07/25/2022
Stocks closed last week higher for the second time in three weeks. The S&P 500 Index jumped +2.6%, while the NASDAQ Composite finished the week higher by +3.3%. Despite risk-off trading on Friday, the S&P 500 ended the week back above its 50-day moving average. Not since April has the Index been able to trade above its short-term trading trend. In addition, the Dow Jones Industrials Average finished up nearly +2.0%.
 
On the week, Growth outperformed Value. Consumer Discretionary (+6.8%) led the S&P 500 higher, supported by large gains in Tesla and Amazon. Technology (+3.6%) also popped higher last week, driven by strength across semiconductor stocks. Notably, Energy (+3.5%) was able to buck the trend lower in crude prices, as oil services stocks put in a solid week of performance. WTI oil finished last week at $94.62 per barrel, and Gold closed at $1722.70 per ounce.
 
One of the more significant macroeconomic factors helping to drive U.S. stock prices higher is the continued pullback in the U.S. dollar and falling U.S. Treasury yields. The greenback has declined roughly 2.0% from its mid-July high, helping to take some pressure off tightening financial conditions and ease fears of lower multinational profits due to currency headwinds. Similarly, the 10-year U.S. Treasury yield closed last week at 2.79%, well below its 3.48% peak in mid-July. And despite the recessionary warnings that an inverted 2Y/10Y Treasury spread continues to flash, investors have welcomed falling yields with higher stock prices this month.
 
That said, the 3M/10Y Treasury spread continues to narrow aggressively, which is a more ominous sign for the bulls hoping the U.S. economy can avoid a recession. Unfortunately, the spread between the 3-month Treasury yield and the 10-year Treasury yield has narrowed by nearly 190 basis points since early May. Given that the 10-year currently outyields the 3-month by just 41 basis points (which is the spread the Federal Reserve pays outsized attention to), recession warnings are likely to grow louder, particularly if it continues to head toward inversion.
 
But despite increasing recession warnings in the bond market, the S&P 500 is higher by +4.7% month-to-date, while the NASDAQ is up +7.3% month-to-date. The question on our minds? Can the stock market continue to look past the building probability of a shallow recession and focus instead on the eventual recovery? Notably, bear market rallies and bear market troughs look very similar in the heat of the moment. In our view, it’s too soon to tell if investors are beginning to look through all the bad news (a positive sign for longer-term investors) or just taking advantage of a typical bear market rally that may eventually fade. This week could bring a critical test for the market, given the barrage of Q2 earnings reports, Wednesday’s Federal Reserve policy decision, and Thursday’s first look at Q2 GDP.
 
Lukewarm market reaction to housing data, overseas news
 
Other items of note last week centered on a batch of disappointing housing data, including June's existing home sales coming in at their slowest pace since June 2020 and July's National Association of Home Builders sentiment posting its second-largest drop on record. Also, weekly initial jobless claims hit their highest levels since November 2021. And helping round out U.S. data updates last week, the July flash Markit Purchasing Managers’ Index (PMI) for manufacturing and services declined to mid-2020 levels.
 
Overseas, the European Central Bank (ECB) lifted its target rate by 50 basis points, the first rate increase since 2011. With the 50 basis point move, the ECB brings its target rate out of negative territory for the first time since 2014, when the central bank was fighting a sovereign debt crisis. The central bank also announced a new bond-buying tool called the Transmission Protection Instrument (TPI). The device is designed to help heavily indebted nations cope with higher borrowing costs due to the ECB's need to lift rates to fight inflation. However, a lack of detail on how TPI would be triggered resulted in a lukewarm response from the market last week.
 
And in Italy, Italian Prime Minister Mario Draghi resigned after losing support from the Five Star Movement and other supporting parties in his coalition government. Given the collapse in Italy’s government, a general election is expected to be held in September or October, with Mr. Draghi remaining in his position as a caretaker until the general election.
 
Investors’ eyes are on the Fed this week
 
Looking ahead, this week could play a critical role in helping shape whether stock prices can continue on the road to recovery after an abysmal first half of performance.
 
On Wednesday, the Federal Reserve is widely expected to lift its fed funds target rate by 75 basis points after investors backed off expectations for a 100 basis point move following the +9.1% year-over-year headline Consumer Price Index (CPI) print for June. The market will likely parse the policy statement this week for clues on how the committee interprets slowing growth trends and record-high inflation. Importantly, investors will pay particularly close attention to what Fed Chair Jerome Powell says in the press conference following the policy decision. We expect Mr. Powell to reinforce the Fed’s commitment to returning price stability to the economy and willingness to lift rates further to bring down inflation pressures and cool demand. Bottom line: We believe the market is looking for clues on if the Fed believes the U.S. economy has slowed down enough to warrant a smaller rate hike in September. If investors believe a 50 basis point hike is likely at the next meeting, we believe stocks may look past this week’s decision and continue to grind higher on the narrative that the Fed is through the most aggressive part of its hiking cycle.
 
On Thursday, the Bureau of Economic Analysis will release its preliminary estimate for second quarter U.S. GDP. The Atlanta Federal Reserve’s GDPNow tracker forecasts economic growth contracted by 1.6% in the second quarter and after the economy also shrank by 1.6% in the first quarter. We believe few investors would be surprised if U.S. GDP posted its second consecutive quarter of negative growth, as stock prices likely reflect a shallow recession at this point. Though the National Bureau of Economic Research (NBER) is the official arbiter of calling a recession, two consecutive quarters of negative GDP growth would likely be enough for most to assume the U.S. economy is in a recession. But the rearview data is unimportant to directing stock traffic moving forward, other than to drive news headlines following its release. Bottom line: Growth in the economy has meaningfully slowed (most know this), and we believe stock prices have already absorbed much of the pain. We believe the critical items to watch are the path forward for inflation and Fed policy. Slowing inflation in Q3 and a less aggressive Fed could help return the economy to a growth trajectory in the second half. Easing supply chain pressures, a still resilient consumer, and a tight labor market are positive factors that could eventually allow stock prices to look past the Q2 print and focus on better days ahead. That said, we don’t expect markets to cheer a weak or negative Q2 GDP print this week.
 
Q2 earnings results better than investors feared, so far
 
Lastly, 175 S&P 500 companies, including in big tech, report Q2 earnings results this week. As of Friday, the blended earnings per share (EPS) growth rate for S&P 500 companies stood at +4.8% year-over-year on sales growth of +10.9%. While that’s the slowest pace of profit growth since Q4 2020, earnings reports and outlooks have been coming in better than feared. On the surface, that’s been enough to add a tailwind to stock prices since the season began, given investors were bracing for worst-case scenarios. However, thus far, S&P 500 company guidance for Q3 profits has been overwhelmingly negative. Yet, themes of a still resilient consumer, easing supply chain pressures, and companies holding margins have helped counter more negative trends in results/outlooks.                        
 
As the books close for July, the bulls can point to the peak inflation narrative gaining some steam, peak Federal Reserve hawkishness, consumer resilience given recent earnings reports, profit estimates coming down, a pullback in the U.S. dollar, and falling commodity prices. On the other hand, the bears can counter with inflation pressures that are broadening across the economy, elevated recession odds, continued moderation in economic activity, slowing housing trends, and a lack of capitulation among investors. In either case, the path forward in our book is to maintain discipline, expect more volatility, and continue to use strategies that mitigate risk, so your portfolio is prepared for the eventual turn.
 
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