The market volatility continued in July, but to the upside this time. From a sea of red exiting the first half of 2022, July saw a 9.1% rally in the S&P 500 and a 12.4% gain in the NASDAQ. The rise in stocks was broad based and even the small cap Russell 2000 was higher by 10.4% for the month. International markets also participated but not to the same extent. The Euro STOXX 600 was higher by 7.6%, the Nikkei rallied by 5.3%, and the South Korean Kospi rose 5.1%. After outperforming through June, the Shanghai composite index was lower by 4.3% in July.
I attribute the rally to a few different factors, and none have to do with a better economy. Firstly, sentiment got really dour in June when the markets hit their lows of the year and that is typically a good contrarian setup for a counter-trend rally. Measuring sentiment by the Investors Intelligence and American Association of Individual Investor surveys we saw a much greater number of bears relative to bulls. The second factor I cite is the belief on the part of markets that the Fed might just be closer to the end of its rate hiking cycle, or at least will be slowing the pace soon. Hopes that inflation is peaking out in terms of its rate of change and worries about a recession create the belief that the Fed will back off its rate hikes. The last factor is the still decent earnings season, which as of this writing, is about half way done. While the rate of growth is slowing and profit margins are contracting, there were fears of worse.
As for the US economy, and the global one for that matter, it is in an economic downturn whether we want to call it a recession or not. The Q2 US GDP report released at the end of July saw a .9% pace of contraction after a 1.6% decline in Q1. Leaving the semantics debate to others on whether this marks an official recession or not, I expect Q3 growth to slow further. This is in response to high inflation which is negatively impacting consumer spending behavior. It is also in response to the rising cost of capital along with international trade that is slowing as Europe struggles with skyrocketing energy prices and China is experiencing the self-inflicted wounds of its strict Covid policy, along with the deterioration in its residential real estate market.
The worries about global growth and the thought that inflation is peaking, culminating in the bet that the Fed is almost done raising rates, saw interest rates fall around the world in July. The US 10 yr. note yield fell from 3.01% at the beginning of July to 2.65% by the end. As the 2 yr. note yield was down by just 7 basis points to 2.89%, this important 2s/10s relationship inverted to the greatest extent since 2001. It’s another sign that the Treasury market is betting on a recession. Corporate credit also rallied on the fall in Treasury yields.
The monetary tightening continued throughout the world in July as the Federal Reserve, European Central Bank, Reserve Bank of Australia, Bank of Canada, the Monetary Authority of Singapore, the Bank of Korea, the Reserve Bank of New Zealand and central banks in Chile, the Philippines, in Malaysia, Hungary, Poland and Romania all moved to raise the cost of capital. The only one of note that has stood its ground has been the Bank of Japan where its yield curve control policy was left intact with no sign yet of when that might change.
The Federal Reserve
In July, the Fed raised the fed funds rate by 75 basis points for a second straight meeting to 2.25-2.5%. That was where the Fed took this rate to in the fourth quarter of 2018 before backing away from doing more. This time however, the consumer price index in July reached 9.1% and that is why the Fed will keep on hiking in September, but more likely by 50 basis points. At the same time, quantitative tightening continues, but only at half of the $95b pace that will be reached in September. So while the Fed will decelerate its rate of interest rate increases soon, it will accelerate QT.
As the rate hikes have been well priced into markets, the focus is more on when the Fed will stop. However, with inflation so high, even though it should start to slow in the quarters to come, it will still remain well above its 2% target for a few more years. The rise in the cost of capital has had an immediate impact on the most interest rate sensitive part of the US economy, that being housing.
July also saw weaker than expected housing data as a 20% y/o/y increase in home prices, and a 40% rise over the past two years along with the sharp rise in mortgage rates badly damaged affordability, especially for the first time home buyer. Single family housing starts, new home sales, existing home sales, pending home sales and the National Association of Home Builders (NAHB) sentiment survey all missed expectations. The purchase component of weekly mortgage applications reported by the Mortgage Bankers Association fell to the lowest level since April 2020 when everything was shut down.
As this sector of the US economy makes up between 15-18% of US GDP according to the NAHB, it of course is crucial to watch. This all said, it would be a good thing to see a sharp deceleration in the pace of home price gains and even some outright declines in some markets would help first time buyers.
Europe and China
The Eurozone economy saw better than expected business activity in the second quarter driven by leisure travel, especially in Italy, Spain and France as many of us break out of our Covid holding patterns. Germany though is suffering from the spike in energy prices, particularly natural gas. As of this writing, Europe is paying about $65 per mmBTU for natural gas vs $8.25 in the US. This is painful for both consumers who want to cool their homes this summer (and soon, heating ones home during the winter) and businesses that rely on natural gas as their feedstock, like petrochemical companies as an example. It is the primary challenge for the entire region in the quarters to come.
Because inflation is running north of 8%, the European Central Bank finally ended its negative interest rate policy by hiking its deposit rate to zero from -.50% in July. We expect another rate increase in September. They are so far behind the curve that they are not even in the same ballpark as where they should be with rates relative to inflation.
China’s economy is the 2nd biggest and thus hugely important to global growth. Its strict Covid stance along with the distress for many residential real estate developers are major strains on their economy. Hopefully the Covid policy eases up after the Party Congress in the fall but the real estate stress will filter well into 2023.
As we all search for the peak in inflation pain, we are beginning to see some moderation in the rate of price increases for goods. The US consumer stocked up on goods over the past two years and are now shifting to spending on travel, leisure, restaurants and other live experiences. Also, we have seen a drop in commodity prices and some easing of high transportation costs that are helping to temper price gains for goods. Unfortunately, offsetting this to a large degree is further expected acceleration in service prices, mostly driven by higher rents.
The question for the Fed is what degree of an inflation drop will satisfy them because they will most likely be ending rate hikes well before they get inflation back to 2%. And as inflation is global, we will likely see other central banks not getting their level of interest rates above the rate of increase in inflation, thus maintaining negative real interest rates.
We did get relief on the commodity front in July as the CRB raw industrials index fell for a 4th straight month and the CRB food price index declined for a 3rd month, helped by grain shipments finally leaving some Ukrainian ports. Crude prices and the average gallon of gasoline fell too but natural gas prices leaped by 53% and are up 125% year to date. We expect commodity prices to remain elevated. While the demand side is at risk because of an economic recession, years of under investment will be the offset.
While it was great to see the rebound in markets in July, we have to be honest that the cross currents flowing through markets and the economy this year are still flowing. While there are some signs that inflation is peaking, or close to it, central banks are still trying to normalize policy and the end result creates major headwinds for both an interest rate sensitive economy and markets that have been addicted to a low interest rate environment. These headwinds are exacerbated by the Federal Reserve simultaneously reducing the size of its balance sheet in the monthly exercise known as quantitative tightening which drains reserves from the banking system.
We do not anticipate that the investing landscape will get easier anytime soon. It is important to remember that recessions and market pullbacks are a natural part of the business cycle. As we continue to navigate this cycle, it remains vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will continue to be a choppy time for the economy and markets. Time horizon is really crucial right now and the best friend of any investor. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and these markets.
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