Inflation is sticky, but economic growth is sticky, too. And that puts the Federal Reserve—and investors—in a bind.
Look no further than Friday’s payrolls report release. The U.S. added 528,000 jobs in July, more than doubling estimates for 250,000, while the unemployment rate dipped to 3.5% from 3.6%. If you’re worried about a recession, there’s no sign of one here.
The strong report caused most of the financial markets to respond just as you’d expect, for the most part. Treasury yields jumped, the U.S. dollar surged, and the chances of a three-quarter-point interest-rate hike in September rose to 65% from 28% the week before. The stock market, however, was relatively quiet, with the S&P 500 index finishing the day down just 0.2%. It was an odd reaction, given that the jobs data likely mean more rate increases.
Still, it makes a strange kind of sense. Such underlying growth resilience is positive for risky assets, even as higher rates are a negative, notes Alan Ruskin, chief international strategist at Deutsche Bank.
Of course, the stock market is worried about more than just the Fed. Heading into earnings season, everyone seemed terrified that profits would fall short and guidance would be slashed. That isn’t quite what has happened. With 432 S&P 500 companies having reported, aggregate earnings have come in 5.8% above expectations, as 77% of companies have reported better-than-expected profits. Revenue, meanwhile, is growing at a 13% clip, helping to drive those earnings beats. That hasn’t kept future earnings estimates from being revised lower, but the drastic cuts that were expected haven’t materialized. That helped the S&P 500 rise 0.4% this past week, while the Dow Jones Industrial Average dipped 0.1% and the Nasdaq Composite gained 2.2%.
Profits may continue to hold up if inflation continues to run as hot as it has been. Corporate sales are generally correlated with nominal economic growth, not real growth, and that’s one reason revenue has grown as quickly as it has. Margins, too, are holding up better than feared thanks to the ability of companies to pass on higher input prices while keeping a lid on other costs. It shouldn’t come as a surprise, then, that some of the strongest earnings growth came during the 1970s, says Keith Lerner, chief market strategist at Truist Advisory Services. That was also a period of lower multiples, as ever-rising rates reduced what investors were willing to pay for those earnings.
U.S. investors could face a similar setup now. The S&P 500’s tumble into bear-market territory was caused not by a decrease in earnings but by a fall in the index’s price/earnings multiple, which fell below 16 as the 10-year yield surged to nearly 3.5%. Its rally off those lows, meanwhile, was driven by multiple expansion, with the S&P 500’s P/E rising to 17.7 by the end of this past week. For now, expect the S&P 500 to be hemmed in by those competing forces.
“It will be a choppy range as the tug of war between P/Es and earnings continues,” Lerner says.
Something will have to give, and that something could be earnings. While companies have been managing inflation well, the Fed is likely to keep raising interest rates until inflation starts to cool down and the economy begins to slow. If that happens, deteriorating demand would hit sales, margins would get squeezed, and earnings would finally fall. That isn’t the base case for Keith Parker, head of equity strategy research at UBS, but it is the biggest risk. “We’re in the danger zone side of the cycle,” he explains. “We can get some pretty steep rallies and some pretty steep selloffs, but the risk/reward is tilted down.”
Still, don’t underestimate the U.S. economy. It has taken the Fed’s punches but hasn’t been knocked out, at least not yet. If it holds up, then it’s time to bet on a resurgence in economically sensitive stocks like banks and energy, says Ironsides Macro’s Barry Knapp, instead of the growth stocks that led the market higher over the past month and change. “The economy is resilient,” he says. “And cyclicals are cheap.”