August 2023 Stonemark Market Commentary

The month of August presented the market with a tidal wave of earnings, economic data, and commentary from central bankers. After a strong month in July, with the S&P 500 returning over 3.5% and closing at a high for the year on July 31, August experienced a pullback. Continued fears over sticky inflation, a hawkish Federal Reserve, and lukewarm earnings caused the index to pullback over 4% leading up to Chair Powell’s Jackson Hole speech on August 25. Investors feared a potential repeat of last year’s Jackson Hole conference, where commentary from Chair Powell sent the S&P 500 lower by over 3% in a single day as he reaffirmed the Federal Reserve’s firm stance on crushing inflation. However, Chair Powell’s commentary was not as fiery as the year before, even despite his continued affirmation of the Federal Reserve’s ongoing war against inflation through the use of restrictive monetary policy. As such, the market clawed back some of the returns that were given up in the selloff leading to Jackson Hole, showing remarkable resilience despite higher bond yields and gloomy forecasts from corporations and economic analysts alike. Economic data continues to flash contrasting signals, with leading indicators and rising debt troubles painting a murky picture, but cooling inflation and a resilient labor market are propelling the economy forward.

The July Consumer Price Index (CPI) report was released by the Bureau of Labor Statistics on August 10, which showed that headline CPI rose by 0.2% in the month of July and 3.2% year-over-year. Both of these numbers were slightly below market expectations, indicating that headline inflation was continuing to fall amidst the ongoing war the Federal Reserve has waged on inflation. However, the 3.2% year-over-year headline CPI number was marginally higher than the 3.0% year-over-year number from the prior month as result of tougher comps from last year. The Bureau of Labor Statistics also released the July Core CPI numbers on August 10, which exclude the more volatile food and energy inputs. Core CPI rose 0.2% in July and 4.7% year-over-year, both slightly below market expectations. Overall, the CPI report released for the month of July shows consistent cooling in inflation, but inflation remains well above the Federal Reserve’s target of 2% year-over-year CPI.

The Core Personal Consumption Expenditures Index (PCE) was released on August 31, showing that the Federal Reserve’s preferred measure of inflation rose by 0.2% in July and 4.2% year-over-year. The Core PCE numbers, while well below the mid-2022 highs, remain stubbornly elevated and signal that the Federal Reserve is likely to maintain restrictive monetary policy. Overall, inflation has fallen significantly since the highs of 2022 across virtually all inflation metrics, but it remains stubbornly elevated warranting ongoing restrictive monetary policy from central banks.

The labor market has started to show some cracks, though unemployment remains low and the overall situation complex. Released on August 4, the jobs report showed nonfarm payrolls grew by 187,000 in July, below estimates of 200,000. This made July the second consecutive miss for monthly job creations, with both June and July coming in below 200,000 jobs. The strongest sectors for job gains in July were health care, social assistance, financial activities, and wholesale trade. In conjunction with slowing job growth was the continued decrease in new job openings, as released in the Job Openings and Labor Turnover Survey (JOLTS) by the Bureau of Labor Statistics on August 29. The JOLTS number came in at 8.8 million job openings, which marked the first sub-9 million number since March of 2021. July’s JOLTS number continued the downward trend in job openings that has been ongoing since the beginning of the year and coincides with falling job gains released in the July jobs report earlier in August.

Also included in the jobs report was the unemployment rate, which ticked lower to 3.5% in July versus estimates of 3.6%. While job gains have slowed in the past two months, unemployment has ticked down to 3.5%, showing continued strength in the existing labor market. Average hourly earnings rose by 0.4% in July and 4.4% on a 12-month basis, both of which were above market expectations. Lower than expected unemployment and slightly stronger than expected average hourly earnings show continued strength and resilience for the existing labor force. The Federal Reserve has continually pointed towards the strength in the labor market as a potential inflationary pressure, as consistent earnings and employment allows consumption and discretionary spending to continue. Additionally, a resilient labor market with an unemployment rate of 3.5% gives the Federal Reserve leeway to continue tightening monetary conditions, as their mandate is simply to ensure price stability and maximum employment. However, consecutive months of below-estimate job gains and falling JOLTS could be indicative of a slowing labor market moving forward as employers slow hiring amid persistent inflation and eroding demand.

The Conference Board released its monthly Leading Economic Indicators (LEI) report, which aggregates 10 “forward looking” economic indicators, on August 17. The U.S. LEI fell for the sixteenth consecutive month in July, signaling that the outlook remains highly uncertain. Continued weakness in new orders and consumer expectations for business conditions led the LEI to the downside, with the S&P 500 being the largest positive contributor to the LEI.

The Conference Board said:

“…in July, weak new orders, high interest rates, a dip in consumer perceptions of the outlook for business conditions, and decreasing hours worked in manufacturing fueled the leading indicator’s 0.4 percent decline. The leading index continues to suggest that economic activity is likely to decelerate and descend into mild contraction in the months ahead. The Conference Board now forecasts a short and shallow recession in the Q4 2023 to Q1 2024 timespan.”

