The bulls remain in charge as the stock rally broadens in July

ANTHONY SAGLIMBENE – CHIEF MARKET STRATEGIST, AMERIPRISE FINANCIAL

WEEKLY MARKET PERSPECTIVES — July 31, 2023

Bulls drive momentum as bears remain cautious 

Importantly, the bullish narrative remains focused on a soft-landing economic scenario, with disinflation trends continuing to support a stable macroeconomic backdrop as price pressures moderate lower. The Federal Reserve nearing the end of their monetary tightening campaign, consumer resilience, and generally better-than-expected second quarter earnings reports have the bulls continuing to drive the market’s momentum. However, a higher-for-longer rate environment and a still strong economic backdrop that could prompt more rate hikes out of the Fed has kept the bears in the game and helped avoid a larger capitulation moment. Also, the lagging effects from aggressive rate hikes since March 2022, near-term overbought stock conditions, and stretched valuations have the bears remaining cautious and patient. In our view, net-net, the bulls may continue to grind the bears down if there is not a more meaningful shift down in earnings trends or economic activity in the third and fourth quarters, particularly if it increasingly looks like the U.S. economy will likely avoid a recession in 2024. That said, the bears can wrestle control of the market (at least temporarily) “if” profit growth in Q3 and Q4 looks like it is weakening instead of strengthening or if core inflation remains sticky and prompts further rate hikes. In our view, if there were ever a time for a generally balanced approach across a portfolio, this would be it.

Central banks signal continued vigilance against inflation

On the central bank front, after pausing rate hikes in June to wait for more economic data, the Federal Open Market Committee (FOMC) resumed rate hikes last week, raising the fed funds target rate by 25 basis points to a range of 5.25% - 5.50%. Since March 2022, the Federal Reserve has raised its target rate eleven times to help combat inflation (which we believe has successfully tamped down price pressures this year). The fed funds target rate now stands at its highest level since early 2001. Notably, markets largely shrugged off last week’s rate hike, as many investors are betting it will be the last for this cycle. However, the Fed’s policy statement and Fed Chair Powell’s comments after the announcement were clear —that is — more work is needed to bring down inflation. We believe the September and November meetings will likely be live meetings for further rate hikes should economic conditions warrant one or two more rate increases. Bottom line: While market odds suggest last week’s rate hike was the last, Mr. Powell and company left little doubt that they are willing to keep raising rates to bring inflation down once and for all. It could be a problem for the market if the Fed delivers on that promise. The next big Fed event will be at the end of August. The Federal Reserve of Kansas City will host its 45th annual Jackson Hole Economic Symposium Aug. 24-26. This year’s event is titled “Structural Shifts in the Global Economy.” Between now and Jackson Hole, a slew of Fed governors will provide their perspectives on rate policy and trends in the economy. However, we believe their commentary will mostly be background noise to earnings reports and economic data over the coming weeks, which could influence stocks more heavily as the dog days of summer kick in. 

Outside of the U.S., the European Central Bank (ECB) hiked its key target rate by another 25 basis points, noting that rates are set to move to sufficiently restrictive levels, implying further rate hikes could be necessary. And in Asia, the Bank of Japan (BOJ) kept short and long-term rates unchanged last week but said it would conduct greater flexibility around its yield curve control rather than imposing hard limits. Since Japanese investors are the largest holders of U.S. government debt and have sizeable positions in European bonds, markets will closely monitor the new flexibility.

U.S. economic trends remain firm

On the economic front, second quarter U.S. GDP grew +2.4% q/q annualized, coming in well ahead of the +1.5% estimate and showing the economy remained incredibly resilient in the first half, continuing to reflect solid consumer spending trends. The June core Personal Consumption Expenditures (PCE) Price Index softened to +4.1% y/y from the +4.6% pace in May. Notably, June Core PCE (the Fed’s preferred inflation measure) stood at its lowest level since September 2021. With one-year ahead inflation expectations sitting at +3.4% in the latest Michigan Sentiment Survey, July Consumer Confidence at its highest level since mid-2021, and job trends holding in a solid position, we believe it’s becoming more challenging to defend positions that continue to press a highly defensive stance. Bottom line: U.S. economic trends remain firm, inflation is moderating lower, and consumers are working and feeling better about the macroeconomic backdrop. That’s not to say there aren’t ongoing concerns or risks, but the data clearly shows a solid economic environment today. Stocks continue to move higher, partly because the U.S. economy is growing at an above-average pace, price pressures are moderating, and aggressive Fed actions have thus far not derailed activity. While near-term stock conditions may be stretched, we believe the dynamics driving stock prices higher appear supportive of the generally upward trend this year.

Turning to corporate profits, with 51% of second quarter S&P 500 earnings reports complete, 80% of companies are beating earnings per share (EPS) estimates, while 64% are beating revenue estimates. While more companies are beating EPS estimates on average for Q2, the beat rates are lower than average, and revenue surprises to the upside are coming in below average. Notably, while disinflation trends across the economy are good for consumers, the pricing tailwind companies have enjoyed for several quarters may be waning. And while companies continue to point to labor inflation and elevated commodity costs as reasons to hold pricing power, investors are concerned normalizing demand could limit companies’ ability to maintain current profit margins over coming quarters.

This week, over a third of S&P 500 companies will report Q2 profit results and against critical updates on employment trends and other key economic data. Apple Inc. and Amazon.com Inc. reports on Thursday will be closely watched. The June Job Openings and Labor Turnover Survey (JOLTS) report drops on Tuesday, as does July ISM Manufacturing. Wednesday brings the July ADP Private Employment report, while Thursday sees July ISM Services and final looks at July S&P Global PMIs hit. Outside of earnings reports this week, Friday’s July nonfarm payrolls report will likely be the week's highlight for investors, particularly for what it may mean for forward Fed policy. FactSet estimates call for job growth to slow to +200,000 in July from +209,000 in June. In addition, the unemployment rate is expected to hold steady at 3.6% in July. This year, the U.S. economy has added over +1.5 million new jobs, averaging over +272,000 jobs a month in 2023. With employment trends continuing to remain solidly positive, some investors are concerned further Fed rate hikes may be necessary to slow employment growth and act as a catalyst to help further reduce inflation pressures. This week’s employment reports may help add credibility to that argument or possibly help to ease some of that concern.