Stocks had their best month in July since 2020, with the S&P 500 Index up 9.2%. Messaging from the Federal Reserve (Fed) that was perceived as dovish after they raised short-term interest rates by 0.75%, and better than feared corporate earnings have supported equities. This is outweighing the incoming economic data, which continues to show deceleration.

Earnings Remain Positive

Earnings provide the key support for stock prices and while they have been mixed at the sector level, in aggregate they’ve been solid. With over 50% of S&P 500 companies reporting, 67% are beating second-quarter (2Q) earnings estimates (vs. 79% avg. last 4 quarters) and 64% are beating revenue estimates (vs. 77%).

Since the beginning of earnings season, 2Q 2022 estimated earnings-per-share has been revised up 1.6% to $56.1 (+7%), though 2022 estimated earnings has been revised down -0.6% to $227.0 (+9% y/y). Sales and Earnings surprise for the S&P 500 were largely supported by Staples (5.0%, 7.8%), Energy (14.9%, 39.1%), and Health Care (2.2%, 8.0%). Financials and Communications were notable drags for both Sales/Earnings beats. This is another big week of earnings news.

What To Make of Second Quarter Negative GDP

Given that equity bear markets tend to coincide with recessions, last week’s report of a contraction in second-quarter GDP drew a lot of attention. GDP (economic output) shrank at a 0.9% annual rate in 2Q, contrary to the consensus of a 0.3% gain. It was the second consecutive decline in output, provoking discussion whether the economy is already in recession.

We think it is too early to make the recession call but see an increased risk of recession in the near-term. Inventory investment was the largest negative drag, subtracting 2.0 percentage points from GDP growth and led by retailers (mostly general merchandise and vehicles). The inventory correction is an expression of the bullwhip effect, where excess inventories accumulated during the pandemic across the inventory pipeline are now being unwound. Excluding inventories, GDP would have grown in 2Q. This speaks to the unique nature of the pandemic shutdown and reopening.

Inventories and net exports can be significant swing factors for the final GDP growth figure. Net exports largely accounted for the decline in 1Q GDP, while inventories were the main culprit for the decline in 2Q. However, while private domestic demand, as gauged by final sales to private domestic purchasers, held up strong in the first three months of the year, it flat-lined in 2Q. Consumer spending growth slowed notably, while capex and residential investment declined, as high inflation and rising interest rates took a bite out of demand.

National Bureau of Economic Research

The NBER’s Business Cycle Dating Committee has been tasked with assessing when downturns are sufficiently deep, diffuse and persistent to constitute a recession. The committee monitors a broad range of indicators and moves deliberately. Some of the indicators they focus on include personal income, nonfarm payroll employment, employment as measured by the household survey, personal consumption expenditures, and industrial production. After raising interest rates last week, Fed Chairman Powell specifically mentioned the strength of the labor market as a key reason why he does not believe we are in a recession.

Business Surveys Moderate Further

Given that it covers April through June, the GDP report is more backward looking relative to the business surveys that come out at the beginning of each month. The manufacturing surveys, released Monday, remain consistent with further growth, albeit at a slower pace.

The ISM Manufacturing PMI edged down 0.2 points in July to 52.8 (above 50 signals expansion), its lowest level since June 2020, but above the consensus of 52.1. It is consistent with continued growth in manufacturing output and the broader economy, but at a slower pace than earlier in this cycle. According to the ISM, the latest PMI corresponds to 1.4% annualized growth in GDP. Growth narrowed across industries, with 11 reporting an expansion, the fewest since May 2020, while seven reported a contraction.

Given the loss in economic momentum that we are experiencing while the Fed continues to raise rates to fight inflation, we are maintaining our neutral stance toward stocks and favor the defensive Health Care and Utilities sectors along with cyclical Energy.

 


 

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