After a rough patch or two in the spring, stocks seem to be in better shape entering July amid hopes that the economy is starting to improve. At the same time, the Federal Reserve still expects to raise rates again later this year to continue battling inflation, while worries about the Chinese economy and the Ukraine war remain top of mind.
Sound familiar? That’s how things looked as July 2022 dawned. Perhaps you noticed some similarities with current conditions and recall last summer’s rally—which got underway in late June before peaking in August—turned into a head fake when Wall Street carved new lows in October.
There are solid reasons to hope that a 2022-type descent back into bear market depths is less likely. The markets finished the first half of 2023 near 14-month highs and performed far better than a year ago between January and June. Plenty of uncertainty remains, but the first half also saw real economic progress and even some life in the downtrodden earnings picture as the market climbed that proverbial “wall of worry.”
Midyear checkup
Before delving into what July might bring, here are some reasons to arguably feel positive as the first half closes:
- The Federal Reserve seems to have made real progress fighting inflation without collapsing the jobs market. Unemployment remains near record lows, wages continue to rise, and interest rates, while at 16-year highs, appear to be cresting. The Federal Open Market Committee (FOMC) paused its rate hikes in June.
- The May Consumer and Producer Price Indexes (CPI and PPI) recently hit multi-month lows on an annual basis, and consumer expectations for inflation over the next year are at two-year lows.
- Job openings remain near record highs, but initial jobless claims began climbing in June, traditionally a sign that the economy and the sizzling labor market might be slowing. Slower job demand would likely clip wage growth, possibly bringing inflation down further.
- A recent dip in stocks following the fierce spring rally was accompanied by the lowest volatility levels since before the pandemic, perhaps a sign that uncertainty remains light and dramatic market moves are less likely.
- The bank failures in March and May, partly attributed to the industry and the Fed not adequately adjusting to higher borrowing costs, haven’t spread to other institutions, and the credit market remains relatively unscathed so far. We’re not out of the woods by a long shot, especially with commercial real estate still vulnerable, but the credit market is functioning relatively normally.
- The first half saw companies fall into an earnings “recession” defined by two consecutive quarters of year-over-year S&P 500® earnings-per-share losses, and the current quarter is expected to make it three in a row. Even so, Q1 earnings ended up being far better than initially expected, and there’s hope that Q2 earnings might not be as big a disappointment as early estimates indicated. The jury is still out, and July marks the start of Q2 reporting season.
“Bad breadth” worries persist
Entering July, the top-heavy U.S. stock market faces a major challenge that could help determine whether the second half builds on this year’s gains or disappoints the way the later part of summer and fall did a year ago.
If you’ve followed Wall Street, you’re likely aware that much of this year’s rally got pulled along by last year’s bottom-dwelling info tech sector. This 180-degree turn by “mega-cap” tech stocks was driven in part by excitement over artificial intelligence (AI) that sent Nvidia NVDA up around 150% in the first half to a $1 trillion market capitalization. The tech-packed Nasdaq-100® (NDX) gained more than 30% between January and June. The S&P 500 index (SPX), dominated by the mega-caps like NVDA, Apple AAPL, Tesla TSLA, and Microsoft MSFT, climbed nearly 14%.
However, this wasn’t accompanied by widespread strength in the hundreds of smaller names that make up the biggest basket of Wall Street’s stocks. The S&P 500 Equal Weight Index (SPXEW), which weighs all 500 members of the index equally rather than by market capitalization, was up just 3% year to date by mid-June. This means the average stock simply didn’t keep up with the high-flying tech behemoths.
There were signs by mid-to-late-June that smaller stocks might be emerging from hibernation even as the mega caps appeared to run into what some called “overbought” territory. This trend, if it continues, would be welcome and perhaps lend the rally a second wind. It also might give these gains a dose of credibility, showing that trillion-dollar mega caps aren’t doing all the work themselves. Still, the “bad breadth” stock market remains a challenge as summer warms up.
As July dawns, keep an eye on key “cyclical” sectors like financials, industrials, and materials, some of which perked up in June. There appeared to be plenty of cash on the sidelines perhaps hunting lower-priced stocks. However, cyclical stocks—which tend to do best when the economy is humming along nicely—face sharp competition this year from 5% yields on short-term Treasury notes or even one-year certificates of deposit (CDs). If the cyclicals start performing better, that could reflect investors are feeling more optimistic about the economy outside of AI and are willing to take more risky positions in stocks instead of looking for possible “safety” in the Treasury market.
