Downside volatility has reappeared with markets responding sharply to Federal Reserve comments about the future of interest rates. Raymond James Chief Investment Officer Larry Adam discusses the outlook for inflation, U.S. consumer strength and various sectors.
At the start of the summer, the S&P 500 rapidly fell into bear market territory (e.g., a decline of more than 20%) with the S&P 500 declining about 24% from its January record high. Then, despite depressed sentiment, it notched an impressive 17.4% rally – lifting optimism that the index would notch its seventh consecutive positive summertime return. However, recent weakness sadly broke that streak.
The shift from goods to services
The “summer of revenge travel” was not a misnomer. Despite elevated travel-related prices, TSA screenings skyrocketed to multi-year highs, hotel occupancies improved, and restaurant bookings reached above pre-pandemic levels. While early trends suggested that consumers felt safe returning to travel, the further easing of restrictions and testing requirements fueled the desire to travel more. On the flip side, many mass retailers underestimated the seismic shift from goods-based spending to services, resulting in bloated inventories, some 20-40% above pre-pandemic levels. As a result, sales and discounting became more common as the summer wore on – a good omen for inflation.
Real vs. technical recession
The U.S. economy posted two consecutive quarters of negative growth, (-1.6% in Q1 and -0.6% Q2), eliciting headlines claiming the economy is in a recession. However, consumers – the biggest contributor to GDP – continued to spend. Whether it was bustling vacation travel or record-setting online retail sales, consumers’ ability and willingness to spend is robust. With the job market healthy (11.2 million open jobs) and $2 trillion in excess savings, the consumer remains well-positioned.
Past peak inflation
The July inflation report provided the first evidence that inflationary pressures may be at an inflection point and set to decelerate from the highest levels since the early 1980s. Much of the cooling at the headline level was driven by gasoline prices retreating from the $5.02/gallon peak. In addition, given that economically sensitive commodities have also fallen, inventory levels remain bloated, and food prices are likely to ease in the fourth quarter, it seems likely that inflation will continue its downward trajectory into year end and beyond.
Markets too quick to price in Fed pivot
U.S. Federal Reserve (Fed) Chairman Powell’s commentary at the Jackson Hole Symposium caught the markets by surprise. Market expectations were reflecting 50 basis points of interest rate cuts in 2023. But with inflation yet to show a consistent pattern of deceleration, the Fed reminded markets that the tightening cycle is not yet over. In our opinion, this rhetoric is setting the stage for the Fed to raise interest rates by an additional 1% by year end, before easing inflationary pressures allow the Fed to go “on hold” for an extended period with a target rate of 3.50% through 2023.The unwinding of the balance sheet is set to ramp up in September with the Fed increasing its reduction pace from $47.5 billion to $95 billion per month. Given that this coincides with the most aggressive tightening cycle in 20 years and that tightening is occurring globally (e.g., Canada, Europe, UK), Treasury market liquidity will likely be challenged, and bond market volatility will likely be elevated in the months ahead.
Stage set for midterm elections
Recently, prospects of a Congressional Republican sweep at the midterm elections have been dampened. With economic expectations (e.g. inflation) and President Biden’s approval rating improving, PredictIt has the probability of the Republicans winning the Senate below 50% (currently 40%) for the first time this year. However, the probability of the Republicans winning the House is ~75%. As a result, a split Congress outcome is growing.
Earnings reassured markets
Robust 2Q22 earnings and sanguine corporate guidance were not consistent with the recessionary conditions that headlines were insinuating – especially with regards to resilient consumer spending patterns. While 2Q earnings growth of 7% was not nearly as impressive as the double-digit quarters we saw through 2021, the upside surprise helped the S&P 500 rally 14% from the unofficial start (big banks reporting) through the unofficial end (big box retailers) of the reporting season – the best earnings season performance since 1Q97. Positive earnings growth should support equities.
Recorded August 31, 2022. Hosted by Paige Lenssen, CFA.