The global equity market continued to push higher last week with the MSCI World Index now up 6.5% over the last two weeks. In the United States, the tech-heavy NASDAQ surged 4.7% as the real 10-year Treasury yield fell sharply last week. The S&P 500 jumped 4.3%. Non-U.S. markets posted positive returns as well but with more muted gains. European stocks climbed 2.6% while Japanese stocks edged 0.9% higher. Emerging market stocks rose just 0.4% as the MSCI China index tumbled 3.7%.
The U.S. economy has now experienced two quarters of economic decline. This would often be referred to as a recession with 1947 providing the only modern example of two consecutive negative real gross domestic product (GDP) prints that there were not labeled as a recession, but strong monthly employment reports suggest that the economic decline is not yet broad-based.
Fed Chair Powell stated that he also does not believe that the U.S. is in a recession. However, he did seem to acknowledge that the economy is indeed weakening. While still deciding to raise interest rates by another 75 basis-points, he also mentioned that the federal funds rate is already near the neutral rate (meaning interest rates are now near a level that neither stimulates nor slows down the economy). While the central bank will likely still raise rates to a moderately restrictive level, the market’s takeaway was that the Fed may start to slow the pace of rate hikes soon. The Fed will now have eight weeks before its next FOMC meeting.
Lastly, President Biden’s Build Back Better proposal has resurfaced as the scaled down Inflation Reduction Act of 2022. The slimmer bill is projected to reduce the federal deficit by about $300 billion over 10 years. It is not expected to meaningfully bring down inflation or materially impact individual taxes.
Two Quarters and Eight Weeks
Last week was a weird week in financial markets. The Fed hiked interest rates by another 75 basis-points (or 0.75% for normal people) and the U.S. economy logged its second consecutive quarter of decline, which used to be called a recession, but is no longer called one. And yet the market continued to rally with the S&P 500 pushing 4.3% higher and NASDAQ adding 4.7%. That sounds like bizzarro world, where you expect one reaction, but get the exact opposite. We will discuss what may be driving the recent rally, but let’s examine the Federal Reserve and the state of the U.S. economy first.
The Federal Reserve surprised absolutely no one by raising rates once again last week. While many market watchers interpreted their tone as hawkish, the U.S. stock market didn’t seem fazed at all and rallied throughout the day. The primary reason is likely due to Fed Chair Powell saying that the central bank was already near a “neutral” setting. Meaning that rates are now at a level that neither stimulates the economy nor slows it down.
Indeed, a fed funds rate of 2.5% is consistent with what Chair Powell called neutral in 2018. Critics will likely argue that the level is too low given that inflation is much higher than it was in 2018 (see figure 1), but risk assets started to push higher after he said it. He did follow up by saying that the central bank will likely need to raise rates to a moderately restrictive level – meaning somewhat above the 2.5% level. Combined, the comments sent a signal that the Fed may be approaching a point where it decides to scale back the size of its rate hikes or pauses altogether. It also means that heading into 2023, the Fed may be more flexible and not on a preset course as it now recognizes that the economy is slowing noticeably. Importantly, the Fed now has eight weeks until its September FOMC meeting. During that time, the Committee will receive two consumer price index (CPI) and employment reports.
We think it’s worth noting a couple of other trends that have been supporting the modest uptrend in stocks as well, including increasing confidence that inflation has finally peaked and a sustained downtrend in Treasury yields. Interestingly, the recent rally in the S&P 500 and the NASDAQ both started in mid-June…around the same time that gasoline prices started to come down (see figure 2). Since June 13th, national gas prices have retreated 16.0%. It has also been a steady decline with the prices dropping every single day for over 45 days. U.S. Treasury yields have also been in steady decline since mid-June with the 10-year U.S. Treasury yield dropping from 3.47% to 2.57% currently. Just like rising yields hurt technology stocks on the way up, falling yields may helping technology stocks on the way down as valuations are once again re-rated due to volatile changes in interest rates (see figure 3).
Turning to the 2nd quarter of 2022 real gross domestic product (or GDP) print of minus 0.9% annualized growth, we have been talking about employment potentially being the better metric of a recession for some time now (please see our, "Weekly Market Update | Can the Fed Stick the Landing?"). However, the second consecutive quarter of economic decline, renewed discussion about whether the U.S. is in a recession or not.
We find it kind of interesting that some investors believe that two consecutive quarters of decline are a “sure thing” in terms of calling a recession when none of the last three recessions started with two consecutive quarters of negative growth. In 2001, the economy never experienced two negative quarters in a row. During the Global Financial Crisis, the recession was said to have started in December 2007 but the economy didn’t experience two quarters of negative growth until the fourth quarter of 2008. And the 2020 recession was determined to have lasted just two months – from February 2020 to April 2020.
