The Resilient Market

The Resilient Market

The resiliency of the US economy has confounded many economists, strategists, financial managers, and pundits of all varieties.  The declining trend in the leading indicators, the inverted yield curve, the ISM manufacturing results, and weakness abroad are some of the datapoints that have been signaling recession.  However, the services sector has continued to move ahead, offsetting the rolling recession in the goods sector.  Consumers remain committed to spending on travel, restaurants, etc., sustaining the COVID reopening theme, and displaying an almost carefree attitude while expanding their debt load.  The funds provided during COVID and the effect of a 2 ½ year lockdown set in motion consumer behavior that has not been adequately reflected in forecasting models.

Moreover, the changing character of the economy over the last decade, with the pervasiveness of technology throughout many sectors as well as the emergence of areas that did not previously exist, make many indicators less representative of what the underlying trends are.  The long-time lag between periods when data is revised only adds to the problem.

On a micro level, market participants see what is happening in various sectors and the nature of the new emerging industries and trends.  They have responded and moved market prices higher.  This movement may explain in part the dichotomy between what the macro implies and what the micro is generating.

Many corporate managements have recognized the changing character of the economy and have adapted their business models accordingly.  As in Q1, the Q2 earnings reports should reflect this dynamic, and we would expect earnings to be better than the 7% decline in the S&P 500 earnings that is the consensus view.

Over the next several weeks, as earnings reports are being digested by investors, the macro will come into focus again.  On July 26^th, the Federal Reserve raised the Federal Funds rate by 25 basis points to the 5.25 to 5.50% range, the 11^th increase.  Moreover, the statement and the press conference provided some insight into what might occur at the September and November meetings.  Data dependence was the dominant theme, and a recognition of the cumulative impact of monetary policy and the lagged effects was mentioned.

The progress made on inflation (CPI and PPI) and the slowing in employment growth were referenced in the press conference.  Moreover, the second quarter GDP report further highlighted the progress made on inflation.  The GDP price deflator fell to a 2.2% annual rate and the core dropped to 3.8%.

Giving the unwinding of the COVID relief funds and the growing debt burden of the American consumer, this slowing trend is likely to continue.  More importantly, the drop in inflation is helping real income growth and sustaining economic growth.  At the same time, the Fed’s rate policy becomes more restrictive as real rates rise (normal rates minus inflation).

Consequently, another pause might be forthcoming, and an end to the tightening cycle could well be anticipated by the equity market.

The strength in stock prices over the last several months has defied many market forecasters, and even placed some of the indices above the level reached before the Fed began raising rates.  Many institutions and hedge funds, anticipating economic and earnings weakness, were on the wrong side of the market and are now forced to pay higher prices to fill their positions.  As often occurs, the market does not reward any form of market timing.

The 10-year Treasury, which spiked to 4.11%, has now receded and stands at 3.97%.  That rate, and the 30-year Treasury yield, suggest a benign inflation picture, a far cry from the rhetoric expressed by many Fed presidents and board members.

The market appears to suggest a change is coming.  The earnings picture, the rate levels, and the position of institutional investors would indicate that maintaining a constructive market position is appropriate.

The equity market is very effective at discounting future events and pays little attention to the many opinions expressed on a daily basis by the experts.  At times, it moves to extreme positions, but most often it captures the nature of the underlying economy and monetary trends.  A bifurcated economy and an innovative infrastructure pose challenges to investors.  COVID and the response to COVID have set in motion changes that are not yet fully understood.  Focusing upon long-term secular trends, being disciplined in maintaining that focus, and avoiding the whims of the daily market commentators should yield long-term risk-adjusted returns.  Trying to navigate the short-term movements in equities often proves to be a futile and costly endeavor.

In a dynamic investment environment, the emerging secular trends, the rate of change in underlying economic and financial variables, and disaggregated data are important market forces.  Focusing upon these factors provides the long-term framework for investment success.