Yield signs
Speaking of Treasuries, they’re also worth monitoring in the weeks ahead. As stocks rose in May and June, Treasuries fell and yields, which move in the opposite direction of underlying notes, hit their highest levels in several months. The yield spread between 2-year and 10-year Treasury note yields remains inverted, traditionally a sign of possible economic troubles ahead. That spread widened in mid-June when the FOMC paused rate hikes but simultaneously projected further increases ahead. This put pressure on shorter-term Treasury notes most closely associated with short-term Fed policy, raising their yields.
When Treasury yields climb, borrowing costs rise for growth companies in sectors like tech and communication services and put pressure on those stocks. It also can hurt sectors like utilities and staples as investors can find better yields in Treasuries than in dividends from those types of companies.
Rising yields and hawkish Fed projections are sometimes accompanied by a rising dollar, which can pressure U.S. companies in tech, materials, and other sectors with heavy presences internationally. The dollar sank earlier this year but has stabilized versus other currencies in recent weeks at relatively high historic levels.
Will the labor market take a summer siesta?
The June Nonfarm Payrolls report comes out Friday, July 7, and analysts expect it to show 250,000 new jobs created, according to Trading Economics. That would be down from 339,000 in May but still historically high. Analysts have been underestimating jobs growth over the last year, and the May report was about 150,000 jobs above the average estimate.
However, investors might want to check for possible revisions to previous data, which could end up being nearly as important as the headline number. Wages are another key metric. They rose 0.3% in May, another warning sign of elevated inflation. Analysts expect a similar wage gain in June.
One wild card for the jobs report is the recent uptick to 20-month highs in Initial Weekly Jobless Claims the last few weeks near 260,000. This metric, which had fallen below 200,000 earlier this year, could be hinting at a softer labor market, which would probably raise spirits at the Fed as it tries to harpoon inflation.
Dialing up earnings
If stocks are to resume their spring rally, a healthy Q2 earnings season would certainly help. Big banks kick off reporting season in July, along with a number of major airlines, industrial stocks, and mega-cap tech names. As always, what the leaders of major banks say about the economy—especially the credit markets—could set the tone.
As it happens, this year’s stock market rally has been almost completely based on multiple expansion, meaning the forward price-earnings (P/E) ratio of the SPX is up significantly since January. The denominator of P/E hasn’t been able to grow even as the “P” rose from around 17 in January to around 19 today. That’s above the 10-year average of 17.3, according to FactSet. While the P/E is well below levels reached during the post-pandemic rally of 2021, it could put a psychological cap on rallies unless the earnings component shows signs of improvement in Q2 and Q3.
Big banks set the stage as some of the largest report starting July 14. This comes after the Fed’s latest “stress tests” that checked the banks’ capital cushions in case of hypothetical downturns. There was nothing hypothetical about the turmoil in regional banks earlier this year that led to several bank failures, so once again, the biggest banks will likely come under extra scrutiny this quarter.
Info tech is another critical sector featuring several major quarterly reports in July. Investors will brace for the latest on AI, the cloud, and the competitive semiconductor chip segments of tech as companies like MSFT, Alphabet GOOGL, Intel INTC, IBM IBM, and Micron MU are expected to report. AAPL and NVDA are August affairs, however.
Fed gets final word
Before August starts, there’s another FOMC meeting July 25 – 26, and the futures market is building in strong chances of a 25-basis-point hike to between 5.25% and 5.5%.
The Fed’s decision in June to “pause” rates while also projecting two additional increases this year puzzled some investors, and the market pulled back from its rally soon after the announcement June 14. Federal Reserve Chairman Jerome Powell and other Fed officials sounded as hawkish as ever in comments the week of June 18, reinforcing ideas that the June “pause” was really more of a “skip” before another move upward in July.
After most of the world’s central banks marched in lockstep to tighten lending conditions last year, it’s a drastically different picture today. The Fed’s June pause came amid continued hikes in Europe, Britain, and Canada, while Japan held steady, and China lowered its borrowing costs. This speaks to economic conditions varying across the globe and perhaps creating a more complex trading environment for fixed income investors.
China’s recent decision to drop rates for mortgages and corporate loans is probably the surprise of the bunch because many economists expected China to recover more quickly from last year’s shutdown.
While U.S. economic data including inflation, jobs, and retail sales will all catch investors’ eyes in July, one question going into the month is what China’s data might tell us. If that economic powerhouse starts emerging from its current tepid performance with the help of recent rate cuts, it might give U.S. stocks a summer breeze at their back.
TD Ameritrade® commentary for educational purposes only. Member SIPC.
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