The S&P 500 Index rallied +9.22 percent in July, recovering its June loss on better-than-feared second-quarter corporate earnings and renewed investor hopes that slowing economic growth might encourage the Federal Reserve to tighten policy less aggressively. Although bottom-up earnings for the S&P 500 fell about -2.0 percent short of consensus in the June quarter, many had feared an even worse outcome.
Whether equities can hold onto recent gains in the seasonally weaker months of August and September may hinge on expectations for further monetary tightening. While the economy is now in a “technical recession” after two sequential quarters of real GDP contraction, extreme swings in private inventories and net exports have had an outsized impact. Conversely, nominal GDP has surged to an all-time high on robust consumer spending and red-hot inflation. As a result, the Federal Reserve appears undeterred from its aggressive tightening path. Futures markets imply another 100-basis point increase in the fed funds rate before year-end, with rate cuts coming as early as next spring on a potential policy overshoot. Ironically, investors also seem to have become more at ease recently with the idea the Federal Reserve can execute a softish landing or mild recession, given the resilient U.S. consumer and a favorable job market. However, a continued trend of higher-than-expected inflation reports may squash this thesis by emboldening the Federal Open Market Committee’s more hawkish members.
The broad-based market correction during the first half, driven almost entirely by valuation multiple compression, has presented opportunities to improve portfolio risk-return profiles. Furthermore, we believe we are in a stock picker’s market and that earnings growth is key to sustained stock appreciation. Accordingly, we continue to invest opportunistically in high-quality companies where recent PE multiple contraction is not justified relative to earnings growth potential and/or further contraction is unlikely.
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