Red-hot inflation data cools stocks, S&P 500 drops nearly 1%

When navigating the financial markets, the long-term investor must keep in mind the four basic dimensions of long-term returns – reward, risk, cost and time – and must apply them to every asset class. Never forget that these four dimensions are remarkably interdependent. – John Bogle 

Higher than expected inflation data, worries over a more aggressive Federal Reserve and unimpressive quarterly earnings from the big money center banks all contributed to another down week on Wall Street. The biggest loser was the technology-heavy Nasdaq Composite Index, which lost about 1.6%, while the S&P 500 Index shed nearly 1%. The results could have been much worse, but the market rallied from steep losses early in the week to keep those losses to a minimum. In anticipation of a red-hot June consumer price index (CPI) print on Wednesday, stocks sold off and rightly so as the headline number increased 9.1% from a year ago, higher than expected and the highest level since November 1981. Core CPI that excludes food and energy prices also was higher than forecast, prompting speculation that the Federal Reserve would raise interest rates by a full percentage point at its meeting in late July. But commodity prices have fallen in recent weeks and the price of crude oil has dropped to below $100 a barrel while housing prices have also come down. These declines may have signaled that inflation has peaked and could trend lower in coming months. Fears of a global economic slowdown also saw the yield curve between the 2-year Treasury and the 10-year Treasury invert as the 2-year yield of 3.13% exceeded the 10-year yield of 2.93%, a difference of 20 basis points. (A basis point is one hundredth of one percent). This difference is the widest since 2000 and could be an ominous sign that a recession is around the corner. Earnings season also got off to a rocky start as JP Morgan Chase and Morgan Stanley both missed revenue and earnings estimates. JP Morgan was forced to add to its reserves for bad loans and Morgan Stanley reported worse than expected investment banking revenue. The next day it was a mixed bag as Wells Fargo’s profits fell nearly 50% as it missed earnings estimates while Citigroup managed to report better than expected earnings as it benefited from a rising interest rate environment. Earnings season has a long way to go, and it will be interesting to see if companies lower their profit forecasts due to rising prices, slowing economic growth and an aggressive Federal Reserve.

Last Week

The producer price index (PPI) in June rose 11.3% from a year ago, higher than forecast, as energy costs were primarily to blame. Core PPI that excludes food and energy was up 6.4%. Retail sales in June increased more than expected and rebounded from a decline in May, but the increase was mainly due to higher inflation. Weekly jobless claims rose to 244,000, the highest level since November 20 ,2021. The University of Michigan consumer sentiment index in July was slightly better than anticipated but still at a low level.

For the week, the Dow Jones Industrial Average fell 0.2% to close at 31,288 while the S&P 500 Index dropped 0.9% to close at 3,863. The Nasdaq Composite Index declined 1.6% to close at 11,452.

This Week

June housing starts are expected to be higher than in May but at the lowest levels since April of last year while June existing home sales are expected to drop for the fourth consecutive month. June leading economic indicators are forecast to be lower and match the decline in May.

The European Central Bank (ECB) meets this week and is expected to raise its key interest rate by 25 basis points from negative 0.5% to negative 0.25%. The Bank of Japan (BOJ) is expected to leave its benchmark interest rate unchanged at negative 0.1%.

The most notable companies scheduled to report second quarter earnings this week are Bank of America,  Charles Schwab, Goldman Sachs, Travelers, American Express, IBM, Netflix, Tesla, Halliburton, Baker Hughes, Schlumberger, Johnson & Johnson, Abbott Labs, Lockheed Martin, CSX, Dow, Union Pacific, D.R. Horton, AT&T and Verizon.

Portfolio Strategy

The primary focus for investors this week will be on second quarter earnings as a broad array of companies from a diverse group of sectors are scheduled to report. Last week was dominated by financial companies and banks and the earnings results left a lot to be desired. Although it is still very early in the earnings season, 35 S&P 500 companies have reported so far and 80% of them have topped expectations. While that’s a good start, it’s a relatively small sample size. Companies are dealing with several headwinds and most strategists expect the second quarter earnings season to contain disappointments and downward revisions of estimates going forward. High inflation, slowing economic growth and recession fears, supply chain issues and Federal Reserve tightening of monetary policy have affected corporate profit margins and have made it difficult to forecast future earnings. Continued strength in the dollar could also negatively impact corporate profits, especially for those multi-national companies that generate much of their revenue from overseas. Right now, second quarter earnings are expected to increase about 6% and expectations are rather low as earnings season get into full swing. If the earnings beat rate continues and companies maintain their forward earnings guidance for the balance of the year, stock investors might be in for a pleasant surprise in terms of performance. The other important economic reports to watch this week involve housing data, which could be affected by the sharp rise in mortgage rates this year as inflation has surged and the Fed has raised interest rates to combat the high prices.