Welcome To Summer – Brace For A Hard Landing (SP500)

Summertime

It’s that time of the year. Summer officially started on June 20th. Usually at this time, investors are talking about a potential summer rally.

Last year around this time, the S&P500 (SP500) made a major breakout and zoomed higher until the 10% correction in late August. In June 2023 the GenAI theme was just taking off, supported by the earnings blowout and guidance from Nvidia (NVDA). In addition, Congress just avoided potential default by lifting the debt ceiling. The Fed signaled the end of the interest rate hiking campaign, and investors were warming up to the possibility of the Fed easing in 2024.

This year, the situation is very different. The AI bubble is potentially topping after the huge rally YTD. The economic data is deteriorating, with consumer spending slowing and weakening labor market, all pointing to a potential recession. At the same time, the Fed has turned hawkish and signaled only one cut in 2024.

In fact, those expected cuts in 2024 never materialized, the Fed has not cut interest rates yet this, and most likely will not until the recession starts. The yield curve remains inverted, but the lagging effects are already starting to hit the economy.

Thus, it appears that the summer of 2024 could be volatile. If the data continues to deteriorate, there is a possibility of a recession in Q3. In addition, the US 2024 Presidential Campaign will start to heat up with the first debates, and the party conventions.

However, the key potential volatility trigger may have come completely unexpectantly, and that’s the political instability in France after the recent European parliamentary elections. Over the next two weeks, there will be two rounds of parliamentary elections in France, where either the extreme right or the extreme left is likely to win. This could trigger another sovereign debt crisis. Given the importance of French banks and the French economy, it could become a global systemic event.

Thus, financial markets are likely to be highly volatile during the summer of 2024 – all while the volatility is near record lows entering the summer.

Weakening labor market

The initial claims for unemployment spiked on June 13th to 243K, and stayed near those levels on June 20th. It appears that the uptrend is developing.

The weekly initial claims for unemployment is the leading high-frequency indicator – and generally it spikes by around 25-35% from the bottom right before the recession starts. We are near those levels at the moment, which suggests that the recession could be near.

Note, the 2Y Treasury Note (US2Y) and the 10Y Treasury Note (US10Y) yields both fell in response to the weekly claims, which means that the bond market is starting to price is recession.

However also note, as the chart below shows, last year around this time that claims also spiked well above the 250K level, which also suggested that the US economy could be heading toward a recession. The unemployment claims fell back to the sub 200K level as the labor market improved.

Thus the current situation could be another recession “head fake.” However, this time retail sales are also dropping, with negative monthly growth in April and barely positive nominal growth in May. On many accounts, the US consumer is struggling, which is evident in a recessionary level low Michigan Sentiment survey data for June. Thus, this time it’s more likely that the uptrend in the claims actually continues, and leads to a recession.

The AI Bubble Burst

The AI bubble has been led by the Nvidia stock, which zoomed higher after the 10-1 stock split, let by inflows from retail investors. Bubbles are difficult to time, but they all eventually burst.

Nvidia had a major price reversal on June 20th, being up 3-4% during the premarket trading, and opening strongly before reversing and finishing 4% lower. The following day, NVDA stock also fell by over 3%.

The price reversal coincided with the options expiration date, and it’s possible that the dealers sold NVDA stock held as a hedge against short call options. However, everybody who bought NVDA over the last five days is now in the “red,” which could lead to more selling as the profit taking continues.

The recent spike in NVDA was highly speculative, as the retail investor not only chased NVDA stock, but also the leveraged ETF that gives 2X NVDA returns (NVDL). Given the speculative nature of the recent NVDA trading activity, the NVDA stock could plunge, bursting the AI bubble.

Politics and geopolitics

The US 2024 election officially starts in June with the debates and Conventions. The major market risk associated with the US election is a possible spike in crude oil price (USO) this summer. The Biden Administration was able to de-escalate the geopolitical situation, and keep the price of oil in range. However, leading to the election, the price of oil could spike as a method of foreign interference in the US election.

The situation in France could leads to a sovereign debt crisis, where the yields on French bonds spike, leading to the widening on the credit spreads globally. France has debt at 111% of GDP, 5.5% budget deficit, with AA- credit rating. The risks are substantial, and there is no positive outcome coming out of the election – either the far left or the far right will win based on the polls. The situation in France could also lead to a weaker Euro (FXE) or stronger USD (UUP), which would further tighten the financial conditions.

Implications

The summer of 2024 could bring the following:

• The spike in the crude oil price due to the US election.
• The widening of the credit spreads triggered by the French elections.
• The beginning of a recession, as the labor market continues to weaken.
• The burst is the AI bubble, as the speculation in NVDA reverses.

None of this is currently priced by the S&P500. The volatility (VXX) is very low, credit spreads are very tight, and analysts are predicting double-digit earnings growth, while the PE multiple is at 24 – very high.

The combination of the events listed above unfolding simultaneously could cause an economic hard landing, and a deep correction in the stock market.

Thus, the outlook for the S&P500 (SP500) is highly negative.