US economics, inflation, and the Fed
The US economy grew much faster than expected in the April-June quarter. Gross domestic product expanded by a 2.8% seasonally — and inflation-adjusted annual rate, according to the Commerce Department’s first estimate. Economists had predicted growth of 2.1%. The second-quarter acceleration was driven by higher consumer spending, as well as inventory and business investment. The personal-consumption-expenditures price index rose by 2.6% in the second quarter. Excluding volatile food and energy prices, the index increased 2.9 percent.
Inflation is moving in the right direction for the Federal Reserve (Fed). The more benign readings on inflation have raised the odds of a Fed monetary policy pivot in the second half of 2024. The Federal Open Market Committee (FOMC) is scheduled to begin its next two-day monetary policy meeting on July 30th. At that get-together, the data-driven central bank is expected to hold interest rates steady at 5.25% to 5.50% for the eighth consecutive meeting. However, given the recent downtrend in inflation, we would expect the Fed to strike a more dovish tone. Chairman Jerome Powell recently said that the lead bank won’t wait for the pace of price growth to reach the Fed’s target rate of 2% to begin reducing interest rates.
Professor Siegel notes:
“Turning to the economic indicators, we’ve entered a critical phase as the Fed prepares for its upcoming meeting on July 31. The market expects the Fed to signal a rate cut in September, provided economic trends continue as anticipated. I agree. This comes after a concerning rise in jobless claims post-July 4, although this was somewhat offset by stronger housing and retail sales data. Some also attribute the rise in jobless claims to Hurricane Beryl’s impact on Texas which should be reversed in the coming weeks.
Such mixed signals complicate forecasts but the big picture suggests a slowing consumer. Moreover, the dramatic shifts within the equity markets, especially between small and large stocks, value and growth stocks, reveal deep undercurrents. The surging strength in small-cap stocks following favorable Consumer Price Index (CPI) data indicates a market highly responsive to even subtle shifts in monetary policy expectations. There remains strong fundamental support for large caps — their earnings expectations have increased much more than small caps. For the recent shifting tides to be longer lasting, we will also need to see small and value stocks further reverse the huge gains in growth stocks over the previous three months.”
Global economy
Disappointment in the Euro area and China, come together with positive surprises from the US and emerging markets (EM) ex. China. Given JP Morgan’s perspective that balance across regions and sectors promotes resilience, this news shifts growth risks downward. The bank judges the US and global expansion as still standing on firm ground at midyear and sees risks to its second-half global forecast for a 2.1% annualized global GDP growth as still modestly skewed to the upside.
A second consecutive disappointing developed markets (DM) manufacturing Purchasing Managers’ Index aligns with weak July national surveys to question whether a mid-year recovery in DM factory output will prove sustainable. More broadly, this month’s manufacturing survey contrasts with an upside surprise in services. The all-industry survey remained stable in July as the services survey moved higher in both the US and Japan. Combined with solid labor market indicators this points to sustained service sector and GDP growth.
Stock market
For some time, the bull market has been fueled by technology sector gains. Recently, however, investors have been rotating capital out of expensive technology issues and into overlooked parts of the market, which may be a healthy development.
Empirical Research Partners explain in one of their recent papers: “The June CPI report, released on July 11th, supported the disinflationary narrative and suggested that a turn in monetary policy lies ahead. In the week after the release, the market followed the playbook for turning points: the equally weighted index trounced the cap-weighted one, small-cap stocks, the statistically cheapest part of the equity market, popped, and value issues saw a modest tailwind. Homebuilders, banks and other lenders, and capital equipment manufacturers benefited, while the 25 Big Growers lagged by more than at other turning points. The excess returns were maintained in week two.
The set-up in the equity market doesn’t suggest to us that a powerful rotation is in the cards. Our valuation spreads are very close to their long-term norm, a function of profitability being strong almost everywhere. The valuation of most cyclicals isn’t depressed, nor is the market’s multiple, that is at a record high for the start of an easing episode. The market’s free cash flow yield is 70 basis points below that of the ten-year Treasury bonds, the biggest deficit since 2002. The nearly 20% free cash flow margins of the Big Growers, which are double those of the rest of the market, represent formidable competition. The free cash flow yield of those issues is at a 175 basis point deficit to the market, a normal reading.
Politics could prove to be more important than usual, given that the ratio of Treasury debt-to-GDP is now 108%, compared to 84% in 2018 and 42% in 2008, reducing the wiggle room. The share of the labor force that’s foreign-born which was 15% in 2010 is now 19%, and immigration restrictions would boost wage growth. A 10% tariff on all goods imports and a 60% one on those from China would also likely add to both inflation and real interest rates. All of that could mean the long end of the curve may prove uncooperative, blunting some of the power of monetary policy.”
While a lot of things are uncertain, what we as investors can count on is the power of corporate earnings and the information they contain. Should we continue seeing healthy profits and increasing profitability among a broader set of companies (excluding IT and Communication darlings) we should find ourselves witnessing healthy markets in the second half of the year.
The information and opinions included in this document are for background purposes only, are not intended to be full or complete, and should not be viewed as an indication of future results. The information sources used in this letter are: WSJ.com, Jeremy Siegel, Ph.D. (Jeremysiegel.com), Goldman Sachs, J.P. Morgan, Empirical Research Partners, Value Line, BlackRock, Ned Davis Research, First Trust, Citi research, HSBC, and Nuveen.
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