Stocks staged a sharp rally on Friday after some earnings disappointments sent stocks lower on Thursday. Economic news was generally positive led by a stronger than expected retail sales report for June. With that said, in most cases, the impact of higher prices suggested Americans were spending more dollars but on fewer goods. That is the crux of the war against inflation which eats away our purchasing power.
After a horrid June, the stock market has traded in a more sideways motion in July as it reflects a variety of cross currents. Interest rates have traded in a very narrow range centered around 3% all along the yield curve. The Federal Reserve meets in a little over a week to decide whether it wants to raise rates by as much as 100 basis points. While talk of such a large increase escalated after the last CPI report, the current feeling within the FOMC is that the risk of moving too fast and crushing the economy is too high. 75 basis points is not quite yet written in ink, but that seems the consensus. The next meeting is in September. Another 75-basis point increase would lift the Fed Funds rate to 3%, a level the Fed feels gets it pretty close to neutral. The goal is to reduce inflationary pressures back toward the target of 2%. One way to achieve that would be to crush growth and, by extension, demand, but while a slightly more moderate pace might take longer, the economic damage would be less.
Everyone today sees that commodity prices have started to rollover from oil, to wheat, to copper and lumber, prices are meaningfully below post-pandemic peaks. While that reinforces expectations that July consumer price data will likely show some meaningful improvement for the first time in months, the focus on any war against inflation has to be rents and wages. Rents are measured in an arcane way in the CPI. They currently are rising at an annual rate of close to 7%. Because of the manner the government uses to measure shelter costs, there will be a lag effect as rents stabilize. Expect shelter cost increases to remain stubbornly high for several more months at least, but housing prices have started to retreat in some markets and the interest rate used to calculate implied rents has also stabilized. Implied rents, therefore, should show hints of rising at a slower pace going forward.
Wages too are rising. So far, however, they have not risen as fast as prices. Thus, the implication is that any gain in wages is an empty victory. Inflation has been eroding all the increase and then some, but as wages continue to rise and inflation starts to ebb, that will change. In June, the only significant category where price increases did not fully offset inflation was eating away from home. It is both obvious and logical that as the cost of necessities from food to gasoline have skyrocketed, we all have less income to spend on more pleasurable discretionary items. Over the short-run, Americans have made up for the difference by decreasing their savings rate. That can’t continue forever. However, for companies that focus on the sale of necessities or near necessities, inflation has created a windfall in the short-term. No better place to look than gasoline refiners. The offset has been things like apparel sales. For now, as we continue to recover from Covid restrictions, sales of experiences from travel to movies have boomed. Again, the losers have been discretionary goods, particularly high ticket items.
Earnings season started mixed last week. The early loser appeared to be JPMorgan Chase# that saw a significant decline as it added loan loss reserves while also seeing a decline in securities related trading. Both had been expected. Last week I highlighted the importance of looking past the actual earnings numbers and concentrating on how the stock market reacted. A gain after a weak earnings report might suggest that the bad news was already priced in. Indeed, while JPM’s stock fell over 2% Thursday after it reported, the losses were fully reversed during Friday’s rally. Another Dow Component, United Healthcare, reported stronger than expected results on Friday and its shares took off. It is only two days but that is exactly what you want to see. Good news sends stock prices higher while bad news is already largely built into share prices.
It is still very early in earnings season. There will be some true earnings misses that make headlines, but a lot of damage has been done since the last earnings season in April. It’s easier to match expectations amid doom and gloom than amid false optimism.
Futures point higher again this morning. Probably the biggest factor is a The Wall Street Journal headline story saying that FOMC consensus is pretty strong around a 75-basis point increase at the July meeting putting to bed fears of a 100-basis point rise. The Fed self-imposes a quiet period of public comment from members for a period of about 10 days in front of a meeting. Just before the period begins, however, it often feeds The Wall Street Journal an indication of its thinking. That’s what is behind this morning’s story. 75 basis points isn’t a certainty but it now should be thought of as highly likely unless intervening data strongly suggests otherwise.
The second headline over the weekend centered around a fist bump between President Biden and Saudi prince Mohammad bin Salman. While the media made a big deal of this given the recent bad behavior of the Saudis, the real news was that the President essentially walked away without any new commitment to increase oil supplies. The White House for days had been talking down any near-term changes. It appears all they got for their troubles was a controversial fist bump. Oil prices are higher this morning.
Back to earnings. Monday mornings and Friday afternoons don’t generally see many important earnings reports. After tonight’s close the headlines will focus on IBM, a big underperformer in recent years but a company that actually surprised to the upside in the first quarter, one of the few tech names to do so. Can it do it again? Stay tuned. The action will pick up tomorrow morning led by Dow Component, Johnson & Johnson#. After tomorrow’s close the big name to watch is Netflix. Last quarter was a disastrous one for Netflix. It saw a decline in U.S. subscribers for the first time and predicted further declines this time around. However, it is taking remedial steps including plans for an ad-supported version of its service and stronger efforts to limit non-subscribers from logging in using passwords they didn’t pay for. Netflix has chosen Microsoft to be its partner to introduce an ad-supported service. Here’s a case where bad news is anticipated already. Is there another shoe to drop? Its stock is already down more than 70% from its highs. Don’t expect a repeat of Q1’s disaster, but a lot of questions remain concerning the growth and maturity of the streaming business. Is it still a growth industry? We will learn a lot more tomorrow.
The stock market’s behavior over the next several weeks will depend a lot on how companies react to earnings. July and August are not likely going to tell us a lot about how the economy is changing. The drop in commodity prices sets the stage for some moderation in inflation but that is already built in. Except for businesses directly impacted by summer vacation season, August is usually a bit of a lull. Thus, how the stage is set for at least the next several months will depend on investor reaction to earnings. It has been a bad 6+ months so far this year. A lot of skepticism is already priced in, but are lower earnings fully discounted? That’s the big question, one that will be answered over the next two weeks.
Today Vin Diesel is 55. Richard Branson turns 72.
James M. Meyer, CFA 610-260-2220