The global equity market logged its third straight week of gains with the MSCI World Index rising 0.3% - the index is now up 6.8% over the last three weeks. In the United States, the tech-heavy NASDAQ added 2.2% while the S&P 500 edged just 0.4% higher. Non-U.S. markets were mixed with European and Japanese stocks both down 0.9% while emerging market stocks jumped 1.0%. The 10-year U.S. Treasury yield rose 18 basis-points to 2.83%.
∂ The U.S. economy added 528,000 jobs in July. There were two takeaways from the report: 1) the U.S. economy is likely not in a recession and 2) the Fed is probably not done raising rates. Later this week, the July consumer price index (or CPI) will be released. It is expected to show headline inflation slowing while core inflation rises a bit.
A strong employment print and slowing headline inflation should be seen as a minor victory for the Fed as it raises the odds of a “soft landing.” But some investors still worry that the strong jobs report could give the Fed a greenlight for even more rate hikes. As time progresses, the Fed’s dual mandates of “price stability” and “maximum employment” may conflict with each other.
Although the strong labor market likely confirms that the U.S. economy is not in a recession, it does not confirm one will ultimately be avoided. As such, we think it is a bit too early to abandon caution, and so we remain defensively positioned.
The Federal Reserve has two mandates: to help the U.S. economy maintain “price stability” and “maximum employment.” However, over the last 30 years, the maximum employment mandate carried the heaviest weight because inflation was largely a thing of the past. Since 1990, the Fed’s preferred measure of inflation (the personal consumption expenditure deflator) has averaged 2.1% - almost exactly in line with the Fed’s target of 2.0% inflation (see figure 1). Currently, that measure stands at 6.8% while the unemployment rate stands at just 3.5% (see figure 2). That makes the Fed’s decision easy – tighten policy to address price stability because the economy can tolerate some weakening in the labor market. That seems particularly true after July’s employment report showed the economy adding 528,000 jobs.
Even prior to the employment report, Fed speakers were making the case for more rate hikes. San Francisco Fed President Mary Daly recent said saying the Fed is “nowhere near” finished fighting inflation, and Cleveland Fed President Loretta Mester said that she wants to see “very compelling evidence” that month-to-month price increases are moderating. Charles Evans said they are “at least a couple of reports away” from seeing the kind of inflation improvement Fed policymakers would want to demonstrate inflation is on the right track. Combined with the strong jobs report, a 75 basis-point rate hike has been put back on the table with the market now putting the odds of one at about 75%. The primary takeaway? The Fed is not done.
While more rate hikes are not what the market was hoping for, we find it encouraging that the labor market has held up thus far. After all, this is the most likely path to a soft landing (inflation decelerating, supply chain pressures ease, with demand cools, no major job losses). In theory, investors and the Fed should both be happy about the July jobs numbers, but it seems the strong labor market is increasingly being blamed for the stubborn inflation.
We find that interesting given that it was government stimulus and supply chain disruptions that caused this problem, not the labor market. In fact, the U.S. economy just recovered all the jobs lost due to the pandemic – some 29 months later. Rising wages might be seen as a concern with the latest print showing nominal average hourly earnings 5.2% higher year-on-year, but don’t forget that real wages have been falling steadily (see figure 3) and even nominal wages have come down from 5.6% in March 2022.
Yes, rising wages could make inflation stickier, but most of the inflation was in response to too much money chasing too few goods (the classic definition of what causes inflation). While transitory may have been the wrong word to use, inflationary pressures should improve gradually on their own given enough time. Just look at retailers that now need to cut prices because of too much inventory. Did the Fed have anything to do with that? It did not. Did the Fed cause the first wheat shipment to leave Ukraine’s ports recently? It did not.
It is understandable that the Fed feels obligated to respond to inflation because of its price stability mandate. In hindsight, the Fed probably should have started raising rates back to neutral in 2021. The potential problem we foresee in 2023 is higher policy uncertainty if unemployment starts to rise while inflation remains elevated. Will the Fed push forward with more rate hikes even if it means pushing the unemployment rate north of 5.0%? Or do they pause with hopes of avoiding significant job losses? We suspect it might be the former.
