Financial assets staged a comeback in July, with the global stock market rising seven percent and U.S. bonds gaining by 2.5%. The recovery in stocks was enough to shake off bear market status, and the improvement in bond prices has shrunk this year’s bond losses to single digits. Two main factors were behind this recovery.
First, well-diversified stock investors have continued to benefit from positive earnings. While some companies reported tough quarters (GM, Intel, Meta, Walmart), other large firms experienced stock gains due to more upbeat results (Alphabet, Amazon, Apple, Ford). While not all large U.S. firms have reported, estimates for second quarter year-over-year profit growth are in the 5-8% range, which provides a firmer foundation for higher equity prices.
The other main driver of asset prices has been a decrease in long-term interest rates. Investors have become more and more convinced that the Federal Reserve won’t need a multi-year interest rate campaign to slow inflation. Related to that idea, investors also believe it’s possible the Federal Reserve could begin cutting rates as early as next year as inflation and economic activity slow. While such an outcome is plausible, we feel that investors are making a mistake by assuming such an outcome is preordained. To recap, the Fed just raised short-term interest rates by 0.75%, and remains firmly committed to fighting inflation. Until we clearly see data supporting the idea that inflation has peaked, we have no plans to shift our bond allocations to riskier territory.
While corporate earnings have been mostly strong, data suggests the Federal Reserve succeeded in cooling the economy with rate increases. Despite many economists predicting an annualized 1% gain in economic activity during the second quarter of 2022, the official data instead showed an annualized decline of almost 1%. Consumer and business sentiment has dipped, too. Still, the labor markets remain incredibly strong. With unemployment still below 4% and 11 million job openings, it’s hard to describe the current economic environment as contractionary. This bolsters the hope that the Federal Reserve can orchestrate the much desired “soft landing”, where economic activity slows enough to bring down inflation without causing severe economic pain.
As we’ve written repeatedly in recent months, we don’t believe volatility will dissipate until inflation subsides and, unfortunately, the latest CPI data showed the opposite. Ongoing price pressures could still cause a reevaluation of future interest rates. While some slowing of economic activity could be construed as a positive sign, it is still too early to declare victory.