That said, we must go back to 1947 to find two quarters of decline that were not associated with a recession. Our primary point here is that the two quarter “technical” definition does not always fit and tells us little about the National Bureau of Economic Research’s official time stamp. For more insights, please see our, "CIO Strategy Bulletin | The "R" Word: What Powell and Markets Are Telling Us."
The other thing to note about the minus 0.9% annualized contraction in real GDP is that it is still reflecting COVID distortions, particularly in the volatile inventories component (see figure 4). Consumer demand surged in 2021 as stimulus checks were sent out, but businesses couldn’t get enough goods to match demand due to broken supply chains. So, naturally, businesses ordered a bunch of stuff and took delivery just as demand for goods cooled off. As a result, retailers experienced an accidental inventory build as “just-in-time” inventory management turned into “just-too-late.” Excluding the drag from the change in private inventories, real growth would have been closer to 1.1%. While the two weak quarters are a strong signal that the economy is vulnerable, they may not yet mark a recession as defined by the National Bureau of Economic Research.
Build Back Better Re-emerges As the Inflation Reduction Act
In other news, Build Back Better (or BBB) is back on the table but has been relabeled as the Inflation Reduction Act of 2002. Senators Manchin and Chuck Schumer apparently came to a tentative agreement in late July and the bill looks very likely to be passed in the next several weeks.
The bill is a much more scaled back version of the original BBB bill that was expected to include more $2 trillion of spending initiatives. While the bill has yet to be scored by the Congressional Budget Office, the total bill as currently outlined could include $433 billion in spending and $739 billion in revenue offsets for a total deficit reduction of about $300 billion. This would be spread out over a period of 10 years. The bill includes the following policy changes:
- An extension of Affordable Care Act (ACA) subsidies. The bill extends the temporary expansion of Premium Tax Credits through 2025. The expansion, which offers eligibility to households above 400 percent of the poverty line, was set to expire at the end of 2022.
- Climate and energy provisions. This includes tax rebates and credits to lower energy costs for households. Tax credits, research funding, loans, and grants will also be used to increase domestic manufacturing capacity for clean energy production. Electric-vehicle incentives have also been proposed.
- A 15% corporate alternative minimum tax. This would be based on the financial statement of corporations with at least $1 billion in such income.
- Addresses the carried interest loophole. The bill proposes lengthening the holding period required for managers of certain investment funds to receive preferential tax treatment for a portion of their compensation known as “carried interest.” This would apply only to taxpayers with income exceeding $400,000.
- Prescription drug pricing reforms. The bill would allow Medicare to negotiate the price of certain prescription drugs and limit Medicare and commercial price growth of certain drugs to inflation.
- Increased Internal Revenue Service (IRS) enforcement. Approximately $80 billion would be spent over the next decade to hire and train new auditors, modernize IT systems, and to increase taxpayer services.
The bill does not include changes to individual tax rates, capital gains taxes, or estates taxes. It also does not include any changes to the state and local tax (or SALT) deduction.
Will the bill reduce inflation in the near-term? Again, the Congressional Budget Office has yet to score the bill, but according to early estimates from University of Pennsylvania’s Penn Wharton Budget Model the bill’s impact on inflation is “statistically indistinguishable from zero.” Though the University does estimate that the bill would reduce non-interest cumulative deficits by $248 billion on the budget window with no impact on GDP through 2031.1
What Should U.S. Investors Watch in the Week Ahead?
The U.S. economic calendar includes some important data prints including the monthly ISM manufacturing index and the July employment report. Both reports are expected to reflect a slowing, but still expanding U.S. economy with the consensus calling for 250,000 jobs to be added during the month.
The unemployment rate is expected to stay near historic lows at 3.6%. Second quarter earnings will also continue to roll in with several big industrial companies reporting. Overall, the second quarter earnings season has been better-than-expected with S&P 500 earnings-per-share (EPS) up 6.6% year-on-year. This is tracking a full percentage point higher than earlier estimates.
|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 (%)||-10 bps||113.8 bps||137 bps||2.65%|
|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
|8/1||10:00||ISMInstitute for Supply Management Manufacturing||JulJuly||52.8 A||53.0|
|8/1||10:00||ISMInstitute for Supply Management Prices Paid||JulJuly||60.0 A||78.5|
|8/2||10:00||JOLTSJob Openings and Labor Turnover Survey Job Openings||JunJune||11000k thousand||11254k thousand|
|8/2||10:00||Wards Total Vehicle Sales||JulJuly||13.40m million||13.00m million|
|8/3||10:00||ISMInstitute for Supply Management Services Index||JulJuly||53.5||55.3|
|8/5||8:30||Change in Nonfarm Payrolls||JulJuly||250k thousand||372k thousand|
|8/5||8:30||Average Hourly Earnings YoY year on year||JulJuly||4.9%||5.1%|