Rally Rolls On

Hopes that the Federal Reserve’s tightening campaign will soon come to an end, combined with better-than-expected Q2 earnings reports, lit up markets for the second consecutive week. Bullish sentiment was in strong supply after the Federal Reserve indicated it may slow the pace of tightening now that prices are showing signs of softening in response to the Fed’s previous hikes. On the earnings front, strong reports from the tech sector breathed life back into the battered industry. Amazon and Apple both reported better than expected results and provided investors an encouraging view into the consumer’s resilience. News that Q2’s GDP declined at a -0.90% annualized rate – it’s second consecutive quarterly decline – also provided a psychological lift. Whether we’re truly in recession or whether we’ve simply met some of the technical requirements of a recession is still a matter of debate, but bulls took comfort that the weaker data could mean that monetary headwinds could soon subside. This allowed the S&P 500 to soar 4.26% on the week and to score its strongest monthly performance since 2020.

Markets Bullish on Fed

In a widely anticipated move, the Federal Reserve announced it would hike the fed funds rate by 0.75% at this week’s FOMC meeting. This is the second consecutive 0.75% rate hike for the central bank, which now brings the benchmark lending rate to a range of 2.25% to 2.50%. The move comes as recent economic reports have shown that demand and production are softening, indicating that the Fed’s previous rate hikes are beginning to have an impact in slowing inflation. At the Fed’s post-FOMC meeting press conference on Wednesday, Powell said he didn’t believe the slowdown signals the U.S. economy is in a typical recession given that there are several areas of the economy that continue to perform well. Powell highlighted the strong labor market and the low unemployment rate as signs the economy remains on a stable footing. Economists expect July to be another strong jobs report with 240K individuals estimated to be added to the payrolls. Powell’s comments reflected the view within the Fed that so long as the labor market remains strong, the economy can continue to absorb additional rate hikes given the array of inflationary factors still present. Nonetheless, markets cheered the Fed’s latest hike and near-term rate guidance because it also came with an acknowledgement that tightening could slow as the economy shows additional signs of cooling.

U.S. in Recession? It’s Complicated.

The U.S. economy posted its second consecutive quarterly decline in GDP, -0.90% in Q2. That follows Q1’s -1.60% decline. While Q1’s decline was driven largely by external factors (a decline in demand due to the Omicron variant surge), Q2’s drop was driven by a decline in fixed investment, inventories, and government spending as both inflation and higher interest rates slowed demand. The consumer, who accounts for more than two-thirds of economic growth, continued to hang in even with inflation taking a larger bite from their wallets. Consumer spending rose 1%, driven by a 4.1% rise in spending on services. Services spending, however, was offset by a decline in spending on nondurable (-5.5%) and durable goods (-2.6%), which pushed the economy into contraction for the quarter. The National Bureau of Economic Research (NBER) is tasked with maintaining a chronology of business cycles, defining a recession as a period demarcated by “a significant decline in economic activity that is spread across the economy and lasts more than a few months”. The definition leaves room for interpretation but as a practical matter it has typically been understood to be a period of two or more consecutive quarters of negative GDP growth.  By that standard, we are presently in a recession. A debate has emerged in recent weeks, however, over whether the U.S. economy is truly in a recession so long as the labor market still remains strong. The unemployment rate – being a very broad and direct proxy for the broader economy – has typically inflected just prior to previous periods that were ultimately deemed to be recessions by NBER (retrospectively). We are not seeing that happen right now, which has left open a window for interpretation into whether we’re in a recession or not. It is possible that even with two quarters of negative GDP growth that the downturn could be shallow enough such that employment levels may not inflect or may inflect only after GDP begins expanding again. Under these circumstances, NBER may not believe the “breadth” test has been met to declare Q1 22 as the start of a recession. The whole debate is ultimately semantics, but investors reacted to the GDP report as a sign to check recession off their pre-requirement list and to begin posturing for the next expansion.          

Final Thoughts

July ended up begin a very strong month for markets as investors bet the worst may be behind us. The S&P 500 rose 9.1% on the month – its best month since 2020. The Fed’s recent rate hiking campaign appears to be having its intended effect, which has sparked optimism that the broader tightening cycle’s end may soon be in sight. With the recent bounce have come warnings that this could simply be a bear rally in a longer downward trend. Bear rallies are a fact of life, but we would counter that the market had become too bearish in June, and the actual data is coming in less bad than expected. Investors had positioned themselves for a downturn consistent with an average recession and sentiment was incredibly poor. Now that earnings and guidance are holding up reasonably well, the consumer is still spending, and inflation expectations are shifting in response to not only the data but now the Fed’s own guidance, investors are recalibrating accordingly.  Markets are going to remain data dependent with the focus being on inflation and employment. Time will tell, but expectations certainly improved in July, rewarding those who remained invested.