Monthly Market Update- August 2022August 01, 2022
July marked the best month for the market since late 2020, and the best July for stocks since 1939…Is this positivity here to stay? That will depend on lingering inflation concerns, job market weakness, looming Fed rate hikes and more. Here’s what to expect in August.
It was time to buy in July despite signs of a technical recession. Was it a premature pivot? Markets and the real economy diverged as asset prices climbed higher and global output contracted.
It was the best month since late 2020 and the best July since 1939 for stocks, concluding with possibly the most important week for investors in recent memory. Equity markets seemed to celebrate the Federal Reserve’s willingness to pursue inflation-busting monetary tightening, pricing in a 75 basis-point (.75%) rate hike and continuing the rally in stocks after the confirmed announcement.
The strong performance and Fed decision held despite reports of negative GDP (gross domestic product) growth (-.9% for the 2nd quarter) which is atypical for monetary policy. In his press conference, Fed Chairman Jerome Powell hinted that the rate of inflation is finally slowing down and that rate hikes could be over by the end of the year. The S&P 500 is now up over 12 percent, the Nasdaq is up 16% and the Dow Jones Industrial Average has increased almost 10% since the US stock indexes’ mid-June low marks¹.
Another bifurcation could be seen in growth stocks with quality taking over as the dominant theme across asset classes. Mega-cap technology companies with unique competitive advantages such as Microsoft, Apple, and Alphabet reported earnings that showed resilience in cloud computing, demand for semiconductors and smart phones/gadgets, as well as better than expected forward guidance for supply chains.
Meanwhile, profit challenged technology firms in social media, and communication services saw a strong slump in prices and collapsed further. Retail giant and consumer staple bellwether, Walmart, along with electronics retailer, Best Buy, reported ominous guidance lowering expectations for profit margins as higher input costs ate away at demand and earnings. Almost 75% of S&P 500 companies that have posted second quarter earnings results so far have beaten expectations².
Was July’s performance irrational exuberance or a bear market rally based on hope for a best-case scenario “soft landing?”
The Fed announcement last week coincided with reports of another quarter of contraction in economic activity in the US and other developed economies. Federal Reserve Bank of Minneapolis President Neel Kashkari warned that investors might be getting ahead of themselves in anticipation of a central bank pivot away from tightening. He noted that the Fed is still a long way away from getting inflation back to its 2% target.
Chairman Powell spoke of interest rates that are now neutral, but many doubt this assessment and fear that wages are chasing higher prices, thus reinforcing each other. Powell’s statements sounded dovish, which would not make much sense given the recently measured 9% year-over-year headline inflation.
As anticipated, the yield curve substantially inverted and appears to be staying that way as the benchmark 10-year note’s yield collapsed from nearly 3.5% to around 2.65%¹. With shorter term yields near 3% and a fed funds rate that now ranges from 2.25% to 2.5%, the bond market clearly expects not just slower growth, but eventually a more accommodative central bank policy as well. The process of Fed bond balance sheet unwinding (quantitative tightening) is just now taking greater effect and will be a must-watch counterforce to bond buyers. Bond market liquidity could become thin with volatility and a flight to quality.
Cracks are starting to show in the domestic economy’s strength, yet there is a paradox in the macroeconomic data.
GDP has now materially weakened two quarters in a row, technically defining a recession, but the labor market is as strong as ever. Typically, these two measures of economic health go hand in hand supporting a narrative of expansion or contraction, but in this rare case they are in stark contrast to one another.
Over 11 million unfilled job openings remain and record low unemployment permeates. There are pockets of layoffs in certain sectors and jobless claims are ticking higher³, so we will continue to monitor for any softness in the labor market. Job market weakness would potentially be a strong catalyst for cooling inflation.
Retail sales down since 2021
Digging deeper, the latest data showed consumers finally have had enough with ongoing price increases as retails sales adjusted for inflation have substantially fallen since 2021. The share of overall spending has switched from discretionary goods to essentials and services. Inventories are building and manufacturing prices are coming down quite a bit. Confidence and sentiment remain depressed, but there is hope that inflation has finally truly peaked. Softer housing data, lower raw materials prices, and demand for oil seem to support this.
It is deal time in DC.
Last week, West Virginia Senator Joe Manchin reached an unexpected deal with Senate Majority Leader Chuck Schumer on some of the most pressing issues including energy, emissions, corporate taxes, and healthcare costs.
The estimated $740 billion in new revenue would come from a minimum corporate tax, IRS enforcement, and Medicare drug savings. Roughly half of those funds would go to programs focused on green energy, the changing climate, and tax credits for buying electric vehicles. The rest would go to healthcare subsidies and reducing the deficit.
The quiet negotiation came just hours after a $280 billion legislative package passed the Senate to boost U.S. semiconductor technology and manufacturing amid fresh threats from China on Taiwan, a chip making hub of the world. The energy deal will still face stiff competition in the Senate.
The transition to renewable energy is proving to be a bumpy one as supply remains limited and the war in Ukraine shows no signs of abating. The actions of the Fed and the high gas prices at the pump have clearly done its job in reducing oil demand as we are seeing prices fall back below $4 a gallon in many parts of the country. Weaker demand from China also contributed to lower oil prices. Natural gas used for heating homes is still at record levels though due to Russian pipeline actions and limited supply.
Internationally, market performance was much more mixed.
Europe continues to face recessionary headwinds with rampant inflation, energy boycotts, and labor concerns. Emerging Markets and Asia have had mixed results with stronger commodity prices, but weaker currencies against the US dollar. China’s manufacturing activity unexpectedly weakened, with Covid restrictions and higher raw material prices eating into margins. China’s home sales fell sharply as a result of mortgage payment boycotts among other factors in July as well¹. Geopolitical risks are still quite elevated with China’s government issuing a bellicose warning to the United States over House Speaker Nancy Pelosi’s planned trip to Taiwan, a country that Beijing claims as their own.
While we share some cautiously optimistic views with the Federal Reserve, we remain defensive in quality exposures across our asset allocation as we have for most of the year.
Despite the recent tech rally, fundamentals are deteriorating, and profit margins are being tested. We are not convinced that volatility is over and we are back to a goldilocks scenario. While we are stringent in our portfolio fundamentals, we have slightly expanded our equity exposure globally to take advantage of depressed prices and diversification, yet still very much overweight US equities.
In maintaining a barbell strategy for bonds, we target intermediate duration and interest rate exposure in line with business cycle expectations. Commodities and liquid alternatives in our portfolios offer less correlation to stocks and bonds and provide some inflation protection. We continue to focus on utilizing the volatility in prices to re-balance our portfolios, deploy cash, and look for opportunities to minimize tax burden. Risks remain, but so do opportunities in these markets.
Looking forward, in the coming weeks we will be watching out for more Fed commentary, readings on over a third of the S&P 500 component companies’ earnings reports for the second quarter, as well as very important inflation and jobs numbers for July. The weather and the inflation prints have been scorching hot. As we enter the dog days of summer, we will look forward to more comfortable days ahead and monitor markets for more stable growth. We are prepared to weather anything that comes our way.
Enjoy your August!
²The Wall Street Journal
³U.S. Bureau of Labor Statistics
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