Markets Rally on Bad News — Here’s Why
Amid highly anticipated economic data, corporate earnings announcements, and a Federal Reserve meeting, the final week of July saw stocks and bonds react favorably to unfavorable results, serving as a reminder that markets often price in bad news well before its arrival or look beyond it to sunnier days ahead. Or sometimes both.
Major news during the final week of July included:
First look at 2Q gross domestic product (GDP) showed the economy slipping into recession territory.
The Bureau of Economic Analysis released its advanced estimate of 2Q U.S. GDP and at negative annualized growth of -0.9% following 1Q’s -1.6% print, the economy has now reached the practically accepted definition of a recession — two consecutive quarters of negative economic growth.
While economists and politicians quickly chose to argue whether that definition should apply to the economy at this point in time (based on very slight inflation-adjusted consumer spending growth and a still strong job market), we believe most investors and consumers now likely view the economy as, in fact, in recession, regardless of what the National Bureau of Economic Research ultimately decides months from now.
The Federal Reserve raised rates as expected, although its future path of hikes was interpreted to be more dovish than expected.
A day prior to the GDP report, the Federal Reserve concluded its July meeting in announcing it had increased the federal funds rate by 0.75% to a target range of 2.25%–2.50%. However, in the meeting’s aftermath, stocks rallied strong and bond yields declined in large part due to Chair Jay Powell’s post-meeting commentary apparently recognizing the slowing impact tighter monetary policy is having on the economy. Specifically, Chair Powell stated, “As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.”
This commentary by Chair Powell was immediately interpreted as a less hawkish profile for the Fed, and pricing in the fed funds futures market adjusted quickly to reflect expectations of a year-end lower bound on the fed funds rate of less than 3.25% versus previous expectations of more than 3.50% prior to the meeting. We would be cautious in coming to the same conclusion and believe the Fed still views inflation as the economy’s predominant enemy, and that continuing hot consumer price reports could push those expectations back up again in the months to come.
Inflation continued to accelerate as the personal consumption expenditures (PCE) price index report once again reached a multi-decade high.
The headline PCE price index report for the month of June came in at a year-over-year increase of 6.8% for its highest reading since January of 1982. The core (ex food and energy) reading was 4.8%, below February’s 40-year high of 5.3% but still above market expectations. In our judgment, this report did not provide evidence that inflation has yet peaked as markets will now anxiously await the July consumer price index (CPI) report scheduled for August 10.
While much of the market’s focus of late has centered on the risk and definition of recession, we will reiterate that elevated rates of inflation remain, in our opinion, the greater long-term risk to the economy and the markets. It is our view that core PCE stands a good chance to mitigate into the sub-4% range by year-end, however, this will be contingent upon the Fed remaining diligent in its pace of rate hikes and tightness in the labor market subsiding to some extent.
Corporate earnings reports for 2Q continued to roll in as official S&P 500® profit estimates finally began to decline.
One of the great paradoxes of the past several months has been that analysts' official S&P 500 net operating income estimates have continued to display rates of growth for CY 2022 and CY 2023 well above investor and market expectations. After months of anticipation and with the current corporate earnings season now in full swing, this convergence between forecasts and reality now looks to finally be in effect.
Since the beginning of June, the widely followed aggregated analyst CY 2023 S&P 500 net operating income estimate (as gathered and calculated by Factset Earnings Insight) has declined from $252 (approximately 10% growth) to $245 (less than 8% growth). We now expect this official CY 2023 S&P 500 earnings estimate to further drop throughout the rest of the year as inflation and recessionary conditions continue to take their toll on corporate income statements, perhaps concluding the year in the $235–$240 range reflecting low- to mid-single-digit growth.
However, despite this series of seemingly negative developments, the stock and bond markets rallied hard during the week. The S&P 500 closed on July 29 at 4,130, more than 13% above its year-to-date intraday low on June 15. The 10-year Treasury bond yield closed at 2.67%, well below its June 14 closing rate of 3.50%, and high-yield credit spreads fell to below 5% versus their early July levels of just under 6%. All of which could leave investors asking if this is a case of the stock and bond markets trading in a parallel universe to the world around them or are there other dynamics at work?
We agree with the latter, based in large part on the following:
- Markets are the great discounters of future events and often bad news is priced in well before its arrival, and better news is priced in even as that bad news arrives. For example, in three of the past five recessions, those lasting from July 1981–November 1982, July 1990–March 1991, and December 2007–June 2009, markets began to strongly recover and begin new upward cycles when those downturns were about three months away from conclusion, as was the case in August 1982, January 1991, and March 2009. Thus, if we are now experiencing a relative short and moderate recession, markets might now be discounting its upcoming recovery.
- Much of the longer-term rate declines are likely attributable to yield-curve inversion, which would be expected under recessionary conditions. As of the July 29 close, the 2-year Treasury yield stood at 2.89% and comparatively above the 10-year Treasury yield of 2.67%. Since May 9, the spread between the 10-year and 2-year Treasury yields has shifted from +0.35% to -0.18% likely reflecting the decline in 2Q GDP during that time and the rising probability of a second consecutive quarter of negative economic growth.
- In recent weeks, the market may have shifted its top concern from inflation to recession. Since about mid-June when the 10-year Treasury bond yield reached 3.50% on rising inflationary concerns, those fears seem to have given way to some extent toward those of Federal Reserve rate hikes driving the economy into recession. As the Atlanta Fed then began to accurately track 2Q GDP falling into negative growth, such recession fears escalated, resulting in yield-curve inversion and lower long-term rates. This likely set up stocks for their recent bounce based on the market’s interpretation of Chair Powell’s post-July meeting commentary and revaluations based on lower long-term rates.
Therefore, declining rates at the longer end of the yield curve combined with what was likely short-term oversold conditions, allowing stocks to move even against a backdrop of unfavorable news. All this likely created a bit of a coiled spring for equities particularly as the market anxiously awaited 2Q GDP, June inflation reports, and the July Fed Meeting. As bad news may have come in not quite as bad as many might have feared, this could then have set that spring in motion. It is also probably worth mentioning that since June 15, the S&P 500 has now regained approximately 40% of its total losses previously experienced from early January through the middle of June.
In summary, we believe investors should brace for potential short-term volatility as the market pendulum continues to swing against the backdrop of recession, continuing inflation, Fed tightening, and declining corporate earnings growth. We continue to believe this recently diagnosed recession is likely to be relatively short and modest by historical standards and, by year-end, core inflation could very well mitigate into the sub-4% range. In a year’s time it is highly probable, in our view, stocks will be higher than where they are now. Nonetheless, the market has had a fast and furious upward move since mid-June, which could in turn create some short-term downside risk as more tough news is processed by investors.
So while we believe the stock and credit markets currently reflect attractive longer-term entry points, volatility will likely continue making this market, as we have said before, not well suited for either faint hearts or short time horizons.
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