past few months, most of the correction in price so far this year has been driven by inflation and the adjustment in real and nominal short term interest rate expectations. The good news is that the fixed income markets are now fairly well calibrated for a 4.75% to 5% terminal funds rate in this cycle. The bad news is that equities probably still have to adjust to the spike in real rates, tightening in financial conditions and the negative implication that has for growth and corporate earnings (chart 1 – the real rate is inverted on the light blue line so a rise in real rates is consistent with a decline in equity prices – note that correlation is not always consistent).
On the positive side, as we noted above, recent guidance (confession) from companies sensitive to the business cycle like FedEx and the Fruit is probably evidence of a capitulation in beliefs on future demand and forward earnings. Indeed, even the trailing data is consistent with a moderation in sales and profit margins on the index and Apple specifically (chart 2).
Apple is clearly one of the largest consumer discretionary companies in the world. The implication for final demand is potentially rather ominous. Moreover, the inference for the supply chain, specially in Asia, is also clearly negative. On the positive side, the sector has already been extremely weak and is a reflection of pessimistic beliefs on markets like Korea and Taiwan which are highly levered to the sector and global growth expectations more broadly. The US semiconductor index has also already fallen considerably over the past year, consistent with the tightening in financial conditions and other leading indicators of the global manufacturing cycle (chart 3). Put another way, price beliefs and valuation is already much more pessimistic in the sector and Asia more broadly compared to the relative optimism in related US equities (Apple is still up around 100% from the COVID episode).
In conclusion, we – ironically – see news flow from the Fruit today as circumstantial evidence of a capitulation in beliefs on forward earnings, not just for the sector, but for the market more broadly. The fact that this is leading to rapid and emotional price action in equities and an impulsive spike in volatility is also consistent with capitulation in the prevailing bias. On the negative side, the capitulation phase is likely to feel deeply uncomfortable but the best trades are often made from a position of profound discomfort. We would also note that valuation and equity risk premium has become very episodic, especially in Asia.