Two-Week Rally Gaining Steam

Stocks opened higher this morning despite a disappointing inflation report. The Dow and S&P 500 are up between .6% and 1% in early trading. Commodities are also rising in price (copper +2.6%; gold +.4%; oil +3%). And finally, the bond market is broadly higher. Long-term Treasuries are up nearly 1%, and even junk bonds are hanging onto a modest rally.

The S&P 500 is up 8% since mid-month, causing investors to wonder whether the bottom is in. Tom Lee of Fundstrat thinks the 2022 bear market may be over. “The stock market…is starting to anticipate a turning point in inflation.” Despite the fact that inflation remains high, he notes that 70% of companies are beating Wall Street earnings projections and the majority are posting positive earnings growth. He thinks the market may be in the “process of re-embracing risk.”

And yet, two reports released this morning confirmed inflation is running hot. The Fed’s preferred inflation gauge—Core PCE Deflator—accelerated to 4.8% y/y growth in June, from 4.7% in the prior month. Core inflation excludes food and energy, which added back pushes inflation closer to 6.8% (highest since the early ‘80s). We know that the Fed’s long-run target is 2.0%. In addition, the Employment Cost Index (ECI) posted 5.1% year-over-year growth, the highest for data going back to the early 2000s.

How does one reconcile still-high inflation with rising stock and bond markets? Two days ago the Federal Reserve’s policy committee raised the Fed-funds interest rate by another .75% to 2.5%. Oddly, Fed Chair Jerome Powell commented that this level represents a “neutral” setting in that it neither encourages more inflation, nor constrains economic growth. Previously, Fed officials led us to believe that a neutral Fed-funds rate would be closer to 3%. Of course, the Fed isn’t through raising rates. Mr. Powell believes rates should be “moderately restrictive” to growth in order to bring down inflation. But his comments seem to represent a softening of his stance in regard to tightening financial conditions. We’ve said all along that a durable stock market rebound will have to coincide with such a move by the Fed.

Economist Larry Summers says Powell’s comment was “analytically indefensible.” That is, a policy rate of 2.5% is far too low to effectively combat 40-year-high inflation. But others agree with Mr. Powell because expected inflation over the next several years is far lower than what we’re seeing today. For example, the 5-year average inflation rate implied by Treasury Inflation-Protected (TIPS) bonds is 2.7%. And by the same token, economic growth expectations are falling. Fed economists predict the economy will decelerate to just 2.0% growth this year and 1.3% next year. These numbers (if accurate) suggest what we call a “soft landing,” which essentially means a slowdown without recession.

Meanwhile, we’re monitoring earnings season closely. About half of the S&P 500 companies have reported second quarter results. Roughly 60% haven beaten Wall Street projections for sales, and 74% for profits. As with everything else in the economy, corporate earnings growth is decelerating, but remains positive. Aggregate second quarter earnings growth is tracking to about 6%. Overall, investors have been pleasantly surprised.