From the Newday Desk — August 8, 2022

The market had a strong week with Consumer Discretionary and Information Technology leading the charge. However, a negative catalyst in the form of exceptionally strong jobs numbers proved to be a headwind for the rally. As global economic data has been slowing in some areas, speculation has been mounting that a dovish pivot from the Fed might materialize sooner than the capital markets were expecting. I believe Friday’s data makes that outcome less likely. This gives evidence to support the more hawkish narrative that underlying economic strength should be able to sufficiently absorb the Fed rate hikes without causing a major recession or threatening financial stability. One thing that caught my attention is St. Louis Fed President, James Bullard, the FOMC’s most hawkish voice, has been saying he thinks the US can avoid recession despite his more headline-grabbing comments on the need for aggressive tightening.

Many investors are also focused on rising US-China tensions around Nancy Pelosi’s trip to Taiwan. The Chinese are conducting choreographed outrage and saber rattling over Taiwan, but for now an outright conflagration has been avoided. China has conducted provocative actions. My concern is Xi Jingping is going to further consolidate his leadership power and make a statement to the people via Taiwan. Geopolitical risks have typically been able to be shrugged off by the market in the past decades. However, in my opinion, what is at stake now is whether we are shifting to a secular period of less international economic integration which effectively means higher prices and less economic efficiency. A sustained reversal of globalization/trading may reduce efficiencies in economies across the world and generally could result in sustained inflationary pressure. So, we are paying attention to the changing international landscape and renewal of great power competition. It may be of great consequence for capital markets going forward.

Last Friday saw a very positive jobs report where US employers added more than two times the number of jobs expected by Wall Street analysts. The market went down on the news because this means those hoping for a quick pivot of Fed policy back toward accommodation will likely be disappointed. Nonfarm payrolls came in at 528,000 and this was the highest level in five months. The prior month’s figures were revised upward as well. Wage growth accelerated, and the unemployment rate fell to 3.5% which ties with a five-decade low. After the release the dollar surged. Prospects for a further 75-bps hike in September also rose in Fed Future markets. This is in line with my base case scenario.

Treasuries declined after the strong labor data. The 2-year moved past 3.20% and the 10-year went above 2.8%. Energy stocks fell this week. There was also very little evidence of cooling across different sectors. Even construction, which is interest rate sensitive, did not show the slowing one might expect. Some economists began speculating that the persistent strength in labor markets might suggest that the neutral rate is higher, perhaps significantly so, than the 2.5% level that has been cited in recent months. If this is the case, the Fed will likely increase interest rates more than markets currently expect. In any event, those who were expecting the Fed to dust off its dovish wings in 2022 may be sorely disappointed. It is possible that declining asset values and the pinch on consumer wallets from inflation are driving more prime-age workers to search for jobs. The Newday equity team has seen evidence in soft data that weakness in labor markets will manifest in the coming months.

There was a lot of apprehension about this earning season. The “Big Tech” earnings reports largely held the line despite absolute misses, aside from Meta, and suggested there was a lot of bad news already priced in. Indeed, the market response to both upside and downside surprises has been well below historical averages this earnings season. If you exclude the Energy sector, then net income is on track to drop around 3.2% which means even though we may not be in the economic recession many had feared, we are likely in a profits decline of a moderate variety. However, it is important to note that while this quarter’s earnings have not brought the pain some feared. growth expectations are coming down significantly for the second half and for 2023. For example, analysts now forecast that 3Q net income, again not including the Energy sector, might rise at only 2.3%. At the end of last quarter this expectation was 5.4% so it has come down by more than half. I like this because this likely plays to our stock selection capabilities.

Many investors have attributed a lot of the market declines to the high P/E stocks experiencing multiple contraction associated with rising rates and declining liquidity. However, for mega-cap stocks as a group, I believe it is important to remember that profits have contracted on a YoY basis over the same period rates were rising. Some of this is tougher comparisons for companies that benefited from anomalous pandemic demand, but the weakness is observable, and in my opinion does not appear to be over, yet. So, there is a lot of noise in the data. One key thing that I am focused on is whether growth can outpace inflation. A major feature of bear markets in the post-war period, is that inflation outpaces growth. The most recent employment number is heartening for those who would like to see growth again eclipse inflation sooner rather than later.