The financial markets have continued their upswing in the last quarter, with equity markets now up double digits this year and more than +20% from their low. This has led many to conclude that the bear market is officially over. While the resolution of several headwinds cleared the way for this rally, fundamentals in the form of growth and earnings will need to continue improving to drive further gains.
The markets faced three significant risks in the first half of the year that have now mostly been resolved. First, fears of a banking sector crisis caused a sharp market selloff, but swift action of regulators staved off a broader contagion from developing. Second, the debt ceiling loomed large with a high-stakes game of political brinksmanship risking a government default. However, negotiators successfully reached a deal in time to avoid a crisis. Lastly, fears of a recession due to higher interest rates have weighed on sentiment, but a moderation of inflation in recent months has allowed the Federal Reserve to significantly slow their rate hikes. Collectively, these developments removed a cloud of uncertainty hanging over the market and compelled buyers that were sidelined to jump into the market.
Fundamentally, the economy has continued to grow as well. GDP growth has slowed to a 2.0% annualized rate, but is still positive despite longstanding fears of recession. Likewise, the job market remains resilient, with the economy adding over 200,000 jobs in June and the unemployment rate still at a low 3.6%. This can be considered a “goldilocks” zone of healthy job growth but without so much wage pressure that it creates runaway inflation. These figures are broadly consistent with a healthier growth profile than we had previously coming out the pandemic, where the economy was essentially bursting at the seams.
This moderation has likewise brought inflation down to just 3-4% annualized, less than half the rate of a year ago. In turn, this has created headroom for the Fed to slow the pace of rate hikes as well as to signal their anticipated end to the hiking cycle. This clarity has been warmly welcomed by the market given how important interest rates are to pricing all financial assets. It’s also given renewed life to the possibility of a “soft landing” for the economy, where the typical recession is averted. While the market has not written off the possibility of a recession, it certainly believes that it will be a very mild one if it occurs.
As we enter the 3rd quarter, the market will grapple with a new set of uncertainties, although now more defined by a game of expectations than anything else. For one, while inflation is declining, much of this has been due to the normalization of commodity and food prices that were driven up in the pandemic period. So called “core” inflation rates, which are driven more by wages than typical supply and demand, are not coming down as quickly as the Fed would like. For this reason, they are leaving the door open to more rate hikes than currently signaled, which would likely catch the market off-guard.
Secondly, earnings will need to improve after a lackluster period that has seen nominal profits decline on a year-over-year basis due to slowing growth and margin compression. Markets have largely looked through this due to improved macro factors, but bottom-line figures will need to confirm the worst is behind us. Some supporting factors for this are that analyst revisions have essentially bottomed out, which tends to suggest the bar is quite low for the upcoming earnings season. Margins should also get some help due to the improving cost environment.
Lastly, market gains year to date have been extraordinarily concentrated, with roughly 90% of the S&P 500’s return coming from just 10 stocks. Besides macro factors, these mostly large-cap technology names have benefited from an anticipated “AI boom” that boosted expectations they can grow profits as companies adopt these new technologies. Time will tell if this hype is warranted, but something we will be critically watching for coming out of the next earnings season is whether the rally can extend its breadth to more sectors and stocks than just a few key names. The more stocks that take out their 52-week highs, the more firmly planted the rally will be.
We will continue to monitor these changing factors and remain vigilant for opportunities to add value in portfolios. We welcome your questions or comments and wish you and your families well. Thank you for watching.