Economic Flash: Mixed Signals Could Be Reason for Optimism

This article is brought to you in collaboration with our colleagues at Laird Norton Wealth Management from their post, Economic Flash: Mixed Signals Could Be a Good Sign.

U.S. Economy: Recession?

U.S. GDP shrank for the second consecutive quarter marking a “technical” recession as rising food and energy prices continue to drive rapid inflation, 9.1% annualized per latest CPI. However, broader economic data complicates the picture, with a healthy U.S. job market, growth in inflation-adjusted consumer spending and manufacturing.

U.S. Stocks: Relief Rally

July was the best month for U.S. stocks since Q2 2020, as 73% of S&P 500 companies beat analysts’ meager second quarter earnings expectations. Investors also interpreted the negative U.S. GDP result to mean the Fed would not need to hike rates as aggressively. Generally, cyclical small-cap stocks and growth stocks sensitive to interest rates outperformed.

Foreign Stocks: Eurozone Strength

Despite ongoing war in Eastern Europe and political stressors like the dissolution of the Italian parliament, the regional economy expanded 0.7% in Q2, with Swedish (+11.3%) and Irish (+10.7%) markets in the lead at +11.3% and +10.7% respectively. Japan rose 5.6% on a stronger yen and stimulus, while China’s 9.7% drop dragged down emerging markets as anticipated economic stimulus failed to materialize.

Fixed Income: Fed Hikes, Rates Fall

The Fed raised its target interest rate another 75 basis points, but the yield on 10-year US Treasuries fell 30 basis points to 2.7% from 3.0%. Bond investors seem to believe inflation will cool and risks are skewed toward recession. Counterintuitively, high-yield bonds performed well, despite recession fears, with investors seeing value in low defaults and yields nearing 8%.

Real Assets: Commodity Rebound

Commodities bounced back from recession fears, as an anticipated drop in Russian natural gas exports to the EU and unseasonably warm weather drove up energy prices. Other corners within real assets also performed well, with REITs aided by both ongoing inflation concerns and expectations that interest rates may rise less dramatically.

Alternatives: Pricing Lag

Some private investments appear to have weathered the 2022 storm exceedingly well. However, that may be somewhat due to the limited number of market transactions, which make it difficult to assess recent valuations. Private funds are traditionally slow to mark down investments but that is a phenomenon that typically does not persist as transactions increase.

Equities Total Returns

Fixed Income Returns

Economic Indicators

Our Take

The early read on Q2 U.S. GDP showed a second consecutive quarterly decline and increased the probability that the U.S. economy has entered recession. There have been other negatives to be sure: While consumer spending grew in July, this marked its lowest contribution to growth since Q2 2020 and inventories shrank, with business sentiment as weak as it has been in a decade. If the data do not spell out an outright recession, they do underscore that inflation is taking a toll on the economy.

The labor market continues to be an outlier, indicating that a pending (or existing) recession may not be all that severe. Unemployment remains at record lows as the U.S. economy is still adding jobs, and wage growth, +6.7% annualized, is at the highest level since data collection began in 1997, having accelerated each of the last four quarters. More jobs and higher wages are not labor market characteristics typically seen in recessions. Not everything is doom and gloom and these pockets of stability are a significant reason the Fed is charging ahead with rate hikes to address inflation.

How high will interest rates go? Futures markets pricing indicates that we can expect another one percentage point increase in the Fed funds rate, which is now at 2.25%-2.50%. While headline inflation continues to mark records relative to recent history, there are indications it will ebb. For example, much of the rise in the latest CPI inflation gauge comes from higher gas prices, which have since fallen 80 cents/gallon from their mid-June peak. Still, even if inflation begins to cool, it is likely to remain above the Fed’s 2% target over the next few years. This is a meaningful portfolio consideration and warrants a continued emphasis on real assets, which are a cornerstone of our long-term philosophy.

Looking Ahead

Overall, the strong rebound in U.S. stocks in July, with the Dow Jones up 6.7%, the S&P 500 up 9.2.%, and the Nasdaq up 12.4%, reinforced a critical premise of long-term investing: Attempts to time the market will likely prove fruitless as the majority of annual gains tend to occur in unpredictable short-term clusters.

