Healthy Breadth

July 31, 2023

By Ellen Hazen, CFA, Chief Market Strategist

July Takeaways:

  • The US economy continues to chug along. June new jobs (reported in early July) reached 209,000, a bit lower than the expectation of 230,000. Inflation has continued to decline: the headline Consumer Price Index came in at 3.0%, down from a peak of 9.1%, while the Core CPI was reported at 4.8%, down from a peak of 6.6%.
  • At its July 26 meeting, the Federal Reserve (Fed) increased the Federal Funds rate by 25 bps, to 5.50% (upper bound). The market is currently expecting one more increase in the fall, followed by cuts starting late in 2023 or early in 2024.
  • As Q2 earnings have been reported, analysts have trimmed full-year 2023 estimate growth a bit, from  -1.6% at the beginning of the month to -1.9% now. Earnings so far have been modestly better than expected. Sales growth has averaged 2% while earnings growth has averaged 4%.
  • Smaller stocks outperformed larger stocks, with the small-capitalization Russell 2000 Index appreciating by 5.8%, compared to the large-capitalization S&P500 at 3.0%. This continues the broadening out of the market that started in June. On a year-to-date basis, the large companies have still dominated index performance: the S&P500 is up 20.5% while the Russell 2000 is up only 14.4%.
  • Bonds were generally flat in July. This brings the year-to-date total return of the Bloomberg Intermediate Government / Credit Index to 1.7%. Bond spreads tightened modestly in the month.
  • Q2 GDP was reported at 2.4%, in line with the Atlanta Fed’s GDPNow tracker and well ahead of economists’ expectations of only 1.8%.

What We Are Watching in August

  • Continued second quarter earnings reports. Analysts are estimating a decline of 8% year-over-year.
  • Will inflation continue to decline? July CPI will be reported on August 10; economists are expecting core CPI to ease slightly, from 4.8% to 4.7%, and headline CPI to increase slightly, from 3.0% to 3.2%.
  • New jobs for July will be reported on August 4. Economists are estimating another 200,000 jobs.
  • The Fed’s annual retreat takes place at Jackson Hole, WY, August 24-26, with Chair Jerome Powell speaking.

Last month we discussed the narrowness of the US equity market, and the underlying drivers of the rally in the first half of 2023: positive sentiment, liquidity, and concentration. Over the past two months, the US equity market has materially broadened out. The five largest stocks are still very positive for the year, but as we had expected, the rest of the market is beginning to catch up. The chart below shows that in both June and in July, the smaller-capitalization Russell 2000 outperformed the S&P500. This broadening out of the market is a healthy development and bodes well for continued positive returns for the rest of the year.

Economic data is more positive than negative on balance. US households still have “excess savings” from COVID checks. The unemployment rate remains very low, at 3.7%. Consumer credit remains strong: credit card delinquencies (30 days) have increased to 1.1% from a pandemic low of 0.8% but remain well below the 2019 average of 1.5%. Second quarter GDP was much higher than expected, at 2.4% (vs 1.8% expected), and the Atlanta Fed GDPNow is forecasting GDP to accelerate to 3.5% for Q3.

The Fed’s effort to slow the economy is having some impact. At over 7%, 30-year mortgage rates are materially higher than the sub-3% rates of early 2021, which has cut existing home sales by a third. Bank lending has slowed as well, with commercial and industrial loans held by banks about 2% lower than the recent peak. The Fed’s quarterly Senior Loan Officer Opinion Survey, published this week, shows that banks are significantly tightening lending standards and increasing the interest rates charged on those loans.

Corporate data is also mixed. Although 82% of companies reporting Q2 earnings thus far have been higher than consensus estimates, increases in company guidance are modest at only 8%. Analysts currently expect a sharp re-acceleration in earnings growth in Q3, and especially in Q4 and 2024, but we are not yet seeing this in company guidance.

On top of this, after a 20% year-to-date return and estimates that have declined by 2%, the price-to-earnings estimate of the S&P500 has increased by 22%, from 15.4 times (15.4x) 2024 earnings at the beginning of the year to 18.8x 2024 earnings today.

When we look at the big picture, we see most consumers in decent shape, companies reporting better than expected earnings, and a still-growing economy. We also see a Fed that is determined to continue to quell inflation and a market that has gone nearly straight up all year. The increased market breadth since May is a positive sign and reflects a healthier market than the one in the first few months of the year, which was dominated by a handful of companies. As we look toward the rest of the year, we expect continued broadening of market performance, tempered by higher starting valuations and the possibility of further slowing from the cumulative impact of sixteen months of Fed tightening. Our investment stance is to continue to stay high quality, while selectively increasing exposure to cheaper areas of the market. These include smaller companies, select healthcare and financials companies, and companies positively exposed to growth areas of the market such as renewable energy and domestic manufacturing.


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