Since our last update, markets continue to trade at the recent highs after posting double digit gains so far this year. The dominant narrative on the street has notably pivoted in the last few weeks from fears of an imminent recession to cautious optimism that an economic contraction can be averted. The strength of the jobs market and acceleration in GDP growth last quarter to 2.4% underscores this underlying resilience.
Inflation also continues to soften, which is critically important for setting expectations for interest rates. The July CPI report (which showed the headline rate down to 3.2%) shows continued progress by the Fed to bring inflation in check. While this was a slight uptick from the June reading of 3.0%, the core rate, which is a better indicator of future inflation, ticked down to 4.7%. As we mentioned before, the headline figure has largely been driven this year by commodities normalizing, while the core rate, which strips those out, has been more elevated. So to see other categories such as used car prices, medical care, and airline fares drop in July is an important marker that the Fed’s program is working.
As a result, markets are now expecting the Fed to stop their hiking cycle, or at most do one more minor hike. The prospect of flat or lower interest rates in the future is being welcomed by the market as it eases the path for further multiple expansion. Corporate earnings, the other primary driver of multiples, are also improving as shown by more than 80% of companies in the S&P 500 beating their earnings estimates in the 2nd quarter. The flipside to this is that analysts have been revising their estimates lower for much of the last year, so the bar was quite low this quarter. Earnings are still down year over year. Nevertheless, with negative revisions bottoming, the stage is setting for corporate earnings to start rising again if the economic strength holds.
While we like to see good news, there are still some risk factors to watch out for as we head into year-end. First, much is riding right now on the expectation that the Fed stops hiking. To the extent the improvements on inflation flatline, then a narrative of inflation “stickiness” could ultimately take hold, which causes the Fed to pivot once again to hiking. While unlikely, it remains a possibility especially given the strength of the jobs market, which is still adding nearly 200k jobs a month at a near record low unemployment rate. Second, while many Wall Street economists are now in the “soft landing” camp, there are some suggesting the improved inflation outlook is masking a weakening consumer that is starting to pare back more on spending and increasingly rely on debt. Considering that consumer spending accounts for over 70% of GDP, this warrants close monitoring in the coming months.
Perhaps for these reasons, stocks have not been reacting as much as normal to earnings beats. The average rise on a beat was about half the typical move this quarter, indicating much of this was already priced in. Mega-cap tech stocks, which have driven most of the gains year to date, have also stalled in recent weeks, as earnings beat but their stocks nonetheless faded in the following days. While this profit-taking could be seen as evidence that the near-term outlook is fading, it could also reasonably be a natural breather after having such a strong rally. This latter interpretation is supported by the fact that market breadth, or the number of stocks that are advancing, is also increasing. To see money rotating out of the tech stocks into everything else suggests some view this rally as both building and spreading out to more sectors.
There’s no question the economy has outperformed expectations this year, and the market has responded with a definitive rally. Nevertheless, markets are not out of the woods by any means and the pressure will be on earnings growth and continued economic strength to drive further gains from here. We will continue to monitor these developments and remain vigilant for opportunities to add value in portfolios.