Soft Landing And Bull Market Still On Track

As the highly anticipated pullback in stocks ensued last week, the underlying fundamentals for the market and economy continue to move in positive directions. That tells me that this pause will be brief, and the drawdown relatively modest in percentage terms. Also as expected, we are seeing the mega-cap technology names that fueled a majority of the index gains this year taking the brunt of the punishment. The “Magnificent 7,” as shown in the chart below, have collectively declined more than any of the major market indices. This is the result of improving market breadth, which is mitigating the damage to the broader market. This is a healthy rotation that was necessary to support a continuation of the bull market.

As for the fundamentals, we saw more progress on the inflation front, as the Consumer Price Index (CPI) for July was better than expected, with the core rate falling from 4.8% to 4.7%, while the overall rate rose from 3% to just 3.2%. The Producer Price Index (PPI) saw a small uptick from 0.2% to 0.3% for July, but the overall rate is just 0.8%. The disinflationary trend in both remains intact.

The most positive aspect of the inflation report was that housing accounted for 90% of the overall increase. As Yahoo Finance notes in the chart below, when we exclude housing costs the rate falls to less than 1%.

The reason this is positive is that annualized rent inflation, as measured by the Zillow Observed Rent Index, has fallen to its long-term average of approximately 4.1%. Rent growth typically slows during the late summer and outright declines in the fall, which should result in a continued decline in the annualized rate. Additionally, nearly one million multi-family units were under construction as of May on an annualized basis, which will significantly increase the supply of rentals and weigh on future price increases.

Consumers seem to be well in tune with these developments. Last week’s University of Michigan Consumer Confidence survey showed the consumers’ inflation expectations for the coming year fell from 3.5% to 3.3%, which is below the 45-year average. This is an important number for the Fed. Chairman Powell has indicated that expectations must be managed to bring the inflation rate down to target. It looks like that battle has been won.

The progress in returning the rate of inflation towards the Fed’s target of 2% is the reason investors see the Fed’s rate-hike cycle having ended in July. The Fed funds futures market sees a 90% probability of no rate hike at the September meeting with a greater than 60% of no rate hike in November and December. Historically, stocks have performed well in the months following the conclusion of a rate-hike cycle during disinflationary environments.

Lastly, corporate profits are coming in better than expected for the second quarter, and we are on the cusp of growth again in the year-over-year numbers for the S&P 500. Bolstering that prospect is the fact that the Fed’s GDPNow model shows a rate of economic growth in the current quarter of 4.1%. That is an acceleration from the 2.4% rate in the second quarter, which was an acceleration from the 2% rate in the first. That is a hugely positive rate of change. In a similar vein, the trough in earnings growth looks to be behind us. The expectation at the end of the second quarter was that S&P 500 earnings would decline 7%, but nearing the end of the season the decline has narrowed to 5.2%. We should see a resumption of annualized growth in the second half of this year.

This year’s market rally has been in anticipation of these developments. There is plenty of fuel left in the tank to power stocks higher, as retail money market fund balances have surged to what the Investment Company Institute estimates to be over $2 trillion. My outlook for a soft landing for the economy and new bull market in 2023 remains on track.

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