While market concerns are centered on recession fears, the incoming data remains consistent with further, but slower, economic growth.

We continue to see the path of inflation and how far the Federal Reserve (Fed) must raise interest rates to cool inflation as the critical determinants for the economy and stocks—a prolonged aggressive hiking campaign raises recession risks, and consequently stock market risks.

Last week brought important readings from the labor market and business surveys, which signaled a further moderation in economic growth but not recession. While there are early signs inflation has peaked, the Fed has stated that they need to see a sustained downward trajectory on inflation before pursuing a less aggressive rate-hiking campaign.

The ISM Services PMI (a timely business survey) fell 0.6 points in June to 55.3 (above 50 signals expansion, below 50 signals contraction), its lowest level since May 2020, although above consensus expectations. While this reading shows a deceleration in services activity over the past three months and a drop-off in momentum since the PMI peak last November, it still sits well above the break-even level of 50, consistent with slower growth but not a recession.

The ISM data showed price pressures eased for the second consecutive month but are still historically elevated. The Prices Index fell below its 12-month average for the first time since May 2020. There were fewer commodities in short supply or up in price than in the previous month, although both categories were still much higher than pre-pandemic.

Last week’s labor market readings were also consistent with further growth but with signs of slowing. The establishment survey showed nonfarm payrolls increased 372,000 in June, well above consensus expectations while the unemployment rate remained at 3.6% for the fourth straight month. Private nonfarm payrolls increased 381,000, the most in three months, and have now surpassed their pre-pandemic peak.

Payroll gains were widely spread across industries. The employment diffusion index picked up to 68.6% from 67.0% in the previous month, while its 12-month average posted its highest level since March 1998. Such broad-based industry participation reflects continued strong labor demand.

Aggregate weekly payrolls, which combines payrolls, hours, and earnings, and is a proxy for labor income, increased 0.6% for the month, and was up 9.4% y/y, nearly double the pre-pandemic pace. This suggests further consumer spending growth and is not consistent with a near-term recession. It also suggests the Fed will remain on their aggressive hiking path.

However, there are signs the labor market is beginning to cool. Job openings and quits are declining (albeit from very elevated levels), jobless claims are rising (from very low levels), and the ISM employment indices in manufacturing and services are signaling future labor market softness. While the establishment survey of payrolls noted above continues to show labor market strength, the household survey of employment has shown essentially no job gains for the past three months.

This speaks to the difficult job the Fed is facing—rapidly raising interest rates to cool inflation while the economy is showing signs of slowing momentum. This Wednesday brings the June consumer price index (CPI) which will be closely watched for signs that inflationary pressures are receding.

Another major test for the market begins this week as second-quarter earnings season kicks off with the largest banks announcing results. Management commentary on cost pressures and their outlook for the second half of the year will be closely watched by market participants. Both sales and earnings are projected to hit record highs, but growth is expected to have slowed and profit margins to have narrowed. The S&P 500 is expected to grow second-quarter earnings by 5.6% on 10.6% revenue growth.

Given the uncertainty around the path of inflation and interest rate hikes, we favor owning high-quality blue-chip stocks and have a defensive sector positioning. With our July sector strategy update, we raised the defensive Utilities sector to an overweight and dropped the deep cyclical Materials sector to a neutral. Energy and the defensive Health Care sector remain high conviction overweights. The Health Care sector has grown its earnings during each of the last six recessions while its valuation is favorable relative to its history. Energy continues to benefit from very low spare productive capacity while valuation is favorable.

 


 

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