Keith Lamoutte, CFA, Chief Investment Officer
Derek Vasko, CFA, Director, Investment Strategy
- The MSCI All-Country World Index rallied in July to post its best monthly return since November 2020 despite an increasingly challenging economic environment.
- The Federal Reserve increased its benchmark fed funds rate by another 75 basis points (0.75%) after inflation hit a fresh 40-year high in June.
- As second quarter earnings season ramped up, profit growth decelerated as persistently high inflation pressured both consumers and businesses.
What is normally a relatively benign month in financial markets was instead very eventful, though there was relatively little in the way of positive catalysts. Among the highlights, the Federal Reserve (Fed) continued its monetary tightening campaign, taking the unprecedented step of raising the benchmark fed funds rate by 75 basis points (0.75%) in back-to-back meetings. The move occurred just prior to the release of second quarter gross domestic product (GDP) data, which showed economic activity declined for a second straight quarter, sparking debates about whether the U.S. is now in a recession. To boot, second quarter earnings season ramped up with mixed takeaways.
Nonetheless, those who stayed the course after monthly losses in April, May, and June were rewarded as global equities1 posted their best return since November 2020, gaining 6.9%. It was a case of investors focusing on the silver linings of the storm clouds. Below we expand on some of the major storm clouds that gathered last month, as well as their silver linings:
Storm Clouds: In some areas, such as the U.S., Eurozone, and U.K., year-over-year inflation continued to reach new multi-decade highs. To combat this, policymakers have taken a more heavy-handed, front-loaded approach to hiking interest rates to demonstrate their commitment to tackling the issue and subsequently will allow for a transition to increasing rates on an as-needed basis (or even stopping/backtracking at some future point).
Silver Lining: The Fed in particular, with its outsized influence on the global economy, provided the silver lining last month in Chairman Jerome Powell’s post-meeting press conference. In unscripted comments, he indicated 75-basis point rate hikes are “unusually large,” that it will likely become appropriate to slow the pace of tightening, and that the full impact of the rate hikes already implemented has not yet been felt. He also said that they are starting to see the requisite slowdown in economic activity and that the extent of the rate hike in September — a rate hike of some degree is still expected — will depend on incoming data. Investors interpreted the comments as an indication that officials could pivot away from front loading sooner than expected. In fact, markets are now pricing in the potential for rate cuts by the end of next year.
Storm Clouds: In addition to GDP, several other data sets painted a less-than-ideal picture of the global economy. In the U.S., housing market activity continued to weaken by nearly every measure, while inflation (+9.1% year over year) hit a new multi-decade high. At the same time, wage growth continued to lag inflation, leading to a further decline in personal savings rates as consumers draw down pandemic-related savings. That contributed to a drop in consumer confidence, which fell for a third straight month. Abroad, a further reduction in natural gas flows to Europe via the Nord Stream pipeline pushed regional prices to record highs and triggered emergency measures to curb usage by 15%, leading to a deterioration in consumer confidence across Germany, France, and Italy. In Asia, ongoing sporadic lockdowns tied to China’s zero-Covid policy continued to hamper economic activity, prompting officials to scrap their 5.5% growth target, instead saying the country should achieve the “best outcome” possible.
Silver Lining: Recent labor market data suggest consumers (in aggregate), which comprise the largest portion of GDP by far at roughly 70%, remain in a relatively healthy state, an uncommon situation heading into — or during — an economic downturn. The unemployment rate has returned to pre-pandemic levels while employers continue to hire at a very healthy clip. Also, commodity prices fell notably in July, a dynamic that has yet to be reflected in inflation data. In Europe, second-quarter GDP unexpectedly accelerated thanks to an easing of travel restrictions which prompted a spike in tourism. Corporations also benefitted with aggregate earnings for the STOXX 600 Index on pace to rise almost 35% year over year according to FactSet data2. In China, government officials are implementing stimulus measures to boost ecommerce, employment, and infrastructure spending to shore up the economy.
Storm Clouds: Second quarter earnings season ramped up in July and has been somewhat underwhelming. Big box retailers including Walmart noted that persistently high inflation is driving shoppers away from more profitable, discretionary items. The shift in consumer spending will require price cuts to clear out excess inventory, crimping both sales and profit margins. Elsewhere, technology firms such as Snap and Facebook parent Meta highlighted a decline in digital advertising as firms emphasized cost controls to maintain profitability. In aggregate, FactSet estimates show year-over-year growth in S&P 500 earnings for both the third quarter and full year declined last month as investors reassessed the economic environment.
Silver Lining: Although lackluster, corporate earnings are on pace to increase 6.8% year over year, while estimates for the third quarter and full year are expected to increase by 5.4% and 8.7%3, respectively. With the price-to-earnings (P/E) ratio now sitting near its 10- and 20-year averages after the selloff over the first half of this year, we believe investors could see reasonable upside to stock prices over the balance of the year from earnings growth alone.
Downside risks abound as central banks remain focused on bringing reducing inflation even if it triggers a recession. However, despite the many storm clouds gathering, the silver linings behind each of them suggest to us that the sun remains in the sky, waiting to shine again. We don’t endeavor to forecast when the skies will clear; however, as is true of all thunderstorms, we do expect those clouds to dissipate.