The month of July was a turnaround of sorts, and very constructive from a technical and sentiment standpoint. After a brutal June, the market continued to advance off the June 16th cycle lows. For the month, the S&P 500, NASDAQ, S%P 500 and DOW gained 10%, 8% and 6% respectively. Yields fell and the bond index advanced 3.5%
All three major indexes (S&P 500, Dow Industrial and NASDAQ) overtook their respective 50-day moving average (MA) – a short term trend line – suggesting higher prices ahead. The 50-day MA also stopped its downward slope and is starting to level out. Expectations for both the Fed’s interest rate normalization and Inflation peaking has also helped the market stabilize.
WHATS DRIVING THE MARKET – Closer to the End
The news flow was heavy in July with 2Q earnings, June inflation readings, a Fed meeting, and 2Q GDP, all of which were market moving events.
It was widely expected that corporate earnings would be revised down, reflecting the slower growth and higher inflationary environment. The strong dollar is also a headwind for multi-national corporations. However, the result is that earnings held up much better than expected, albeit with a few exceptions. Most notably, Walmart had a big earnings miss as a shift in consumer spending from discretionary items and other goods (foodstuff and gas) resulted in lopsided inventory that will take a bite into their margins. Walmart, being the nation’s largest grocer, is a good indicator of the challenges the consumer is facing. AT&T missed the mark too, noting that they saw a significant uptick in delinquent cell phone bills. That the consumer is choosing to delay payment on what is arguably an essential device is telling. Snapchat also had a big miss, noting that advertising spend has declined meaningfully.
On the other end, credit card processers AmEx and Visa hit their marks as more consumers are utilizing their available credit and are charging more, both on travel, vacation and essentials. Once again, this data points to the challenges that the consumer is facing after a brutal year of rampant inflation. We believe this is just the beginning. Big tech (Microsoft, Amazon, Google, Apple) reported lower revenue and margins, but not as bad as the market expected. Enterprise (business) spend is not deteriorating as fast as consumer discretionary spending.
Inflation readings for June rose to their highest level in decades, printing a 9.1% year-over-year rise in prices, higher than the prior month. Immediately after, the market began pricing in a 1% rate hike at the Fed’s July meeting, which spooked the market over concern that the Fed would have to be more aggressive in cooling down the economy. However, the June reading did not fully reflect the recent declines in gasoline and other commodities, so there is a possibility that we’re past “peak” inflation. This would be a welcome reprieve that would indicate the Fed’s actions are helping prices stabilize.
As widely expected, the Fed increased the Fed funds rate an additional .75% in July, demonstrating their commitment to reduce demand and further cool the economy and abate the forces of inflation. The market rallied hard after this announcement since the Fed will be taking pause until their next meeting in September. At which point they will provide two more data points on inflation, housing/energy/food prices, consumer spending and job and wage growth, which can change dramatically over the two months. The logic is that if inflation and spending cool down meaningfully over the next two months, the Fed may be able to take its foot off the gas and not be as aggressive as the market had been pricing. Expectations are a strong driver of near-term market direction, and the expectations of a less aggressive Fed have helped the market continue its ascent considering the challenges that are still working their way through the global economies. Rising rates take approximately six months to have meaningful impact on the economy, and the ongoing effects of the Fed’s interest rate policy as still yet to be fully felt. We suspect that conditions will become even tighter in the months ahead, in which case the market may have gotten a little ahead of itself.
Second quarter GDP showed a .9% contraction on top of a 1Q negative GDP. This is one definition of a recession – two consecutive quarters of negative growth. However, no formal declaration of recession has been made. Other economic conditions that are typical during a recession are just not present, notably rising unemployment and declining wage growth. This is the big data point that in our opinion is propping up the overall economy – unemployment is simply too low, and jobs too plentiful for a truly adverse impact to economic activity. So as long as the populous is widely employed and earning a “decent” wage, demand can only slow down so much. Add in a softening of inflationary forces, and discretionary spending can pick back up. At the end of the day, all these economic readings are important, but if inflation does not decline meaningfully in the months ahead, then the Fed will likely have no choice to keep raising rates, which increases the chance of their making a policy error and tipping the economy into a more severe downturn. Our base case is that a recession looks likely, but it will be shallow.
PORTFOLIO ADJUSTMENTS
By design, our process is objective and simply observes price. This, in turn, eliminates making investment decisions based on news flow, or gut intuition. Earnings expectations were so negative and many market participants were expecting the Fed to be uber aggressive and inflation was not going to come down fast enough. Bad news became good news last month, as signs of a slowdown implied that the Fed is closer to the end of its rate hike cycle than the start, and corporations were given a pass on earnings results that were less bad than feared. As such, the market was able to shake off the concerning economic data and look further ahead into the future when economic headwinds would be less harmful. While it felt good at times, and uncomfortable at times to have such a large cash position, we simply cannot sit around waiting for the next proverbial shoe to drop. We incrementally moved cash back into the stock market, raising our position in S&P 500 equal weight by a few percentage points, and also adding 10-15% back in RPV, our pure value fund. These trades reduced our cash position down to the 30% range, from the mid 40’s a month ago.
We’ll take the gains that the market has provided, but remain vigilant and cautious. There is still significant risk out there, and a long way from inflation getting back to the Fed’s 2%+ target.
LOOKING AHEAD
While we are in no way out of the woods yet, the fact that the market has stabilized considering the many signs of a growth slowdown is encouraging. The market feels like it is getting used to a growth slow down, and has been able to shrug off economic data points that would normally crush the market. If the next two months signal that inflation has rolled over significantly, and continue to trend down for several months, then the Fed may very well get confirmation that their rate hikes have begun to have the intended effects and may feel appropriate to take pause, or at least reduce the pace of, rate increases. However, the longer it takes for inflation to come down meaningfully, as it probably will, the more likely that we see additional signs of recession, such as layoffs and delinquencies.
The consumer is still hanging in there, but signs of stress are starting to emerge. The duration of this low growth/high-rate cycle is most critical to us. The longer it takes to get inflation down meaningfully, the more the consumer will continue to struggle, as their elevated savings coming into the year begin to dwindle. This scenario will likely require more consumers to cut even more discretionary spending to just be able to get by with the basics. Credit card utilization, particularly in a rising rate environment, could hurt the consumers balance sheet for years to come as they pay down higher debts incurred by a sustained economic slump. This, in turn, could dampen consumer activity for years to come. But as the Fed’s rate increases continue to work its way through the economy, supply chains continue to regain their balance, China reduces the frequency of its lock downs, and some signs of peace in Ukraine, inflation should naturally come back down to more favorable levels. This scenario has us optimistic that the economy can get back to a more productive state, and growth should then resume, leading to higher asset prices.
We continue to monitor the environment daily, and as the price stream continues to adjust (either up or down), the amount of risk we re-introduce or remove from your portfolios will adjust accordingly.
As earnings season winds down, and no Fed meetings until September, we think the market should remain in a state of relative calm, which can also soothe sentiment and improve expectations. There are likely to be ongoing speedbumps, but we feel that the worst price declines are probably be behind us and we’ll unlikely see the huge price swings that we saw in the first half of the year.
We hope you take full advantage of the dog days of summer that is August, and you find peace and meaning in the beauty of sunny days, walks with friends, and meals with loved ones.
