Despite a little early month volatility, equity markets continued their rally in July, led by emerging markets, with the MSCI Emerging Markets index rising 6.23% on a total return basis. The S&P 500 and MSCI EAFE lagged by 300 basis points, with the S&P 500 returning 3.21% and MSCI EAFE returning 3.24%. Earnings have helped continue the rally as well as softening inflation and a resilient economy. Through the first half of the latest earnings season, over 80% of the S&P 500 companies that have reported have beat analysts’ earnings expectations. That’s slightly ahead of longer-term averages, according to FactSet. Further, after two quarters of earnings declines, the S&P 500 is on track to return to earnings growth.
In July, bonds effectively tread water, down 7 basis points, despite the Bloomberg US Aggregate index being down over 1% early in the month. The Federal Reserve increased rates another 25 basis points in their July meeting while keeping their statement effectively unchanged though the market interpreted Chairman Powell’s press conference as having a slightly dovish tone and perhaps nodding to a pause in their September meeting. As of the end of July, the Fed Fund Futures market was implying a one-in-five chance of a rate hike in September.
The economy continues to be more resilient than most had thought, with GDP rising at a 2.4% annualized rate, compared to 2% in the first quarter. Consumer spending increased at a 1.6% pace, outperforming forecasts, and the Federal Reserve’s preferred underlying inflation metric (core Personal Consumption Expenditures (PCE) price index) rose at a slower-than-expected 3.8% pace. Positive job market conditions, robust consumer spending, and easing inflation have fueled hopes that the US will avoid a recession, and the slowdown in price and wage growth over the past year has added to hopes that the Federal Reserve can control inflation without causing an economic downturn.
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After a brief pause in its interest rate hike campaign, the Federal Reserve decided to raise rates by a quarter of a percentage point in July. This widely expected move brings the Federal Funds Rate to a 22-year high. The question now is if this increase might be the last. Based on remarks by Chairman Powell after the announcement, the answer is probably not.
Despite the drop in inflation in June, Powell acknowledged that inflation has proven more resilient than expected and said the Fed might make further rate decisions based on the Consumer Price Index, unemployment rate, and other data. While there might be a few more data points to consider in the seven weeks before the Fed’s next meeting, Powell made it clear that another hike is on the table in September. He reiterated, “We are strongly committed to bringing inflation back to our 2% goal.”
The Fed is walking a fine line between its dual mandates of price stability and maximum sustainable employment. By raising rates to continue cooling inflation, the concern is that it may overshoot and push the economy into a recession that would cause higher unemployment.
It has been over a year since the yield curve has inverted, raising concerns among investors and economists. Historically, the yield curve reflects the market’s sense of prospects for the economy, particularly inflation and central bank policy. Preceding each of the past seven US recessions, there has been an inversion of spread between three-month bills and 10-year notes. The idea of the yield curve predicting recessions is debated, with some viewing it as market speculation rather than a foolproof signal.
There has been gradual improvement in the economy over the last several months, though the overall economic picture remains mixed. Employment continues to be strong, and improvements in areas such as consumer sentiment, financial system stress, and high-level economic conditions have outweighed continued weakness in services conditions and certain leading indicators. The improvements this year have provided some cautious optimism about a “soft landing”.
Despite headlines and fears, commercial real estate delinquency rates have improved substantially and are fairly low relative to the past. However, there may be risks on the horizon. The office sector is an exception, facing challenges in leasing and refinancing, impacting REIT shares and property values. There are substantial commercial mortgage-backed securities with maturities in the second half of the year. Data-center, industrial, apartment, and senior-housing REITs are expected to experience revenue growth in the second half of the year.
We remain cautiously optimistic and continue to use a quantitative investing approach. In times of uncertainty, it is more important than ever to follow the data and not make decisions based on emotions. Hilltops partnership with Helios relies on facts and data, which we use during our recalculations on a bi-weekly basis. Our models adjust appropriately to market conditions.
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