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Assessing the Strong Summer Rebound

Tom Wald, CFA®, Chief Investment Officer, Transamerica Asset Management, Inc.

Markets have had quite a summer. Between June 15 and August 21, the S&P 500® posted better than an 18% total return and a recoup of more than half of its year-to-date price losses. Despite the Fed’s continuing tightening cycle, long-term bond yields dropped considerably, as seen in the 10-year Treasury rate moving from 3.5% in mid-June to a closing low of 2.67% at the end of July, and high-yield credit spreads (ICE BofA Index Option-Adjusted Spread) narrowing from just below 6% in the first week of July to 4.2% by mid-August. All of which has left investors to ponder whether the past two months have been a bear market rally or a bear market exit.

Given this backdrop, we believe it is important to quickly review the criteria and catalysts in our judgment behind the markets’ strong move since June. These include: 

Bad news has been “not as bad” as expected. In our Mid-Year Market Outlook, we expressed our belief that stocks stood a good chance to recover from their June lows based on the premise that a lot of bad news had already been priced into the markets pertaining to inflation, slowing economic growth, Fed rate hikes, and corporate earnings. This has since largely turned out to be the case, as recent data across these market factors have for the most part come in not as bad as perhaps most feared a few months ago.

The macroeconomic environment now appears less ominous in nature. While the economy did descend into the widely recognized measure of a recession — that being two consecutive quarters of negative economic growth, including 2Q gross domestic product (GDP) of -0.9% annualized economic contraction following the 1Q -1.6% decline — this unwelcome data was immediately followed by an extremely strong July employment report in which more than a half million new jobs were added to the economy and accompanied by a 3.5% unemployment rate. The practical result of this unlikely combination of events was to move the prognosis of bad economic signals to mixed ones, as the markets saw recessionary growth data but certainly not recessionary employment data.  

 The decline in long-term interest rates has favorably impacted markets. Even when taking into account the stronger than expected July jobs number, the fear of further economic slowing over the next year or so has remained pervasive. This has resulted in an inverted yield curve, as the rate on the 10-year Treasury bond fell more than 0.75% from mid-June (3.5% on June 14 to 2.67% on July 29). This decline in long-term yields has served to favorably impact valuations in the stock and credit markets.  

Speculation of a Fed pivot. In addition, there continues to be speculation the Federal Reserve could ease the pace of rate hikes at its final three meetings this year and perhaps even pivot to rate reductions in 2023 based on the prospect of further economic slowing and declining rates of inflation. While we are quite weary of this outcome coming to fruition, it nonetheless has become a perspective shared by many in recent months.  

The case for peaking inflation. The first sign that inflation might finally be peaking may have appeared in the July consumer price index (CPI) report, which came in at a flat monthly pace and, despite posting a year-over-year headline increase of 8.5%, still reflected a decline from June’s 9.1% result. While still dauntingly high, particularly when combined with the July year-over-year core (ex food and energy) inflation rate of 5.9%, the CPI report did provide some support to the argument inflation rates may have peaked, at least directionally speaking.  

3Q economic growth tracking positive. More than halfway through the current calendar quarter, most tracking estimates for GDP growth are in positive territory (Atlanta Fed +1.6% as of August 19). Should positive growth actually be achieved as of the end of September, this would represent an important shift in the macroeconomic momentum.

Corporate earnings growth has remained positive. While the expected growth of corporate profits, as defined by S&P 500 net operating income growth estimates for CY 2022 and CY 2023, has declined in recent months, they remain in positive territory (FactSet Earnings Insight +9% in CY 2022 and +8% CY 2023) and well above the types of negative earnings growth profiles typically seen in past recessions. These aggregated earnings forecasts are currently far better than where most had previously expected them to be at this point in time.

With all of this in mind, we put forth the following perspectives as markets move into the final months of the year.  

  • Markets have come very far and fast since June and investors should brace for volatility between now and year-end. Recoveries from bear markets and tough economic conditions are rarely linear in nature and are typically fraught with fits and starts, both in terms of the markets and the data driving them. While this strong market rebound has certainly been welcome, it very well could wind up adding to short-term volatility in the upcoming months. 
  • Bear market lows may be in place. In our judgment, there is now a high probability the recent June 16 intraday S&P 500 low of 3,636 could prove to be the bottom of this recent bear market as fear and pessimism regarding inflation, recession, Fed rate hikes, and corporate earnings probably peaked at that time.  
  • Core inflation trends could be setting up well for stocks in 2023. In our opinion, core rates of inflation stand a good chance of declining into the sub-4% range by year-end as Fed rate hikes impact demand, the labor market begins to show slack, and supply chain bottlenecks ease to some degree. Should this prove to be the case, stocks could be well positioned for CY 2023.
  • Corporate earnings estimates could soon decline then quickly recover. While the months ahead are likely to include reductions in CY 2023 S&P 500 net operating earnings estimates, resulting in perhaps close to flat growth as compared to CY 2022, a silver lining in those revisions could be a meaningful corporate earnings recovery in CY 2024, recognized by the market in CY 2023 and representing a longer-term opportunity for stock investors.  
  • We view stocks as being somewhat range-bound between now and year-end. We believe the S&P 500 could likely trade within a range of about 5% to the upside or downside from current levels, or between approximately 3,900–4,400. Given recent events, we see upside probably capped until further data confirms a lower probability of current inflation rates continuing into next year as well as that of a prolonged and severe recession.
  • The Federal Reserve will likely have to raise the federal funds rate by at least 50 basis points at each of its upcoming three meetings to sufficiently curb inflation. In doing so, this continued tightening would take the federal funds rate to a lower bound of 3.75% by year-end. As a severe recession potentially proves to be less likely in the months ahead, the yield curve should flatten from its currently inverted slope with the 10-year Treasury yield moving closer to that level as well.

Although market volatility could increase during the months ahead, we see upside for stocks over the upcoming one-year time frame. In our judgment, by mid-2023 there is a strong probability core inflation could decline into the sub-4% core range, a prolonged and severe recession can be averted, and corporate earnings growth could be setting up well for CY 2024, all of which should ultimately prove beneficial for stocks and the credit markets.   


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