Market Commentary: August 2022

Stocks and Bonds Rally on Hope for a Soft Landing

KEY OBSERVATIONS

Two straight quarters of shrinking GDP drove a 9% rally in the S&P 500^® during the month of July. Let’s call it a soft-landing rally. Many investors are hoping that a bit of economic slowdown will convince the Federal Reserve to reign in the path of rate hikes. Among optimistic indicators was the June payroll report that tallied up an increase of 372,000 non-farm jobs.

The rally in stocks was not just driven by reduced fear of the Fed (and lower interest rates across the yield curve), but also surprisingly decent corporate earnings. With second quarter results for nearly two-thirds of the S&P 500 reported, companies have in aggregate exceeded earnings estimates by over 4%. That’s not a big number, but for a market that was arguably priced for companies to miss expectations, it was enough.

The coast may not be entirely clear for stocks, however. Many companies seem unable to raise prices enough to overcome their rising costs—so far this earnings season, S&P 500 earnings growth has been less than half of sales growth. Not all stocks suffered from margin compression though. Again, with about two-thirds of companies reporting, the S&P 500^® Dividend Aristocrats^® have delivered both robust sales growth and earnings growth that was nearly double sales growth.

Chart of the Month

The coast may not be entirely clear for bonds either. After several months of declines, the 10-year breakeven inflation rate rose roughly 20 bps in July. Wages rose as well. The Bureau of Labor Statistics Employment Cost Index rose 5.1% in June. While that didn’t keep up with inflation, it’s still a big number. Congratulations to those bond bulls who have gotten the call right since mid-June, but with 10-year U.S. Treasury real yields close to zero again and the pace of Quantitative Tightening accelerating, complacency might not be warranted.

Performance Recap

Economic Calendar

Here’s a list of upcoming key economic releases, which can serve as a guide to potential market indicators.

Equity Perspectives

Despite outperforming their large-cap peers over the long-term, mid-cap stocks have been chronic underperformers over the past several years. Given the large cap dominance over the last few years, many investors are likely under-allocated to smaller-capitalization stocks. Market drawdowns like we’ve witnessed this year are never pleasant, but they can be an opportunity to reset portfolio asset allocations.

In addition to stronger earnings growth, there are a few other reasons why mid-cap stocks may be well positioned in the current environment. Relative valuations remain compelling, with the S&P MidCap 400^® trading at roughly half of the value of the S&P 500. In addition, more domestic-based revenue should continue to insulate the middle market in the event the U.S. dollar continues to maintain its strength.

Investors should be selective with their mid-cap allocations in what remains a difficult equity environment. One potential solution worth consideration are strategies that have weathered market turbulence in the past, such as investing in dividend growth stocks. Akin to their large-cap peers, the S&P MidCap 400^® Dividend Aristocrats^® are high-quality stocks that have grown their distributions for a minimum of 15 consecutive years. They have also delivered an attractive combination of upside and downside capture that may be right for the times.

Fixed Income Perspectives

It was green across the screen in July, as a rally in U.S. Treasurys and tightening credit spreads drove prices higher across both government and corporate bond segments.

A tightening of credit spreads goes hand-in-hand with a rally in stocks. Generally, if companies are generating decent earnings growth, then they are improving their ability to pay back their debts. Credit spreads for both high-yield and investment-grade credit are in the neighborhoods of their long-term averages, but corporate-debt levels are very low. If decent corporate earnings results continue over the next several quarters, those spreads may narrow even further. The rally in U.S. Treasurys, however, may have gone too far.

Falling prices at the gas pump is a hopeful sign that inflation may be receding, but rising wages are a potentially bigger concern. Last month’s 5.1% increase in the Bureau of Labor Statistics Employment Cost Index is nearly twice the average of this century. The historical stickiness of wages suggest that it may take a little while for inflation to come back down to the Fed’s target of 2%. It might not take very long at all for U.S. Treasury yields to rise after what has—admittedly—been quite an impressive rally.