Recession defies inflation, main fear of stock and bond investors

It’s easy to want to hide given the carnage seen this year in stocks and bonds, especially with the Federal Reserve vowing an unconditional battle against high inflation.

While inflation, which has reached its highest level in 40 years, still tops the list of concerns for many investors, another potential problem for the markets has begun to loom, in the form of higher growth. slow in corporate earnings – and potentially the broader US economy.

“I would say there is definitely a concern that earnings expectations are falling again. Softening, but not falling off a cliff,” Jake Remley, senior portfolio manager at Income Research + Management, said over the phone. .

Ahead of new corporate earnings from mid-July, analysts pegged the SPX to the S&P 500 index,
+3.06%
estimated the profit growth rate for the second quarter at 4.3%, according to a Friday report from FactSet, a level that would mark its lowest annual growth rate since the fourth quarter of 2020.

“You could say the bad news is going to ease the pressure on the Fed,” Remley said, speaking of the Federal Reserve’s plans to significantly tighten financial conditions this summer, in a bid to calm runaway inflation.

“They don’t want to break the consumer, or the corporate bond market, or bank balance sheets,” he said. “But it will take more than what they have done, from our perspective,” to prevent the high cost of living from taking root.

“The faster they do it, the better.”

Recession or inflation?

It’s a delicate dance. The Fed wants to cool the demand for goods and services, through significantly higher interest rates, but without going too far, by laying off workers by triggering an economic recession.

San Francisco Federal Reserve Chair Mary Daly on Friday added support for another sharp interest rate hike in July to target high inflation, without derailing the economy.

“The biggest fear isn’t one or the other – it’s both,” Mark Heppenstall, chief investment officer at Penn Mutual Asset Management, said of whether a fear of growth or inflation matters the most.

The US economy shrank 1.4% on an annualized basis in the first quarter. With higher interest rates and tighter financial conditions, the economy could be on the way to a technical recession, he said by telephone.

“It definitely looks like a period of stagflation, which is why we see such volatility in asset prices and interest rates.”

Stocks rallied this week, with the S&P 500 SPX,
+3.06%
ending up 3.1% on Friday, to book its best day in more than two years. But the broad market gauge was still down 17.9% for the year, in a bear market, with the Nasdaq Composite Index COMP,
+3.34%
25.8% so far in 2022, according to FactSet.

The top-notch Dow Jones Industrial Average DJIA,
+2.68%
jumped 5.4% for the week, but was still down 13.3% for the year so far.

Lily: Stagflation, reflation, soft landing or meltdown – what Wall Street expects in the second half of 2022

Tracking layoffs

A key element of 1970s-style stagflation was the mix of high inflation and a weak labor market. In comparison, the current employment situation still looks quite robust.

That could change quickly, however, if more companies start reporting disappointing earnings, not just due to a strong dollar dampening international sales, but more broadly from the ripple effects of inflation at 8.6. %, its highest level in 40 years.

“The rhetoric of inflation is cooling, while the narrative of recession is making headlines,” Bob Schwartz, senior economist at Oxford Economics, said in a Friday note. “This pivot of sentiment is running through financial markets.”

He also pointed to falling bond yields as a potential harbinger of an economic slowdown. The benchmark 10-year Treasury yield TMUBMUSD10Y,
3.135%
was at 3.125% on Friday, a far cry from the recent high of 3.482% hit on June 14, according to Dow Jones Market Data.

“Layoffs are on the rise and job offers are rescinded,” Schwartz said.

Layoffs are on the rise

Economy of Oxford

While “job seekers have more than enough positions to choose from,” Schwartz said, he also echoed some of the concerns voiced this week by Senator Elizabeth Warren during the President’s two-day testimony. Fed Powell on Capitol Hill. They both pointed out that the labor market could weaken due to the central bank’s tactics to fight inflation.

Namely that “the strong bargaining position that workers have enjoyed over the past two years could be eroded”.

Among the key economic data available: Monday will bring pending home sales for May, followed by April’s reading of the S&P Case-Shiller US home price index on Tuesday. Wednesday brings the updated US GDP for the first quarter. Thursday has more inflation data for May.

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