July 2022 Market Commentary
August 11, 2022
Wall Street is full of adages. “Markets hate uncertainty” is perhaps the most well-known. “Markets climb a wall of worry”, is another. In July, markets strapped on their climbing harness and ascended the wall, even as economic uncertainty and concerns of a recession intensified. Despite 2Q22 GDP declining for a second consecutive quarter, the most common definition of a recession, and the Fed raising rates by another 0.75%, the S&P 500 recorded its best month since November 2020.
In the best of times, divining the economic and market tea leaves is challenging. Of late, it has been downright arduous. With nearly every recent data release, a glass-is-half empty, or half-full, argument can be made. Take GDP, for example. In 2Q22, economic activity contracted for a second consecutive quarter, satisfying the most common definition of recession. Yet the underlying details present a more nuanced view. First quarter’s decline was driven by a contraction in government spending, inventory drawdowns, and a surge in imports (net imports detract from the calculation of GDP). Second quarter’s decline was driven by further declines in government spending and inventory levels, as well as a downturn in business spending. Notably, and importantly, consumer spending, which accounts for ~70% of economic activity, remained positive, though it did decelerate sequentially in both quarters. Within spending, consumers continue to shift their focus from goods to services, reflecting ongoing pent-up demand for hospitality and leisure-related activities.
Another good example of the confused state of economic data is the labor market. Nonfarm payrolls added 2.74 million jobs in the first half of the year, better than the annual growth recorded from 2015-2019. June alone saw 372k new jobs created, while the unemployment rate remained unchanged at 3.6%, suggesting labor markets remain strong. Pessimists would argue, however, that the unemployment rate is a lagging indicator, providing little useful real-time insight into the economy. Instead, one should examine unemployment claims, considered more of a leading economic indicator, to gain a better real-time view of the economy. In July, unemployment claims rose to their highest level since November, suggesting slowing growth. Continuing claims, however, did not experience a similar rise suggesting that many of the individuals who lost jobs quickly found new employment opportunities.
Housing is perhaps the one sector where opinions are relatively consistent. After experiencing a strong post-pandemic recovery, rising mortgage rates have quickly sapped housing activity. New and existing home sales have slowed to their lowest levels since June 2020 and April 2020, respectively. Housing starts are at their lowest level since last September. Reflecting just how significantly rising rates have impacted the sector, mortgage applications fell in July to their lowest level in 22 years. While the decline in housing activity could have a spill-over effect into broader consumer spending- fewer houses sold equates to less spending on household items- it could also help improve historically low inventory levels as well as affordability, which now stands at its lowest level since 2006.
Hanging over every current economic and market discussion, like the sword of Damocles, is inflation. At 9.1%, headline consumer inflation now stands at its highest level since November 1981. Food and energy prices, to which most consumers are highly attuned, rose 10.4% and 41.6%, from the prior year, in June. Of late there have been signs of consumer fatigue in the face of higher prices. Several large retailers have reported noticeable shifts in spending patterns, with consumers focusing more on staples while eschewing non-discretionary items such as clothing and household items. Many economists expect inflation to begin slowing in the coming months, aided in part by gasoline prices which have fallen from a record high of $5.01/gallon to under $4.30/gallon. Inflation might also benefit from slower consumer spending that in turn could lead to increased discounting by retailers.
Until such time that easing prices are reflected in the official data, the Federal Reserve has few other options to fight inflation than raising rates, which it did so again, by 0.75%, at its July meeting. Lacking any ability to solve supply-side problems, the Fed’s only remedy for higher inflation is to reduce demand, thereby leading to price normalization. Currently, however, the Fed is in a precarious position as it attempts to raise rates despite growing signs of an economic slowdown. Perhaps, that is why Fed Chair Jay Powell stated after the July meeting that the Fed should return to making rate decisions on a “meeting by meeting basis and not provide the kind of clear guidance that had been provided” ahead of other recent meetings. To some, Powell’s comments seemed to intimate that the Fed might turn more “dovish” on policy, sooner than markets are otherwise anticipating.
While markets continue to face significant uncertainty regarding the trajectory of economic growth, in July they were encouraged by signs that inflation may be peaking and expectations that the Fed, at the margin, might not be as aggressive in raising rates as previously expected. In addition, the start of earnings season revealed that while companies are facing their own inflation-related challenges, not the least of which is defending margins, corporate earnings growth remains positive. That combination of factors resulted in large caps (S&P 500) gaining 9.1%, their best month since November 2020, while small caps (Russell 2000) jumped 10.4%. International market returns were mixed with developed markets (MSCI EAFE) gaining 4.9% while emerging markets (MSCI EM) fell 0.7%.
Similar to equity markets, fixed income markets enjoyed strong returns, with the Bloomberg US Aggregate Bond Index gaining 2.4%, its best month since August 2019. For Treasuries, July was a mixed month with yields at the short end of the curve continuing to climb higher on Fed rate hike expectations, while bonds maturing two years and beyond saw yields drop on concerns of slowing economic growth. The decline in longer rates intensified after the European Central Bank (ECB) raised rates for the first time in 11 years, and Italian PM Mario Draghi resigned. Both actions raised the specter of cracks in the European coalition, already under pressure from energy complications borne from Russia’s invasion of Ukraine. The stability and safety of the Treasury market grew in appeal as a result. Weaker economic data further fueled the Treasury rally to end the month, as did an impromptu comment from Fed Chair Powell declaring that U.S. interest rates were closing in on “neutral”, which the market took as an indication that rate hikes were nearing an end.
The municipal bond market saw its best month of performance since the rebound from the initial Covid scare in early 2020. The rally was the result of two factors: 1) recessionary fears sent buyers back into the fixed income markets, seeking the relative safety of Treasury and municipal bonds; and 2) the summer months have been heavy with municipal bond maturities, driving up reinvestment demand while supply has remained somewhat constrained. Demand had been very suppressed as the market struggled through the first half of the year, but signs of a pickup started to emerge in June and continued in July, helping drive prices higher.