The stock and bond markets rebounded nicely in July, unemployment dropped to a post-pandemic low of just 3.5%, manufacturing remained solid, and gas prices at the pump retreated – all favorable signs for the economy.
But for the Federal Reserve (Fed), which is pulling out all the stops to slow the economy in order to fight inflation, the continued strength of the economy has been a double-edged sword. The better the economy, the more difficult it becomes for the Fed to stem inflation.
The Fed hiked rates an additional 0.75% in July and has raised rates a total of 2.25% so far this year, while tightening the money supply. Its efforts have shown some signs of progress, with the economy posting its second straight quarter of negative growth. Gross domestic product (GDP) slipped 0.9% on an annualized basis in the 2nd quarter after dropping 1.6% in the 1st quarter.
While two straight quarters of negative GDP growth meets the traditional definition of a recession, the current state of the economy is much different than most past recessions because of the strong labor market, solid consumer and corporate balance sheets, decent wage growth, and continuing demand for goods that are in short supply.
On the other hand, the Fed’s actions have been effective in slowing the overheated housing market, curbing consumer spending, and driving up credit card balances by about 13% over the past year, according to the Federal Reserve of New York.
In addition, some companies have announced that employee lay-offs could be on the horizon, indicating some softening in the labor market.
The manufacturing sector recorded its 26th consecutive month of growth in July, although that growth has slowed, according to the Institute for Supply Management (ISM) August report. Eleven of 18 sectors tracked by ISM reported growth in manufacturing activity in July while seven reported a contraction in activity. The report also noted that new order rates have continued to slow, supply deliveries have improved, and prices of supplies, which had been inflated, have trended lower.
Outlook: As the Fed continues its efforts to tighten the money supply, that may lead to additional weaknesses across the economy. The Fed is expected to continue to raise rates over the next few months, which could trigger continued volatility in both the stock and bond markets.
The U.S. could see a continuing softening of the labor market, although with about 11 million current job openings, employment should remain stable for some time to come. A strong job market could keep consumer spending at a relatively healthy level in the near future. The banking system, which has been strong in recent months, could benefit from rising interest rates.
The housing market has already seen a drop-off in new mortgage applications and housing starts in recent months, which may continue in the months ahead.
Stock market valuations, which reached a relatively high level at the peak of the market, have fallen to a more reasonable level as stock prices have declined. Although valuations would not be considered excessive at this point, they could fall further before reaching historically low levels. While stocks regained some lost ground in July, uncertainty over inflation, interest rates, corporate profitability, and the economy could drive prices back down in the coming months. However, for long-term investors, falling stock prices could be seen as an opportunity to take advantage of lower prices.
Bond market investors may also sense an opportunity at current interest rate levels, with yields now in the 4% to 8% range, depending on quality and term to maturity.
U.S. stocks rebound
The S&P 500 Index surged 9.11% in July, from 3,785.38 at the end of June to 4,130.29 at the July close. The total return of the S&P 500, including dividends, was up 9.22% for the month. Year to date, the total return was a negative 12.58%. (The S&P 500 is a market-cap-weighted index that represents the average performance of a group of 500 large capitalization stocks.)
The NASDAQ Index did even better, up 12.35% for the month, from 11,028.74 at the end of June to 12,390.69 at the July close. However, year to date, the NASDAQ was still down 20.80%. (The NASDAQ – National Association of Securities Dealers Automated Quotations – is an electronic stock exchange with more than 3,300 company listings.)