This July, for example, bad news was good news, with investors betting the Fed interest rate hiking cycle would end sooner and lower than previously expected. That possibility is why you do not detour from your financial plan without a thoughtful assessment of objectives. We construct portfolios to achieve longer-term client goals, and the adjustments we make in the short term are in areas where we can identify ways to lower risk or increase return.

To that end, we are evaluating a range of emerging opportunities created by current trends, including credit dislocation and the on-shoring/near-shoring of industries deemed critical to national security.

Glossary of Indices

U.S. EQUITIES

U.S. Large Capitalization = S&P 500 Index

Tracks the performance of a representative sample of 500 leading companies in the major industries of the U.S. economy.

U.S. Small Capitalization = Russell 2000 Index

Tracks performance of the 2,000 smallest companies in the Russell 3000 Index, representative of the U.S. small capitalization equity market.

U.S. Growth Equities = Russell 3000 Growth Index

Tracks the performance of those Russell 3000 companies that have higher price-to-book ratios and higher forecasted growth values.

U.S. Value Equities = Russell 3000 Value Index

Tracks performance of those Russell 3000 companies that have lower price-to-book ratios and lower forecasted growth values.

 

INTERNATIONAL EQUITIES

International Equities (Developed Countries) = MSCI EAFE Index

A float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. Consists of the stock market indices of these 20 developed countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

Emerging Market Equities = MSCI Emerging Markets Index

A float-adjusted market capitalization index designed to measure equity performance in the major emerging markets. Consists of the following 25 emerging-market -country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

 

U.S. FIXED INCOME, TAXABLE

U.S. Aggregate Bond = Barclays Capital U.S. Aggregate Bond Index

Covers U.S. dollar-denominated, investment-grade, fixed-rate, taxable bond market consisting of SEC-registered securities. Includes U.S. Treasuries, U.S. agency bonds, U.S. corporates, mortgage-based securities (MBS, CMBS) and asset-backed securities (ABS).

TIPS (Treasury Inflation-Protected Securities) = Barclays U.S. Treasury Tips Index

Measures the performance of TIPS of various maturities issued by U.S. Treasury.

 

INTERNATIONAL FIXED INCOME

International Developed Bonds = BofA Merrill Lynch Global Government Bond II ex U.S.

Measures the performance of non-U.S. developed-market government bonds on an unhedged currency basis.

Emerging Market Bonds = BofA Merrill Lynch Emerging Markets Sovereign

Bond Index Measures the performance of emerging markets government bonds on an unhedged currency basis.

 

U.S. FIXED INCOME, TAX-EXEMPT

Intermediate Municipal Bonds = Merrill Lynch Municipals, 3-7 Yrs Index

A subset of The Merrill Lynch U.S. Municipal Securities Index, including all securities with a remaining term to final maturity of between 3 and 7 years.

Municipals, Broad Market = Merrill Lynch Municipal Master Index

Tracks the performance of U.S. dollar denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions.

 

HEDGE FUNDS

Absolute Return Funds = HFRX Absolute Return Index

Tracks the performance of hedge funds aiming to provide stable performance regardless of market conditions. Such funds tend to be less volatile and less correlated to market benchmarks. Data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month and is subject to revision.

Market Directional Funds = HFRX Market Directional Index

Tracks the performance of hedge funds that add value by participating in the direction of various financial markets. Such funds characteristically have higher expected volatility than Absolute Return strategies (see above). Performance data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month, and is subject to revision.

 

ECONOMIC INDICATORS

Equity Volatility = CBOE VIX Index

Aims to measure investor expectations for near-term stock-market volatility as conveyed by the pricing of stock options on the S&P 500 index that mature within 30 days.

Implied Inflation = 10-Yr TIPS Implied Inflation

Gauges investor expectations for future U.S. inflation based on the difference between the yield on a 10-year TIPS (Treasury Inflation Protected Security) and the yield on a nominal 10-year Treasury.

Gold Spot $/oz.

An index intended to measure the current price of gold, based on futures contracts deliverable in the following month priced in U.S. dollars per Troy ounce.

Oil = Brent Crude Oil Spot Price $/bbl

Brent Crude Oil refers to a particular grade of crude oil often quoted in financial reports as the global benchmark for the price of oil. It typically trades at a premium to the West Texas Intermediate price.

U.S. Dollar = Trade-Weighted U.S. Dollar Index

Value of the U.S. dollar relative to a composite of 26 currencies of major U.S. trade partners, weighted based on trade data.

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