However, despite the LEI index’s historical accuracy in predicting recessions, Gross Domestic Product (GDP), a measure of the overall health of the economy, has been robust year-to-date and is currently forecasted at being exceptionally strong in the third quarter. Real GDP was up 2.0% and 2.1% in the first two quarters of the year, respectively. The Atlanta Federal Reserve’s GDP Now model forecasts GDP for the current quarter and is at 5.9%, as of August 24. Of note, the 5.9% forecast is the “maximum” for third quarter GDP and simply the GDP growth rate at that point in time, but the forecast shows that the economy is growing at a substantial rate despite a full reversal in monetary policy over the past 18 months.

There was no Federal Open Markets Committee (FOMC) meeting in August, with the next meeting scheduled for September 19-20. As of August 31, the market is pricing a near 90% probability of no rate hike at the September meeting and slightly above 10% probability of a 25-basis point rate hike. However, the market as of August 31 is pricing a 44% probability of a 25-basis point rate hike at the November 10 meeting and a 50% probability of no rate hike at the November meeting. Overall, the market is pricing a majority probability that the Federal Funds rate will remain at its current level of 525-550 basis points through year end, with a substantial minority pricing at least 25 basis points of additional rate hikes by year end.

The minutes from the FOMC’s July meeting were released on August 16, which showed that Federal Reserve officials saw “upside risks” to inflation that could lead to additional rate hikes and potentially high rates for longer. The general consensus within the committee was that inflation remained too high, but optimism was warranted in the fight against inflation and overall resilience of the economy. Movement in the 10-year Treasury yield as well as market positioning with Fed Funds futures correlates with the sentiment expressed in the FOMC minutes. Yields on the 10-year in August reached the highest levels since November of 2022, indicative of a market digesting that rates will remain elevated for longer than previously expected.

The Federal Reserve hosted the Jackson Hole Economic Symposium from August 24-26, where numerous central bankers, policymakers, and economists from around the world discussed current global economic conditions. Chair Powell’s speech on the 25 was the highlight of the symposium, where he addressed a variety of economic topics that shape Federal Reserve policy. Powell reiterated the Federal Reserve’s commitment to returning inflation to their target of 2%, definitively quelling discussion surrounding raising the target to 3%. He also touched on the importance of non-housing services inflation abating, which includes numerous sectors such as food services and health care. Commentary surrounding the hotter-than-expected economic growth revealed that the Federal Reserve had not anticipated the economy being as resilient as it currently is. Powell cited persistent “above-trend growth” as a potential inflationary pressure, as well as continued strength in the labor market. He reiterated that some softening in the labor market would likely be necessary in order to return inflation to its 2% target and indicated that monetary conditions are likely to remain tight for longer than previously expected.

August was a heavy earnings month, with juggernauts like Apple, Microsoft, Alphabet, and Nvidia all reporting earnings for the second quarter of 2023. Overall, earnings declined by 5.2% year-over-year for the second quarter of 2023, which was the largest decline since the third quarter of 2020, according to FactSet. Additionally, revenue grew by 0.6% year-over-year for the second quarter, also the lowest rate since the third quarter of 2020. 79% of companies reported earnings per share (EPS) above estimates and 65% of companies reported revenues above estimates. However, the market reacted in a lukewarm manner to earnings this quarter due to low estimates heading into earnings season, as well as cautious guidance being issued across a variety of sectors. Numerous companies continue to signal potential macroeconomic headwinds in the second half of 2023, citing interest rates and student loan payments resuming as headwinds to near-term earnings growth.

Contrasting economic data, lukewarm earnings, and a persistently hawkish Federal Reserve leaves the market in a complex position at the end of August. Markets have been strong year-to-date, with the S&P 500 up over 17% and the tech-heavy Nasdaq up over 33% as of August 31, sparking optimism and bullish sentiment after the washout that was 2022. However, economic conditions remain tight and difficult, with defaults and bankruptcies on the rise, as well as continued uncertainty surrounding the lagging effect of interest rate hikes. The ongoing strength in the labor market has allowed consumption and spending to remain robust, yet also poses a threat to cooling inflation. The Federal Reserve sees continued inflationary pressures present throughout the economy, prompting them to maintain restrictive monetary policy and continue their process of quantitative tightening. With all of this in mind, maintaining discipline and prudence is paramount to navigating a complex economic environment. We continue to seek out companies with strong balance sheets, consistent cash flows, and recurring revenue streams. Earnings will drive the market over the near-term as they come under greater scrutiny amidst a potential slowdown and investors should keep an eye out for downward revisions. Staying the course and maintaining discipline in one’s approach to investing will prove beneficial in the long run, despite potential near term volatility.