That said, the market appears to be expecting the latter as it is pricing in rate cuts in the back half of 2023 (see figure 4). While some investors see a Fed pause as reason to throw a “pivot party” and to take on more risk, we think a Fed cut would be a signal that it’s worried about a recession and that a soft landing may no longer be possible. Would it be a deep recession? Probably not, but recessions do tend to last about 11 months on average and the unemployment rate tends to rise by about 2.6%.
If the assumption is that the July employment report confirms the U.S. economy is not in a recession, then we must also assume that stocks may not have bottomed if a recession could still be ahead of us. Traditionally, the S&P 500 tends to bottom about four-to-five months prior to the end of a recession, not prior to one (see figure 5). So, it is good news that the market has rallied on better-than-expected earnings, increasing confidence that inflation has peaked, and falling bond yields, but it might still be too early to declare an all-clear in markets. Please see our CIO Strategy Bulletin | Attention Investors: That Was Not a Recession for additional insights.
|Length of Recession||281.1||209.0|
|Number of Days that Peak Occurred Prior to Recession||111.4||134.5|
|Peak Prior to Recession to Trough During Recession(%)||-32.61%||-27.11%|
|Days Between Peak and Trough||257||261.0|
|Days into Recession that Trough Occurred||170.0||117.0|
|Depth into Recession that Trough Occurred||51.6%||59.3%|
What Should U.S. Investors Watch in the Week Ahead?
The U.S. economic calendar’s most important data point will be the July consumer prices index (or CPI). The consensus is calling for headline inflation to fall from 9.1% to 8.7% while core inflation increases from 5.9% to 6.1%. There is a very good chance that July marks peak headline inflation, but like the boy who cried wolf, the call for peak inflation has come and gone many times already. The other interesting report will be the University of Michigan’s consumer sentiment index. Not necessarily the headline index, but the 5-10 year inflation expectations component. If consumers’ inflation expectations ease, the market may see it as a sign that inflation is starting to trend in the right direction.
The earnings calendar will be quite heavy with the bulk of reporting on Wednesday and Thursday. Thus far, second quarter earnings have been remarkably stable with S&P 500 earnings-per-share (EPS) tracking about 7.6% higher year-on-year. That’s a full two percentage points higher than estimated just a few weeks ago….though a decent portion of that is coming from the red-hot energy sector.
|Index||Weekly Chgchange in percent||YTDyear to date change in percent||12 Months12 month change in percent||Div. Yield division yield in percent|
|Instrument||Weekly Chgchange||YTDyear to date||12 Months12 month change||Level|
|10-Year Treasury Yield (%)||17.8 bps||131.6 bps||160 bps||2.83%|
|Index||Weekly Chg change in percent||YTD year to date in percent||12 Months12 month change in percent||Div. Yield division yield in percent|
The Week Ahead
|8/9||6:00||NFIBNational Federation of Independent Business Small Business Optimism||JulJuly||89.5||89.5|
|8/9||8:30||Nonfarm Productivity||2Q P||-4.6%||-7.3%|
|8/9||8:30||Unit Labor Costs||2Q P||9.5%||12.6%|
|8/10||8:30||CPIConsumer Price Index YoY year on year||JulJuly||8.7%||9.1%|
|8/10||8:30||CPIConsumer Price Index Ex Food and Energy YoY year on year||JulJuly||6.1%||5.9%|
|8/11||8:30||PPI Final Demand YoY year on year||JulJuly||10.4%||11.3%|
|8/11||8:30||PPI Ex Food and Energy YoY year on year||JulJuly||7.7%||8.2%|
|8/12||10:00||U of Mich.University of Michigan||AugAugust P||52.5||51.5|
|8/12||10:00||U of Mich.University of Michigan 5-10 YrYear Inflation||AugAugust P||2.8%||2.9%|