Looking back, looking ahead

Consensus agrees that the first half was a “consensus killer.” The economic data kept surprising to the upside, particularly jobs and consumer spending. Stocks rallied. Volatility fell. Despite a higher for longer Fed, credit spreads tightened and growth strategies outperformed. Indeed, 2022’s laggards were the big YTD winners through June (Information Technology +42%, Communication Services +36% and Consumer Discretionary +32%), while 2022’s leaders were the laggards (Energy -7%, Utilities -7% and Health Care -2%). Tech titans drove the market, with eight mega-cap stocks surging a collective 59% the first six months. Nasdaq’s 32% gain represented its best first half since 1983 (following its worst first half ever in 2022). It was the narrowest market in history—just 25% of stocks outperformed the S&P 500—though participation broadened somewhat the final month. June’s 7.7% gain in the equal-weighted S&P topped the cap-weighted benchmark’s 6.6% rise, and value outperformed growth while small caps outperformed large caps. Still, the gap between styles was vast over the entire six months, with the Russell 2000’s relative underperformance to the Russell 1000 the third widest since 1979 and the widest ever vs. the Nasdaq 100. Interestingly, despite tech’s run, cumulative flows into the Nasdaq 100 since October just turned positive, a skeptical sign that could suggest staying power.

There are signs the FOMO trade is starting to settle in. Overall equity inflows accelerated last week, pushing the June total north of $50 billion, the most in eight months. The real federal funds rate just recently reached positive territory, potentially supportive for equities. In the nine past periods of a rising real fed funds rate, the average S&P annual return was 12.1%, beating the overall compound annual return of the market since 1960 by 150 basis points. As the Q2 reporting season starts, the bottom-up consensus is for lower earnings, just nothing severe. For the year, the EPS estimate is around $220, where it stood at the beginning of a Q1 season that strongly beat and marked the first sequential rebound since earnings peaked in Q2 2022. S&P forward revenues hit another record high last week as analysts stopped lowering margin expectations. It seems the market is growing more confident that weak parts of the economy are set to improve, and that good parts may stay resilient. “In a sense, bad is seen as good,” JP Morgan says. For example, China data flow is so weak it may spur stimulus. Manufacturing PMIs are so low they are bound to rebound (more below). This is creating an interesting divergence in the performance of cyclicals vs. defensives, with the former up 20% over the past year vs. the latter in both Europe and the U.S., even as manufacturing PMIs and the ISM are contracting.

Can the Fed pivot if there is no pain? June’s jobs report came in slightly below consensus (more below), but wage gains rose and unemployment fell. Unlikely to move the needle for the Fed, which in its minutes made several references to “very tight” labor markets and core inflation that hasn’t shown much “sustained easing.” At this writing, the 10-year Treasury yield is at 4.04%. It broke through resistance last week and is up 33 basis points in just six days. 2-year and 5-year yields are challenging their cycle highs. This comes even as headline CPI has more than halved in the past year, from roughly 9% to 4%, reminding Strategas Research of rates’ behavior in the mid ’70s and early ’80s, when they didn’t peak until well after inflation. Jefferies notes that going back 96 years, whenever the first half rallies more than 10%, the back half has been positive 76% of the time, with an average gain of 6.5%. Pretty good odds. And since 1945, Evercore ISI says markets that have started +10% have finished stronger 19 out of 23 times, gaining another 10.5% on average. Even better odds. It arguably comes down to the consumer, whose pockets are still flush with cash. M2 remains about $2 trillion above its pre-pandemic uptrend, suggesting there’s still a lot of excess savings, and Yardeni Group estimates demand deposits (checking, savings, etc.) at banks are still $1.5 trillion above their pre-pandemic trend line. Liquid assets among generations range from $11.4 trillion for baby boomers to $2.2 trillion for millennials. While Wolfe Research thinks spending could slow on the low-end amid rising layoffs, tightening credit, fading “excess savings,” lower transfer payments and a restart of student loan repayments, it sees high-end spending remaining resilient. For the middle-income spectrum, hard to see a slowdown until there’s a noticeable increase in unemployment. And that seems unlikely anytime soon.

Positives

• The consumer is spending a lot on services ISM services unexpectedly jumped in June to a 4-month high, led by a surge in business activity and a large increase in new orders. S&P Global’s separate services PMI also was revised higher, continuing spring’s acceleration.
• Can autos & chips give manufacturing a second wind? June light vehicle sales soared 20% y/y, their 10th-straight increase, and construction of manufacturing facilities has doubled over the past year on infrastructure spending and incentives supporting green energy & computer chip development.
• Housing is finding a bottom In line with other recent data, residential construction spending rose 2.1% in May, its first increase in a year and the latest sign the sector could be contributive in the year’s second half. The increase helped lift overall construction spending by the most in four months.

Negatives

• The Fed’s got its work cut out for it While nonfarm jobs came in below consensus and prior months were revised down modestly, June’s gains were still solid and the unemployment rate dipped while average hourly earnings rose. ADP estimates surged 497k, though analysts were suspicions of seasonal anomalies. Elsewhere, job cuts unexpectedly fell to an 8-month low, a small increase kept jobless claims below historical averages, and May job openings slipped while the quits rate rose.
• Manufacturing retrenchment deepens overseas … June’s manufacturing PMIs showed only a third of countries in expansion, the lowest since December, with Europe hit the hardest. Germany plummeted to its lowest reading in three years, with employment declining for the first time since January 2021, and Italy suffered its steepest decline since April 2020. With services also slowing, German unemployment posted its largest increase since 2009 (ex the pandemic).
• … and in the U.S. May factory orders and June’s manufacturing ISM disappointed, the latter falling to a 3-year low and marking an eighth straight month of contraction. The bulk of deterioration was in production.

What else

Decent odds In 16 instances since 1957 that the market has rallied 20% off lows, 13 resulted in a new all-time high, Renaissance Macro shares. The other three (all in the aughts) saw the market deteriorate and undercut the previous low.

The U.K. has issues It has a distinctively severe inflation problem, Evercore ISI says, originating in the interaction of Brexit with the pandemic and Russia-Ukraine war shocks, and amplified by the Bank of England’s failure to anchor expectations. Markets are now pricing a 6.5% policy rate following June’s half-point hike to 5%.

Too bullish? That’s what Yardeni wonders with the percentage of Investors Intelligence bulls at its highest since the bull run from March 23, 2020 through Jan. 3, 2022. What happened next? The bull got gored as the S&P plunged into a bear market over the subsequent seven months.

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