Stick the Landing
Defying most expectations, the stock market has moved higher this year, even as inflation remains elevated, and the Fed pursues its most aggressive rate-hiking campaign in four decades. Hope for an economic soft landing has emerged among investors, leading many to anticipate better days ahead. In hindsight, we can observe that stocks actually put in a bottom last October — perhaps not coincidentally, the same day the closely-watched Core CPI rate (excludes food & energy) reached its high-water mark.
Historically, the central bank’s track record of slowing an overheated economy without actually engineering a recession has been abysmal. The “long and variable lags” inherent in monetary policy hamper officials’ ability to accurately gauge the impact of their actions. Sixteen months have passed since the tightening spree began. Inflation seems to have peaked and yet, while slowing, the U.S. economy still appears fairly resilient.
Walls of worry
At the beginning of 2023, Wall Street strategists held an uncharacteristically gloomy view for stocks. This inherently optimistic group predicted that the S&P 500 Index would decline this year, their first negative outlook since Bloomberg began publishing the survey in 1999.
Investors themselves have been wary, with many seeking alternatives to stocks. According to Morningstar, U.S. stock funds experienced net outflows of $65 billion through May, while bond funds saw inflows of over $100 billion. Money market funds attracted $400 billion due to their enticing yields and perceived safety.
Sentiment has meaningfully improved over the last few months as the market rally gained traction. Nonetheless, a June survey by Bank of America indicated that global fund managers still remain significantly underweight stocks and overweight bonds compared to their typical positioning. Many investors still seem to be looking over their shoulders.
The technology space has been the one area where the mood has been effusive. It has also been the main driver of the market’s overall performance this year. Indeed, seven large technology-related companies accounted for 80% of the S&P 500 Index’s first half gains. Market breadth — individual stocks’ participation in the rally — has been extraordinarily narrow. Eight of eleven industry sectors were either down or up only marginally over the period.
Some of the impetus for surging tech shares relates to buzz around an emerging and potentially disruptive technology known as Generative AI. OpenAI’s release of ChatGPT — a tool that creates content from natural language prompts — has piqued the public’s interest in the field. And some students have discovered this ‘chatbot’ will write term papers.
Generative AI is a branch of artificial intelligence that creates models like ChatGPT that can generate new and original data and content by learning from existing data. This technology can improve decision-making by analyzing vast amounts of information and providing insights. Its versatile nature opens up a wide range of potential applications across industries and firms. For instance, AI models could be built to facilitate software coding and drug development; they could produce images, music, and written content for the entertainment industry.
Regarding inflation – after soaring last year at the highest rate in more than a generation, price increases are moving back towards more normal levels. Financial markets celebrated the news that consumer price inflation had eased to 3% in June (year-over-year), the slowest pace in more than two years. Since peaking at a 9.1% rate, the overall CPI has decelerated for 12 straight months. The Core rate has also steadily trended lower but has proven stickier (increasing 4.8% in June).
Housing costs continue to be the main driver of inflation. Rising rents and other shelter costs accounted for over two-thirds of core inflation in June. However, asking rents, as reported by private sources such as Zillow, have been growing fairly slowly in recent months. Official measures of shelter inflation should begin to reflect this trend. A number of other leading indicators of inflation also point to further normalization.
Higher for longer
Federal Reserve Chair Powell recently expressed the view that core inflation would not return to the Fed’s 2% target until 2025. In any event, after ten rate hikes and five percentage points of tightening, the bank has signaled that it will pause soon to allow policy to run its course. The bond market anticipates one more hike this month followed by a shift to a lower rate regime beginning in early 2024.
Nevertheless, Fed policy still represents the biggest risk to the economy and financial markets. Taking one’s foot off the brake is not the same as depressing the accelerator. Will Powell & company correctly anticipate the business cycle, easing monetary policy with sufficient lead time to avoid recession? As stated earlier, history suggests this is a difficult challenge.
As goes the consumer
The ability of stocks to squeeze out further gains will depend on whether inflation can continue to fall amid a still-resilient economy. The American consumer will be the firewall between continued growth and recession, and key to the soft-landing narrative.
Buoyed by a tight labor market, consumer spending has expanded at a solid pace, much of it directed lately to services and experiences as opposed to goods. Businesses have added an average of 275,000 jobs a month in 2023 and, while dropping, job openings remain plentiful compared to the number of unemployed workers. Critically, wage growth has exceeded inflation for four consecutive months, boosting spending power.
But could these tailwinds fade? Recent small business surveys suggest slower hiring ahead. And firms have been cutting worker hours — the length of the average workweek has dropped below pre-pandemic levels. And in June, the number of individuals who worked part-time despite wanting a full-time position increased by 450,000, the biggest jump in three years.
Meanwhile, consumers have burned through a sizable portion of the excess savings accumulated during the pandemic. Lower-income households, in particular, have less cushion today to prop up their outlays. With the moratorium on student loan repayments ending soon, Moody’s forecasts a $5.5 billion monthly hit to consumer spending.
Living up to expectations
Although not obvious from the market’s performance this year, corporate America has been experiencing an earnings recession. Revenue growth has slipped, pricing power has ebbed, and some cost pressures have persisted. Analysts expect the S&P 500 to report a third straight decline in profits with the release of second quarter results this month.
Despite this weakness, the outlook for earnings has actually been improving for much of the year. With economic activity still fairly firm, corporate profits have not turned out as negative as presumed. Wall Street expects the second quarter to mark the low point of the earnings cycle, penciling in a resumption of growth later this year.
In June, the shares of 417 constituents of the S&P 500 closed the month higher, indicating a significant reversal of the narrow market breadth witnessed for most of 2023. Broader participation is a healthy sign and will be crucial for sustaining the uptrend. However, valuations have expanded as investors look beyond the current earnings contraction and anticipate a growing economy with less inflation. While the news on those fronts has been largely positive, there is little room for disappointment in stock prices today.
— Christopher J. Singleton, CFA, Managing Director
July 19, 2023