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Markets were tuned to the signals coming from Jackson Hole, Wyoming.
During World War II, United States armed forces often relied on high-powered radio sets to communicate. When determining whether transmissions were garbled by static or obscured by the sounds of battle, the sender would ask, “Do you read me?” If communications were easily understood, the answer was, “Loud and clear.”
Last week, markets heard U.S. Federal Reserve Chair Jerome Powell loud and clear. He spoke at the Federal Reserve (Fed)’s policy forum in Jackson Hole, Wyoming, and said:
“The U.S. economy is clearly slowing from the historically high growth rates of 2021, which reflected the reopening of the economy following the pandemic recession. While the latest economic data have been mixed, in my view our economy continues to show strong underlying momentum. The labor market is particularly strong, but it is clearly out of balance, with demand for workers substantially exceeding the supply of available workers. Inflation is running well above 2 percent, and high inflation has continued to spread through the economy. While the lower inflation readings for July are welcome, a single month's improvement falls far short of what the Committee will need to see before we are confident that inflation is moving down. We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent.”
It wasn’t the speech stock market bulls had hoped to hear. They were anticipating the Fed would take a doveish policy turn, and would soon begin to raise rates less aggressively, according to sources cited by Lu Wang and Elaine Chen of Bloomberg.
Following Chair Powell’s remarks, major U.S. stock indices headed south.
“The Dow Jones Industrial Average declined 3% on Friday…while the S&P 500 index fell 3.4%...the tech-heavy Nasdaq Composite took the brunt of the damage, falling 3.9% on Friday to end the week down 4.4%. That makes sense, given that expensive growth stocks are most sensitive to rising interest rates,” reported Ben Levisohn of Barron’s.
Is this a bear market rally or a new bull market?
Investment professionals are in the middle of a heated debate. Since mid-June, United States stock markets have moved higher, regaining about $7 trillion as many investors who had sold shares during the first half of the year began buying again, reported Lu Wang of Bloomberg. The debate is about whether the stock market is in the midst of a bear market rally or a new bull market.
A bull market occurs when share prices rise steadily over time. In a recent Morning Briefing on LinkedIn, Edward Yardeni of Yardeni Research, explained the debate:
“From a fundamental perspective, the bears expect that inflation will remain elevated, forcing the Fed to raise interest rates much higher, causing a severe recession. The bulls, like us, believe that inflation might have peaked in June and that the Fed is likely to pause for a while following one more rate hike of [0.50 to 0.75 percent] in late September. The bears see lots more downside for earnings and valuation multiples. We see flattening corporate earnings through the end of this year and believe that forward valuation multiples bottomed on June 16. In our bullish narrative, the market could move sideways for a while before moving to new record highs next year.”
Will Daniel of Fortune reported, “Morgan Stanley has repeatedly argued that the recent stock market rally is nothing but a bear market trap, while Bank of America has warned that stocks have more room to fall based on historical trends.”
In an effort to determine whether it is possible to distinguish bull markets from bear market rallies, one Minnesota research group examined data going back 65 years, reported Bloomberg. “The answer is that it remains next to impossible to say in real time which ones will last. Methods people claim work often fall apart when looked at rigorously.”
Last week, a pause in the rally added fuel to the debate. The Standard & Poor’s 500 Index declined after four weeks of gains, reported Ben Levisohn of Barron’s. U.S. Treasury yields moved higher as investors parsed Federal Reserve commentary, reported Samantha Subin and Natasha Turak of CNBC.
Rally caps were waving.
In recent weeks, investors have embraced the idea that economic data will persuade the Federal Reserve to slow the pace of rate hikes. Last week’s inflation data fanned their enthusiasm.
The big news was that the Consumer Price Index (CPI), which measures inflation, didn’t change from June to July. That doesn’t mean all prices remained the same during the month. They didn’t. For instance, the cost of energy dropped by 4.6 percent, while the cost of food rose by 1.1 percent. When all price changes were combined, the overall result was zero percent inflation for July. Year-to-year, though, the CPI was up 8.5 percent.
