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Despite the heat and humidity—and the resumption of Federal Reserve rate hikes—the bull market kept running in July. At this point in the cycle, it’s entirely possible that the stock market could notch a new all-time high in the month of August.
The S&P 500 put in a bravura performance in the first seven months of 2023, rising more than 19%. The Dow Jones Industrial Average added more than 7%, while the tech heavy Nasdaq Composite rose an astonishing 44% through the end of July.
A better-than-expected mid-year earnings season has buoyed markets, but the real enthusiasm appears to be driven by the dawning realization that the Fed has effectively suppressed inflation without causing a recession.
It remains to be seen whether this outlook survives the heat of summer—and potentially one more rate hike—but with labor markets strong and GDP growing robustly, recession fears have evaporated. That’s great news for stock investors in August.
Another Fed Pause Could Be Right Around the Corner
The Fed has made tremendous progress on the inflation front so far this year, and many investors are optimistic it has finally reached its terminal interest rate of the current cycle.
The consumer price index gained just 3% year-over year in June, down from peak 2022 inflation levels of 9.1%, and not far at all from the Fed’s 2% long-term target.
Stocks rallied in July despite the FOMC delivering yet another quarter-percentage-point rate hike. This put the federal funds target rate range at 5.25% to 5.5%, its highest level in 22 years. Currently, professional investors are betting that there is only a 32% chance that the Fed will raise interest rates again by November, according to CME Group.
Quincy Krosby, chief global strategist for LPL Financial, sounds a cautious note on this kind of market exuberance. She warns that investors shouldn’t be too quick to cheer the Fed’s progress on inflation. The core personal consumption expenditures price index, the Fed’s preferred inflation measure, was up 4.1% in June.
“Core PCE inflation came in at 4.1% from a year ago and under a consensus estimate for 4.2% still won’t settle the dove/hawk debate at the Fed,” Krosby says. Doves are Fed officials who want lower rates, while hawks are officials who prefer more rate increases.
“It is one thing to applaud core inflation is edging lower, but another for the Fed to declare victory when inflation stubbornly remains double the Fed’s desired long-term goal of 2%,” she says
Investors will be closely watching the Jackson Hole Economic Policy Symposium on Aug. 24-26 for any hints from Federal Reserve Chair Jerome Powell about the outlook for inflation, the U.S. economy and interest rates.
U.S. Recession Watch
The next couple of months will determine whether or not the Fed can engineer a so-called “soft landing” for the U.S. economy. That’s the term market participants use to describe the possibility the U.S. economy can avoid a recession despite all the rate hikes.
Economists from Bank of America, Vanguard and JPMorgan Chase still see a high likelihood of a U.S. recession later in 2024. The New York Fed Recession indicator suggests there is a 67.3% probability of a recession sometime in the next 12 months.
But so far, the most convincing indicator of a soft landing has been the resilience of the U.S. labor market. The Labor Department reported the U.S. economy added 209,000 jobs in June, continuing the relatively strong showings in this key monthly data series.
Nevertheless, the pace of job growth has also trended steadily lower over the past two years. Yet the unemployment rate remains historically low at just 3.6%.
Which angle should an investor believe? GDP helps inform the outlook: U.S. gross domestic product grew 2.4% in the second quarter, marking the fourth consecutive quarter that the economy has expanded by at least 2%.
A year of decent growth hardly paints a picture of a lurking recession, although the current crop of corporate earnings reports also shined a cautious light on the next few months.
Earnings Slowdown—New Bank Regulations
Second-quarter earnings season kicked off in mid-July, and results have been better than analysts had expected.
S&P 500 companies that have disclosed quarterly results to date have reported a 7.3% year-over-year decline in earnings per share in the quarter. This puts the stock market on track for its biggest earnings decline since the second quarter of 2020—in the wake of the last U.S. recession.
The consumer discretionary sector is reporting the highest earnings growth of any sector so far in the second quarter, with EPS up more than 36% from a year ago. The energy sector has reported a 52% year-over-year drop in earnings so far in the second quarter and is battling difficult year-over-year comparisons.
Wall Street analysts are expecting earnings to stabilize in the second half of 2023, projecting a 0.2% increase in S&P 500 earnings in the third quarter and another 7.5% growth in the fourth quarter.
U.S. regulators unveiled a new set of capital requirements for large U.S. banks in late July. The new regulations are aimed at addressing some of the issues that contributed to a banking crisis and the failures of a handful of U.S. institutions earlier this year.
Rising interest rates led to huge losses on regional banks’ bond portfolios and the failures of First Republic Bank, Silicon Valley Bank, Signature Bank and others in early 2023. While much of the market has rallied so far this year, the SPDR S&P Bank ETF (KBE) is down 6.3% year-to-date.
Regulators estimate the new capital rules will increase aggregate common equity tier 1 capital requirements by about 16% over currency levels. The heightened requirements will apply to all U.S. banks with at least $100 billion in assets. Banks will have until July 2028 to comply with the new regulations.
How to Invest in August
Adam Turnquist, chief technical strategist for LPL Financial, says a growing percentage of S&P 500 stocks are trading above their 200-day moving average, and broadening participation in the 2023 stock market rally is an indicator the bull market rally could have legs.
“Nearly 75% of S&P 500 stocks are back above their 200-day moving average, with cyclical sectors posting the highest percentages among sector peers,” Turnquist says. “Overall, we view the expansion in market breadth as a constructive sign for the sustainability of this bull market.”
Michael Landsberg, chief investment officer at Landsberg Bennett Private Wealth Management, says investors should be prepared for a possible rebound in inflation in August.
“August is a historically volatile month for the stock market, as many market participants are on vacation. August’s volatility could be extra elevated if we see hotter-than-expected inflation readings in August, given the rise in gasoline and commodity prices over the past few weeks,” Landsberg says.
For investors concerned about the lagging economic impact of Fed tightening on the U.S. economy, Landsberg recommends investors diversify outside of the U.S. by looking for opportunities in growing economies such as Japan, India and Latin America.
Carol Schleif, chief investment officer at BMO Family Office, says investors should be careful not to be too exposed to the technology sector.
“Big tech stocks have run very far and valuations are rich and it may be time for investors to trim their big tech holdings and lock in some profits, as some tech positions may have become too large of a weighting in a portfolio,” Schleif says. “It’s important for investors not to exit their big tech positions completely, since big tech companies are investing heavily in exciting technologies like artificial intelligence that are bound to pay off over the long-term.”
