Since our June 30th quarterly commentary, the equity market has materially rallied with a variety of catalysts triggering a wave of buying. This has resulted in the market recuperating a bit under half of its losses from the June low. What remains to be seen is whether this recent bounce is simply a relief rally within a continued bear market or whether markets have in fact bottomed. This distinction largely rides on whether or not inflation has peaked, as this largely determines when and at what terminal level the Federal Reserve stops increasing interest rates.
While consumer inflation readings themselves have yet to markedly move lower, the Fed has seen data in recent weeks suggesting their effort to cool demand is working. Economic indicators such as manufacturing orders, services PMIs, new home sales, and building permits have all markedly slowed since the Fed began hiking rates. Commodities likewise have reversed with oil prices down 25% from their June highs. Inventories are also starting to build due to lower discretionary demand as shown by retailers beginning to cut prices on a variety of goods.
These developments may help cool inflation readings, with the latest July reading already showing some moderation. Forward inflation expectations as judged by consumer surveys and yields in the TIPs market have moved lower as well. If this trend continues, the market is likely to anticipate the Fed eventually pausing the rate hikes, which in turn would remove a major headwind for further gains.
Critically, the slowdown so far has yet to cause the more widespread economic disruptions typical of a large recession. Many of the indicators just mentioned actually reversed course and improved in July. Most notably, the labor market remains exceptionally strong as illustrated by the 3.5% unemployment rate and blowout July jobs report. Earnings likewise have broadly come in better than expected for the second quarter, even as the forward guidance paints a more mixed picture. Nevertheless, the extreme bearishness coming into these earnings set the bar very low, particularly in the mega-cap Tech group, which is broadly weathering the storm quite well. Markets also seem to be cheering the recent climate bill which sets the stage for billions in tax credits and incentives for both industry and consumers alike.
While this rally has been welcomed, markets are not out of the woods yet. Importantly, inflation could still surprise to the upside, as volatile commodities and tight labor markets could reverse the July improvements. Wage gains in particular will pose a challenge for a Fed seeking to return inflation to 2%. This dynamic could cause the Fed to raise interest rates further than anticipated, increasing the inversion of the yield curve and driving markets to price in a larger downturn than the shallow or “near-miss” recession currently reflected. Lastly, it remains to be seen if the relative resiliency in earnings is indicative of a broader level of support in the economy or simply the result of a delayed weakening of the operating environment which is yet to be fully felt. Interest rate hikes take time to work their way through the economy, and while price cuts certainly help on inflation, they are not good for the bottom line, as some recent misses in the retail and semiconductor sectors speak to.
We continue to monitor these developments closely but remain cautiously optimistic as we look forward for the remainder of the year. While risks remain, we take solace in the fact that much of the “hot air” has already been removed from the market, with the latest economic data suggesting we could be turning a corner for the better. Within a few months, markets will likely find out whether or not the Fed has been successful in engineering the “soft landing” for the economy that they desire. As always, we remain vigilant to add value in portfolios when opportunities present themselves.
We welcome your questions and comments and wish you and your families well. Thank you for watching.