Throughout my financial career, I have continually witnessed examples of other people that I have known being ruined by a failure to respect risk. If you don’t take a hard look at risk, it will take you. – Larry Hite, hedge fund manager
Stronger than expected economic data last week eased recession fears and the major stock averages responded with gains. The biggest beneficiary was the technology-laden Nasdaq Composite Index, which posted its fifth consecutive up day and rose nearly 5% while the S&P 500 Index turned in a solid performance with a gain of nearly 2%. The most important piece of economic data released last week was the June employment report, which showed that 372,000 new jobs were created, much higher than estimates of 260,000, and that the unemployment rate remained unchanged at 3.6%. Average hourly earnings increased modestly and were slightly less than in May, a hopeful sign that could lead to lower inflation. Minutes from the June Federal Open Market Committee (FOMC) meeting showed that the Fed is firmly committed to bringing down inflation and pointed out that the July meeting would likely see another 50 or 75 basis point (a basis point is one hundredth of one percent) move higher in interest rates. While Fed officials acknowledged that tightening monetary policy could slow the economy, they believed that returning inflation to its 2% target is essential to achieving maximum employment. They also lowered their GDP forecast in 2022 to 1.7% from 2.8% and cited the war in Ukraine, ongoing supply chain bottlenecks and Covid lockdowns in China as concerns. The Fed’s aggressive stance on fighting inflation coupled with the strong jobs data sent Treasury yields higher as the 2-year ended the week at 3.11% and the 10-year finished at 3.08%, a slight inversion of the yield curve which can portend a recession. Another hopeful sign last week was the continued weakness in commodity prices as the price of oil tumbled and is down nearly 20% from its high. Other commodities such as metals and minerals, agricultural products and forest products have also seen their prices drop in recent weeks. Perhaps the Federal Reserve’s policies are working and inflation will continue to decline, allowing the Fed to pause its tightening cycle and avoiding an economic slowdown or a recession.
The ISM services sector index for June was better than expected but slightly lower than the reading in May. The number was solidly above the 50 threshold, indicating that growth remains strong. Weekly jobless claims were 235,000, an increase of 4,000 and slightly more that the estimate of 230,000. The JOLTs report for May showed that job openings totaled 11.25 million, considerably lower than in April, but still about twice the number of people looking for work. With so many job openings, a recession becomes more and more unlikely.
For the week, the Dow Jones Industrial Average rose 0.8% to close at 31,338 while the S&P 500 Index added 1.9%% to close at 3,899. The Nasdaq Composite Index jumped 4.6% to close at 11,635.
The consumer price index (CPI) is expected to increase nearly 9% year-over-year in June while the producer price index (PPI) is forecast to rise nearly 11%. Core CPI and PPI, which exclude food and energy prices, are expected to decline slightly from their record high levels in March. Retail sales in June are expected to increase nearly 1% after declining in May as consumer spending remains fairly strong. The University of Michigan consumer sentiment index for July is forecast to be the same as in June, a record low for the index.
Second quarter earnings season begins this week and the most notable companies that are scheduled to report include JP Morgan Chase, Citigroup, Wells Fargo, Morgan Stanley, BlackRock, PNC Financial Services, State Street, U.S. Bancorp, PepsiCo, Conagra Brands, Delta Airlines, Cintas, UnitedHealth Group and Taiwan Semiconductor Manufacturing.
This week could be another volatile one for the stock market as it marks the beginning of second quarter earnings season and key inflation data will also be released. The big money center banks will dominate the earnings reports and investors will be watching to see if higher yields translate into higher profit margins. Banks may also be forced to increase their loan loss reserves to weather a recession if one should occur. Bank stocks have already fallen sharply this year and probably have priced in a shallow recession. With the S&P 500 having dropped 18% so far this year and in a bear market, the price earnings ratio is now about 16, its historical average, compared to about 22 at the start of the year. The decline in stock prices has largely reflected the increase in bond yields as analysts’ earnings estimates have remained mostly unchanged for 2022. But with economic growth slowing and inflation surging, the worry is that profits will be lower than expected both in the second quarter and the balance of the year. Probably more important than the actual earnings announcements themselves will be the guidance that companies issue for the rest of the year. Right now, second quarter earnings for the S&P 500 are expected to grow by about 6% with third and fourth quarter estimates roughly 10%. If expectations are too high and must be adjusted downward, the stock market may be vulnerable. Investors will also be focused on the consumer price index (CPI) and the producer price index (PPI) for June as both are expected to remain elevated and will likely mean another 75-basis point increase in the federal funds rate when the Federal Reserve meets later this month. Fortunately, core inflation, which excludes food and energy prices, could be lower and the price of West Texas Intermediate crude oil has fallen in July from over $120 barrel in June to about $100 a barrel. Other commodity prices have also declined, which should help lower inflation and hopefully make the Fed’s job easier.