Bank earnings strong but stocks close lower on inflation fears

There seems to be an unwritten rule on Wall Street. If you don’t understand it, then put your life savings into it. Shun the enterprise around the corner, which can at least be observed, and seek out the one that manufactures an incomprehensible product. – Peter Lynch

The three major stock averages posted record highs to start the week as optimism grew over the second quarter earnings season, but by Friday’s close the gains had vanished and stocks finished the week in the red. The biggest loser was the technology-heavy Nasdaq Composite Index with a loss of nearly 2%. The decline in the stock market certainly could not be blamed on earnings as the major banks such as JP Morgan Chase, Bank of America and Goldman Sachs kicked off the reporting season with excellent results. As a group, the banks and other financial companies beat estimates by over 25% on average. But expectations are for 65% earnings growth for S&P 500 companies from the same period a year ago and much of that good news is already priced into the market. Investors were also spooked again by the inflation data as both the consumer price index (CPI) and the producer price index (PPI) in June jumped and were higher than expected. The CPI has now risen 5.4% from a year earlier, the biggest increase since 2008 just before the worst of the financial crisis. Despite the worrisome rise in inflation, though, Federal Reserve Chairman Jerome Powell in his testimony before Congress still maintained that he expects inflation to moderate by the end of the year. He also said that the economy still has to make ‘substantial further progress’ towards its goals before it will consider changing its easy monetary policies. In his words, the labor market has improved but still has a long way to go.  Apparently, the bond market was in agreement with those remarks as the yield on the 10-year Treasury ended the week at just 1.31% with the yield curve continuing to flatten. The second quarter marks the peak in economic or GDP growth and earnings growth and both are expected to decelerate and slow in subsequent quarters. To be sure, growth should remain positive but both the economy and the markets are entering a more uncertain period at a time when stocks are priced near their all-time highs.

Last Week

Both the June core CPI and PPI data that excludes food and energy prices were higher than expected but most of the price increases came from sectors most affected by the shutdown caused by the pandemic – used car prices, air fares and transportation costs. Weekly jobless claims fell by 26,000 to 360,000, a 16-month low. The University of Michigan consumer sentiment index in early July fell to its lowest level in five months on inflation worries.

The Federal Reserve Beige Book for July showed the economy strengthened with moderate to robust growth, but many businesses struggled to hire people even though millions are still unemployed.

For the week, the Dow Jones Industrial Average lost 0.5% to close at 34,687 while the S&P 500 Index fell 1.0% to close at 4,327. The Nasdaq Composite Index declined 1.9% to close at 14,427.

This Week

Existing home sales for June are expected to approximate the number in May and have declined for four straight months while June housing starts are forecast to be slightly higher than in May. June leading economic indicators are expected to increase but slightly less than in May, which was a solid number.

The European Central Bank (ECB) meets to review its monetary policy and is widely expected to keep its short-term interest rate unchanged at negative 0.5%.

Among the most notable companies scheduled to report quarterly earnings this week are IBM, Netflix, Texas Instruments, Intel, Coca Cola, Chipotle Mexican Grill, Kimberly Clark, Philip Morris International, Travelers, Northern Trust, American Express, CSX, Union Pacific, Nucor, Honeywell International, Johnson & Johnson, Abbott Labs, Newmont, Southwest Airlines, Halliburton, Baker Hughes, Schlumberger, Verizon and AT&T.

Portfolio Strategy

With little in the way of economic reports on the calendar this week, the focus for investors will be squarely on second quarter earnings. Unlike last week when the earnings reports were dominated by banks and financial companies, this week’s agenda includes a diverse group of companies representing a broad range of sectors. Although the banks easily beat earnings estimates, their stock prices moved lower instead of moving higher, suggesting that the good news was already priced in to their stocks. A more troubling development last week was the decline in the yield of the 10-year Treasury to 1.31%. With the recent spike in inflation and the expectation that economic growth would be strong for the rest of the year, most economists had forecast that the 10-year Treasury yield would rise and approach 2% by year-end. Lower bond yields typically are positive for technology and other growth stocks but the technology-laden Nasdaq Composite Index was the worst performing index last week. The drop in the 10-year Treasury yield may be signaling that the economy is not as strong as many people had thought and could slow with the continued surge in new positive cases of the Delta variant of the coronavirus. Part of the reason for the decline in the 10-year Treasury yield can be explained by less new issuance of securities by the Treasury and the yield advantage of U.S. government securities over comparable yields overseas. Of equal concern could be a sooner than expected hike in interest rates by the Federal Reserve due to higher inflation, which could also slow the economy.