August 4, 2022
Dear Clients & Friends,
The last week of July was epic for market-followers. A Federal Reserve rate hike, a much-anticipated gross domestic product (GDP) report, and the busiest week of earnings season got most of the headlines. There was even a surprise out of Washington D.C., with a Schumer-Manchin agreement on a climate-healthcare-tax bill and some inflation data that added to the evidence that inflation may have peaked.
The stock market expressed approval over these latest developments, posting two consecutive weeks of positive market advances. Which allowed the S&P 500 Index to enjoy its best month since November 2020 and its best July in over 80 years (finishing up 9.2% for the month). Last week’s gains were very encouraging for investors. For those of you keeping score, here are the monthly returns in the S&P 500 Index so far year: January -5.2%, February -3.0%, March +3.7, April -8.7%, May +0.2%, June -8.3%, and July +9.2%. It has been a very wild ride! As I've mentioned before, in order for the market to resume its permanent upward advance we need to see inflation brought under control.
Now let's look at each piece of news last week individually. First, the Fed hinted at slowing the pace of interest rate hikes later this year. Whether markets may have gotten a little ahead of themselves remains to be seen, but in the past six weeks, nearly three-quarters of a percent has come out of the market’s expectation for the peak fed funds rate (the short-term rate controlled by the Fed to affect monetary policy). The inflation battle is far from over, but the market’s reaction was encouraging, and the Fed may be poised to surprise the market with a pause by year-end.
Next, the first read on second quarter GDP revealed the U.S. economy contracted for the second straight quarter. The rule of thumb is two quarters of negative GDP defines a recession, but the National Bureau of Economic Research (NBER) uses a much broader definition to officially declare a recession. With a strong (albeit slowing) job market and resilient consumer spending, it is reasonable to conclude that enough sectors of the economy are contracting to qualify as an official recession. If a recession does come—probably a 50-50 proposition for the first half of 2023—it will likely be mild. A mild recession was probably already priced in at the June stock market lows, suggesting June 16 may (emphasis added) mark the S&P 500’s ultimate low this cycle.
Capping off the busy week, the flurry of earnings reports demonstrated that corporate America has managed stiff headwinds effectively. Given the slowing economy, intense cost pressures, and a strong U.S. dollar clipping foreign-sourced profits, a 6% year-over-year increase in S&P 500 earnings per share during the second quarter is quite impressive. Estimates for the second half of 2022 and 2023 have come down as expected, but with expectations so low, stocks generally rallied on results even as estimate were cut.
Looking ahead, August has historically been a weaker month for stocks. But consider that midterm election year lows, which typically come around this time on the calendar for the S&P 500, have historically been followed by an average gain of over 30% over the subsequent 12 months. Moreover, some of the timeliest indicators of inflation, such as commodity prices and various consumer and business surveys, indicate some cooling ahead, even if it may be a slow process. Market-based interest rates—those not controlled by the Fed—have come down quite a bit, supporting stock valuations.
At the same time, geopolitical tensions are rising as House Speaker Nancy Pelosi visits Taiwan and the war in Ukraine continues. But it is reasonable to believe with the combination of low valuations, lower interest rates, prospects for inflation reducing, and the possibility that the Fed signals a pause over the upcoming months tip the scales toward the bulls. The ride probably won’t be smooth, but I'm optimistic that long-term investors who stay the course won’t have to wait too long to be rewarded for their patience.
As always, thank you for your continued trust. Please contact me if you have any questions—that’s exactly what I’m here for.
-Nick