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Key Points for the Week

  • Core PCE inflation, which excludes food and energy, rose 0.3%.
  • Personal consumption rose 0.2% as higher spending on services overcame a decline in spending on goods.
  • The S&P 500 fell 20% in the first half of the year — its worst first-half performance since 1970.

Economic Update

This has been a challenging year in many respects. Here is a brief look back at the last three months.

  • Will the real inflation please stand up? Prices continued to rise during the second quarter, although there was a significant difference in inflation readings. The Consumer Price Index (CPI), which reflects price changes in cities, showed inflation was up 8.6 percent in May, year-over-year. The Personal Consumption Expenditures (PCE) Price Index (excluding food and energy) which measures price changes in urban and rural areas, showed inflation was up 6.3 percent for the same period.
  • The Federal Reserve attacked inflation. The Federal Reserve’s inflation target is 2 percent. With inflation well above that level, the Fed began to tighten monetary policy aggressively. It ended its bond buying program, began to shrink its balance sheet, and raised the fed funds rate by 1.50 percent year-to-date (with 1.25 percent of that increase coming in the second quarter).
  • Bond rates rose. Bond rates moved higher during the quarter. Since bond prices move lower when bond rates rise, many investors saw a decline in the value of bond portfolios. By the end of the second quarter, the benchmark 10-year Treasury was at 2.98 percent, up from 2.32 percent at the end of the first quarter.
  • Stock prices fell. Evie Liu of Barron’s reported, “Energy stocks were the only ones that posted gains in the first half [of the year] on the back of soaring oil prices, but even that sector has lost its momentum…Although energy companies are still pocketing record profits today, traders are quite aware that a recession would drag down demand, curb oil prices, and cut into their earnings.”
  • Consumer sentiment tumbled. The University of Michigan’s Consumer Sentiment Survey showed that consumer pessimism deepened throughout the second quarter, largely due to inflation concerns. The June sentiment reading was 50, which is the lowest on record.
  • The yield curve isn’t feeling it – yet. Many people anticipate a recession next year, but bond markets don’t seem to think so. One of the most credible recession-forecasting tools is the U.S. Treasury yield curve. When the yield curve inverts, meaning shorter-term Treasuries yield more than longer-term Treasuries, there is a significant probability that a recession is coming.

More specifically, when a three-month Treasury bill yields more than a 10-year Treasury note a recession is likely in the following six to 18 months, according to a study from the Federal Reserve Bank of New York. At the end of June, the three-month Treasury yielded 1.72 percent and 10-year Treasury yielded 2.98 percent. In other words, the yield curve was not inverted.

Markets are likely to remain volatile until investors are confident the U.S. has avoided a recession, and no one is sure when that might happen.

Last week, major U.S. indices rallied late in the week, but finished lower overall, according to Barron’s. The yield on benchmark 10-year U.S. Treasuries moved lower.

This Week in the Markets

The Personal Consumption Expenditure (PCE) Price Index increased 0.6% in May, after rising only 0.2% in April. PCE inflation is an alternative inflation measure to the Consumer Price Index (CPI), which is released earlier. The two measures both show inflation to be very high, but the CPI indicates prices have risen 8.6% in the last year, while PCE inflation has increased only 6.3%. The biggest difference is the basket of goods that make up each measure. For example, PCE inflation includes a wider range of medical costs, which have not increased as much as energy prices. Energy comprises 7% of the CPI and just 4% of the PCE. The Fed has indicated it favors the PCE measure, modified to exclude food and energy. PCE ex food and energy increased just 0.3% as gasoline prices rose significantly in May.

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One trend likely to help the Fed reduce inflation is increased spending on services. Services spending rose 0.7% while goods spending dropped 0.7% last month. Services account for a larger share of the economy, so the net effect was a 0.2% increase in overall spending. Service inflation has been lower than goods inflation, and decreasing goods spending is likely to reduce price pressures on some items in short supply.

The S&P 500 declined last week as markets became more concerned about the risks of recession in the next twelve months. The index of large-cap U.S. stocks fell 20% in the first half of the year. Global stocks matched the S&P 500’s decline as well. Bond prices increased because the concern was more about recession than inflation. The Bloomberg Aggregate Bond Index added 0.4% last week and posted its second week of gains. The Department of Labor’s update on the U.S. employment situation leads the list of economic releases this week.