Investors didn’t care that a single month is not a trend, and stocks moved higher. “The gains this week continue a longer run for the stock market, which had already been optimistic that evidence would point to peak inflation…The hope is that cooling inflation will make the Federal Reserve more likely to slow down the pace of interest rate hikes,” reported Joe Woelfel and Jacob Sonenshine of Barron’s.
“That narrative got another boost Thursday. The producer price index for July gained 9.8% year-over-year, below expectations for 10.4% and below June’s result. That further validates the peak inflation thesis, as companies would raise prices at a slower pace, given that their costs are rising at a slower pace.”
The bond market was less optimistic about what the future may hold. The U.S. Treasury (UST) yield curve steepened after CPI data was released, which suggests some optimism about the future. However, the curve remained inverted, suggesting that bond investors think the current Federal Reserve policy – raising rates and tightening monetary policy – may eventually lead to a recession, reported Liz McCormick of Bloomberg.
Bloomberg’s July survey of economists put the chance of a recession within the next year just below 50-50, reported Vince Golle and Kyungjin Yoo.
Last week, the Standard & Poor’s 500 Index delivered a fourth consecutive week of gains, the Dow Jones Industrial Average trimmed its losses for the year, and the Nasdaq Composite was up 20 percent from its June low, reported Andrew Bary of Barron’s.
The strength of the United States economy continues to surprise.
If you have ever been camping, you may have banked your campfire by covering the hot coals with ash. It’s a process that keeps the coals burning low so the fire can be easily rekindled. The U.S. Federal Reserve has been trying to bank the fire of U.S. economic growth – and it’s proving to be challenging.
There are signs that U.S. economic activity is burning less brightly. For example, economic growth declined during the last two quarters, the U.S. housing market appears to be cooling, and consumer sentiment is low, reported Colby Smith of Financial Times. However, last week’s data suggested some parts of the economy are still ablaze.
Last week, major U.S. stock indices delivered mixed performance, while U.S. Treasury yields rose, reported Jack Denton of Barron’s.
Investors thought they heard a dovish note from the Federal Reserve and markets rallied.
Last week, we learned from the Bureau of Economic Analysis (BEA) that economic growth in the United States slowed for the second consecutive quarter. Economic growth is measured by gross domestic product, or GDP, which is the value of all goods and services produced during a specific period. GDP includes household, business and government spending, as well as exports and imports.
Before inflation, the U.S. economy grew by 6.6 percent in the first quarter of 2022 and by 7.9 percent in the second quarter, according to the FRED Economic Data. After inflation, GDP shrank by 1.6 percent in the first quarter and by 0.9 percent in the second quarter.
Is it a recession or isn’t it?
Two consecutive quarters of negative growth is the popular definition of recession, and there was a lot of debate last week about whether the U.S. is in a recession. One reason for the debate is that the main driver of U.S. economic growth is household spending, which accounts for about 68 percent of GDP. During the first half of the year, household spending continued to increase, although it slowed.
“While a low unemployment rate and still-healthy consumer and corporate balance sheets mean the economy continues to show resilience for now, expectations that the U.S. will enter a formal downturn within the next year continue to rise,” reported Megan Cassella of Barron’s.
Financial markets rallied
In unscripted remarks, Fed Chair Jerome Powell indicated that interest rates had reached a neutral level. When rates are neutral, monetary policy is neither contractionary nor expansionary. Investors took Powell’s comment to mean the Fed might ease rates sooner rather than later, and markets rallied, wrote Economist Mohamed A. El-Erian in a Bloomberg opinion piece.
“The S&P 500 soared 4.3% for the week and 9.1% in July, the best monthly advance since November 2020…Treasury yields dropped across the curve as well…Taken together, the equity and bond rallies helped loosen U.S. financial conditions,” reported Katherine Greifeld and Vildana Hajric of Bloomberg.”
While the rally was welcomed by investors, looser financial conditions are the opposite of what the Fed wants to achieve. It is trying to tighten financial conditions and reduce demand. It appears the Fed has more work to do.