July 2022 | Equity Commentary
Published on August 9th, 2022
U.S. and global stocks have rallied sharply off mid-June lows, with the S&P 500 index rising nearly 13% from the mid-June low through the end of July. Perhaps counterintuitively, stocks may have staged this rally in response to weakening global economic data. In our view, market participants are wagering that slowing economic growth—which contributes to falling commodity prices and reduced inflationary pressures—will prompt the Federal Reserve to moderate its pace of monetary tightening. The bond market also seemed to confirm a slowing economic growth outlook, as the 10-year U.S. Treasury bond yield fell from a June 14 high of 3.47% to 2.65% by the end of July.1
As expected, the Federal Reserve raised the fed funds rate by 75 basis points at the July 26-27 meeting, marking the fourth rate increase in 2022. In comments delivered after the announcement, Federal Reserve Chairman Jerome Powell acknowledged the US economy was slowing, particularly as consumers are facing challenges from higher food and energy prices. These comments combined with weakening economic data had bond and futures markets betting the Federal Reserve would raise rates through the end of 2022 only to lower them in early 2023. As of early August, the Fed Funds futures market indicates that investors believed the Fed Funds rate will plateau at 3.44% in February and March, with rate cuts commencing in May 2023, bringing the fed funds rate down to 2.9% by December 2023.2
We think these market-based views of future interest rate policy may be too optimistic, as they assume the Federal Reserve is making policy decisions based on economic growth data alone. Bond traders appear to have grown accustomed to 40-plus years of monetary easing from the Federal Reserve any time the economy shows signs of weakening, an assumption we think fails to acknowledge the central role inflation is playing in policy-making decisions today. While there are signs inflation pressures may be easing, particularly with falling commodity prices over the past month, it is hard to imagine that inflation will be low enough next spring for the Federal Reserve to feel comfortable cutting rates.
However, the US dollar has been very strong year to date, and the Federal Reserve is in the early stages of its quantitative tightening program (the flip side of quantitative easing when it was buying bonds to hold on its balance sheet). These two factors are believed to effectively add to the monetary tightening already brought about by the Federal Reserve’s rate hikes, so it is possible the Federal Reserve may not need to hike as much going forward as some investors with more hawkish views may believe.
While the inflation picture remains uncertain, the case for an economic slowdown in the US and abroad is growing. July factory activity in the US saw its weakest growth in two years, with the Institute for Supply Management’s index of manufacturing activity declining to 52.8 from 53 in June. New orders fell for the second straight month as many businesses worried about softening demand, seeing inventories build back up in the supply chain. On the positive side, production and the backlog of orders grew in July, and an index of prices paid fell sharply from 78.5 in June to 60 in July. The ISM attributed this sharp decline to the impact of falling commodity prices.3
The US housing market appears to be showing more signs of cooling off. Construction spending on single-family homes fell by 3.1% in June, the largest percentage since early in the pandemic. The Commerce Department also reported that new home sales in June fell to their lowest level since the early days of the pandemic, which all suggests that rising mortgage rates and higher costs are pulling builders and buyers out of the market.4 Existing home sales fell for a fifth month in a row, to a two-year low.
Even as the broad economy weakens, the jobs market continues to power ahead. The US added 372,000 jobs in June, and the Labor Department reported that there are still a seasonally adjusted 10.7 million open jobs in the economy.5 Payroll growth in the US economy has continued to defy weakening output, with more jobs being secured in the first six months than any other post-WWII period when the economy was technically contracting. Services employment has particularly been in short supply—the Institute for Supply Management’s services survey showed an increase to 56.7 in July from 55.3 in June, with growth in new orders suggesting the shift of consumer spending to services has persisted this summer.6 The bottom line is that even as consumers pull back, companies are still appear to be struggling to hire enough workers to supply enough goods and services to meet demand.
With economic data mixed and output clearly slowing, the stock market nevertheless staged a sharp rally in July, which we think was driven by three factors. The first factor we cited above, a growing expectation the Fed might slow and possibly reverse course on rate increases over the next year or so. The second is that we believe the market was oversold in mid-June as indicated by a number of sentiment and technical measures. The percentage of stocks on the New York Stock Exchange trading above their 200-day moving average had fallen to a very low 15% by mid-June and usually registers as a contrarian indicator. Similarly, the American Association of Individual Investors (AAII) Sentiment Survey showed the number of bearish investors surging to 59.3% by June 22,7 a level of extreme bearishness that has tended historically to align with market bottoms. Wall Street sentiment as measured by a Bank of America reading of sell-side strategists also fell to a five year low in early July, which again has historically signaled a potential rally was in the offing.
Finally, there were S&P 500 earnings reports and outlooks, which to date have not been as negative as many investors may have feared given the market’s weakness in June leading into earnings season. Shortfalls in profit were generally not accompanied by shortfalls in sales, and banks largely reported strong loan and consumer credit activity. Major corporations are also reporting strong investment activity, with capital expenditures growing at a faster pace than stock buybacks for the first time since Q1 2021.
As of July 31st, 2022