U.S. stocks rallied again in July, with both the S&P 500 Index and the NASDAQ Composite Index generating the strongest performance in the first seven months of a year since 1997. July’s performance was notable for seeing a rise in all 11 sectors of the S&P 500 Index, led by Energy, which was supported by a surge in oil prices over the month.
Sustained, if moderate, strength in economic data supported the markets’ gains and prompted the U.S. Federal Reserve (Fed) to again raise interest rates by 25 basis points at its July 26 meeting, citing the “moderate pace” of economic activity, “robust” job growth, and “elevated” inflation in their public statement.
Indeed, the Personal Consumption Expenditures (PCE) Index rose 3% for the 12 months ended June 30, 2023, according to the July 28 report from the Commerce Department. While the rate declined for the second consecutive month, the core PCE Index (removing the more volatile food and energy components) increased 4.1% from last June and remains well above the Fed’s target rate near 2%.
While geopolitical news was relatively light in July, oil prices were strong over the month and Saudi Arabia added fuel to that rally when they announced in early August that they would be extending their current production cuts.
More dramatically, Fitch Ratings announced on August 1 that they were downgrading the U.S. government’s long-term rating to AA+ from AAA, with a stable outlook. In their press release, Fitch cited the expected deterioration of the country’s fiscal accounts in the coming years, the growing deficit, and the “erosion of governance” manifested in “repeated debt limit standoffs and last-minute resolutions.”
While long-dated Treasury yields had risen over the period on sustained economic activity, the news has pushed the yield of the 10-year bond towards its one-year highs near 4.25%.
Outlook: The U.S. economy has proven resilient to persistently high inflation, rising interest rates, ongoing geopolitical instability, and even domestic banking failures. A strong labor market, fueling solid consumer spending, has helped both economic growth and market optimism but in our view a slowdown and possible recession has most likely not been averted, just delayed.
Consider the consumer: consumption has been robust, surprising to the upside. At the same time, adjusted for inflation, spending has softened. Delinquencies are increasing on the margin and the surge in excess savings that accumulated during the pandemic has been whittled lower. Meanwhile, the strong job market that provided consumers’ confidence remains robust but has shown signs of softening. More broadly, leading economic indicators continue to point to a more challenging environment over the coming quarters, and the yield curve remains severely inverted – which has often been a precursor to a recession. Certainly, the combined rate hikes from central banks across the world are likely to be draining financial liquidity. And while the economic impact of this lags, we think it is a question of when, not if, the economy feels its full impact.
While it is true that the current, more sanguine, economic environment has led to better than expected overall corporate earnings and equity returns in recent months, these have been influenced by a very small number of mega-cap, technology-oriented stocks sparked by (justifiable) enthusiasm for artificial intelligence (AI) and all the infrastructure it requires. Furthermore, profit margins look to us to have peaked. Broad-based corporate profitability, while better than expected, has been buoyed by the ability to raise prices in a stimulus-driven inflationary environment. But in an environment of slowing inflation and economic growth, it will be more difficult for corporate profits to continue to beat expectations.
However, we do think the market is right to see AI as the spark for a new, emerging trend fueling technology investment, and we think it’s worth keeping an eye on small cap stocks. If history is any guide, the time to increase exposure to this sector is when the economy is in, or clearly headed into, a recession.
But turning points in the U.S. economy are notoriously difficult to time. And today’s more globalized economy adds additional complications as geopolitical wild cards abound. Might we see a post-Putin Russia in the second half of 2023? How, and when, will the tensions between China and Taiwan be resolved? How convoluted and disruptive might the 2024 U.S. Presidential election become in the coming quarters? In this uncertain environment we encourage equity investors to stay focused on the longer-term trends and – absent clarity – wait patiently for clearer signs of the economy’s direction.
In the meantime, both short and intermediate government bonds, with current yields of 5 - 5.5%, continue to look compelling if the market is right that there are only a few (or less) interest rate hikes remaining. Longer-dated U.S. Treasury bonds also deserve a closer look as they, like small-cap stocks, historically perform well as the economy turns into a recession.
Mortgage-backed securities are another sector which look appealing given their combination of relatively high credit quality and yields near 5%. While similarly rated investment-grade corporate bonds are also attractive, we do not see the same value in the lowest spectrums of the corporate credit market, where high-yield bonds look rich insofar as any further economic weakness will weigh more heavily on the lower-rated segments of the corporate bond market. Bottom line, the credit markets, like the equity markets, can be attractive to buy-and-hold investors, but the likelihood of high shorter-term volatility and geopolitical uncertainty makes a long-term view a necessity.
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