Five Reasons to Expect a Better Second Half

The S&P 500, including dividends, declined 20% in the first six months of the year. The fall represented the worst first-half market performance since 1970. Emotionally, this market has taken its toll through a decline that started the second day of the year and accelerated in the second quarter. High inflation has been the biggest challenge, and every time we get gas, buy groceries, or check the market we are reminded of it.

The propensity in down markets is to expect current trends to continue. In difficult markets, it is also easier to focus on known negative factors that have proven to be challenging. Yet, as we enter the second half of the year, there are strong reasons to expect improvement. Here are five forces we believe will make the second half of the year more attractive than the first.

  • Much of the bad news is already reflected in market prices.

    The first half of 2022 contained a lot of bad news for markets, and prices fell in response. Inflation continued to increase, COVID shutdowns slowed the repair of supply lines, and Russia invaded Ukraine. In response to high inflation, the Federal Reserve pivoted and raised interest rates three times, once by 0.5% and once 0.75%. Europe reacted to Russia’s invasion of Ukraine by drastically reducing its purchases of Russian oil, contributing to slower economic growth and higher inflation. While those events had negative consequences, remember the market has already reacted to the news. With the S&P 500 20% lower than at the start of the year, it’s hard to argue that markets have ignored what has occurred.

  • Inflation seems to be moderating.

    The Fed’s favorite measure of inflation increased 0.3% for the fourth consecutive month. But the Personal Consumption Expenditures Price Deflator (PCE) ex Food and Energy has moderated in recent months. From October to January, core PCE increased approximately 0.5% per month. An increase of 0.3% is still too high. Multiplying it by 12 creates a simplified annual inflation rate of around 3.6%, which is well above the Fed’s target of 2%. But our view is the steps the Fed is taking are starting to work, and additional hikes will contribute to slower price increases in coming months.

  • Political uncertainty is ebbing lower.

    In the presidential election cycle, the second year of the administration is statistically the most challenging. Domestic political uncertainty has made this year even more so. House and Senate majorities are very narrow, and both houses of Congress could switch parties in November. The Supreme Court has been full of surprises, and the Jan. 6 commission has added to the mix. By the fourth quarter, and possibly even the third, polling data will provide some clarification on how midterm elections will turn out. The high inflation has also undercut any desire for a major spending initiative. Because the last support package seemed to feed inflation, avoiding high government spending should help reduce inflationary pressure.

  • Much of the economy remains strong.

    While the current bear market is the 11th since 1950, it is only the fourth to occur outside of a recession. Non-recessionary bear markets are usually shallower, averaging a 28% decline, compared to an average 39% decline for recessionary bear markets. This week, the government will release the Job Opening and Labor Turnover Survey (JOLTS) for May and the Employment Situation report for June. The ideal result is decent job creation while companies choose to pull back open positions to reduce the excess demand for labor.

  • The system works.

    Hopefully, as investors lit off fireworks celebrating our country’s founding 246 years ago, they appreciated the resiliency of the American system. Investors who focus only on the short-term swings in inflation, political winds, and Fed policy should take note of the longer-term success of this republic and how people and equity markets have prospered. Even with two bear markets, inflation and a global pandemic, the S&P 500 is up double digits over the last 10 years.

The key is to find the right balance. This has been a tough year, and we will continue to monitor a wide range of near-term risks and how they affect markets. Because many of those risks are already reflected, at least partially, in current prices, the more impactful data points may be those showing how a system with a long record of success is recovering.

Did you Know? This Week in History

July 8, 1776: Liberty Bell Tolls to Announce Declaration of Independence

On July 8, 1776, a 2,000-pound copper-and-tin bell now known as the “Liberty Bell” rang out from the tower of the Pennsylvania State House (which is now known as Independence Hall) in Philadelphia, summoning citizens to the first public reading of the Declaration of Independence. Four days earlier, the historic document had been adopted by delegates to the Continental Congress, but the bell did not ring to announce the issuing of the document until the Declaration of Independence returned from the printer on July 8.

The question of when the Liberty Bell acquired its famous fracture has been the subject of a good deal of historical debate. In the most commonly accepted account, the bell suffered a major break while tolling for the funeral of the chief justice of the United States, John Marshall, in 1835, and in 1846 the crack expanded to its present size while in use to mark George Washington’s birthday. On June 6, 1944, when Allied forces invaded France, the sound of the bell’s dulled ring was broadcast by radio across the United States.

Weekly Focus

The bad news is time flies. The good news is you’re the pilot.”

Michael Altshuler, Performance Coach

Life is like riding a bicycle. To keep your balance, you must keep moving.

Albert Einstein, Theoretical Physicist