Will good news for the economy mean bad news for stocks?

ANTHONY SAGLIMBENE – CHIEF MARKET STRATEGIST, AMERIPRISE FINANCIAL

WEEKLY MARKET PERSPECTIVES — August 21, 2023

Evidence points towards a soft landing

A batch of retail earnings reports last week showed results that needed to be taken case-by-case, but overall, confirmed the consumer remains resilient. Home Depot beat estimates but warned spending on big-ticket items has seen pressure, while Walmart exceeded Q2 estimates driven by a 24% jump in e-commerce. Target, TJX, and Ross Stores reported results, guidance, or inventory and freight cost trends that largely satisfied investors.

But stocks were principally driven lower last week due to the backup in interest rates and subtly changing views on how much higher the Federal Reserve will need to raise the fed funds target rate to help once and for all crush the back of inflation. At one point, the 10-year U.S. Treasury yield hit 4.33%, its highest level since 2007. Similarly, 10-year TIPS yields (a form of protection against rising inflation) hit their highest levels since 2009. A batch of stronger-than-expected economic data last week, including a July retail sales report showing consumers continued to spend at a healthy clip, sent bond yields higher across the curve. 

Bottom line: Yields are climbing higher because there is building evidence that the U.S. economy is headed for a soft landing. The Atlanta Federal Reserve’s GDPNow forecast currently points to an eyepopping +5.8% growth rate in the third quarter, while our estimate for Q3 growth stands at +3.0%. But faster-than-expected growth could lead to the Federal Reserve raising rates more aggressively in an effort to pump the brakes and slow activity more quickly, which risks a scenario in which the economy eventually falls into a recession. Month-to-date, the 10-year Treasury yield has climbed nearly 30 basis points. As a result, the outlook on long-duration assets (such as stocks) has dimmed a bit in August. Simply, as rates have climbed higher this month, the value of a company’s future profits has become less valuable when discounted back to the present. Unsurprisingly, areas of the market focused on Growth, Technology, and Small-Caps have seen outsized selling pressure in August compared to Value as well as the broader S&P 500. Valuations in these select areas are more closely tied to their profit “potential,” hence their sensitivity to rates has led to steeper MTD declines. 

Cumulative effects of tighter policy remains uncertain

Helping to shed a little more perspective on Fed policy last week, the July FOMC meeting minutes showed “almost all” participants believed a quarter-point rate hike last month was appropriate. However, “a couple” members noted holding rates steady would be appropriate. Notably, the minutes reflected that a gradual slowdown in economic activity appeared to be in progress, despite a solid first half. Yet, the Federal Reserve wants to see further evidence that inflation is headed to its 2% target before deciding to change its current policy course. And while growth trends remain solid (evidenced by our comments above), some participants felt it necessary to balance the risks of inadvertently overtightening policy versus not doing enough to curb inflation pressures for good. Here, the minutes reflected the risk of the cumulative effects of prior rate hikes leading to a sharper downturn than what most expect. Bottom line: The minutes reflected some optionality for the Fed should they need to hike rates further while acknowledging there remains some uncertainty on the cumulative effects of tighter policy on the economy — particularly on the labor market. All that said, most of the market continues to see the Fed holding rates steady in September. Yet odds have come down that rates will be materially lower by the spring of 2024. At this week's annual Jackson Hole event (Thursday through Saturday), investors will get another chance to game where Fed policy may be headed. Fed Chair Jerome Powell will speak at the event on Friday, August 25, though expectations are low that he will provide any meaningful hints on the direction of policy from here. This year’s conference theme is titled “Structural Shifts in the Global Economy.” 

Good news on the economy may mean bad news for stocks

Last week’s stronger-than-expected July retail sales report, hotter import and export data, lower-than-expected inventories, new home market strength, and improving industrial and manufacturing trends all point to a resilient economy. Thus, we could be moving into a period of good news on the economy may mean bad news for stocks. Moving forward, investors likely want to see some softness in incoming data, which remains firm but not hot enough to imply further Fed rate hikes. In our view, the following items are also weighing on stock prices in August:

• Overbought conditions and stretched valuations coming into the month.
• Weakening near-term trading trends as we have moved through the month.
• Five months of consecutive gains without much of a correction or pause.
• Rapidly rising bullishness among investors (contrarian indicator).
• Deteriorating economic trends in China.

Taken in total, we believe these conditions have cooled buying momentum in August. And with bonds and cash-like investments offering real competition for new money today, stocks are finally seeing some increased headwinds. By the way, the 11% decline in Apple Inc. this month (the largest stock by market-cap weight in the S&P 500) certainly isn’t helping overall market conditions either.

Bottom line: A roughly 5.0% decline in the S&P 500 from its recent peak is hardly an all-clear signal for investors. With the S&P 500 still trading well above its 100-day and 200-day moving averages, elevated interest rates, weak seasonality factors, and concerns about a more aggressive Fed, we suspect the bears may look to press into the weakness. However, this month’s modest declines have helped to smooth near-term overbought conditions, which is a slight positive for the bulls looking for an excuse to challenge the selling pressure. Regardless of how markets trend over the very near term, a slightly defensive but generally balanced portfolio continues to be a prudent way to position for a seasonally weak period for stocks, in our view.

Looking ahead this week

Although the Q2 earnings season is essentially complete, this week’s batch of retail sales reports from Lowe’s, Advanced Auto Parts, Bath & Body Works, and Dollar Tree will provide investors with further insight into the consumer's health. However, Wednesday’s Q2 earnings report from NVIDIA will likely be the earnings report the market keys in on. The semiconductor giant has created the potential for a very lucrative opportunity across Artificial Intelligence in the coming years, as its graphics processing units (GPUs) are the backbone of the advanced technology. While the application of AI across industries, how end users will use the technology and the ultimate winners/losers in the economy have yet to be written, investors clearly see NVIDIA as an early winner in the arms race to advance AI. The chip stock is up over +196% year-to-date and trading at a forward price-to-earnings (P/E) ratio of nearly 42X next year’s earnings per share. Needless to say, a high degree of optimism is already reflected in the stock price today. That optimism regarding the future has also contributed to carrying broader indexes like the NASDAQ Composite, NASDAQ 100, and S&P 500 Technology Index higher this year. Look for this week’s profit results out of NVIDIA to either help stem some of the recent selling pressure across stocks or add to the volatility.

This week's key economic releases are preliminary looks at August manufacturing and services activity, home sales, and a final look at August Michigan Sentiment. Particularly on the manufacturing and services front, stronger-than-expected results could be greeted by the market as a negative, as it may imply tighter Fed policy over the coming months.