As of market close July 28, 2023. Returns in percent.

Investment Insights

 — Steve Orr 

A good one

July was a good month across the board for risk assets. History says preelection Julys average about a 1% gain. The S&P 500, mid- and small-cap indices finished 3% or higher. Earnings reports are not bad, the Fed telegraphed another rate increase, and the economy grew better than expected in the second quarter. Among the headliners, Emerging Markets posted the highest return at 5.8%. A weaker dollar helped in June and July but the biggest move for the foreign index came last Wednesday. The Bank of Japan announced it would allow the maximum yield on its 10-year bond to float around the 0.5% level. It had been capped at that level since December. Japanese bond yield levels are still negative for short-term rates and traders view them as the “floor” of the global rates markets. We expect the yen to appreciate versus other currencies and some upward pressure on all interest rates. 

Recession worries are taking a back seat in the Dow Transport index. Despite in-line earnings by most of the airlines, lower guidance and strike worries dropped companies in the segment between 1% and 10% (JetBlue). That was the “bad” news. The trucking and rail segments did just fine, thank you. Expeditors, rising 5.8%, was chasing Ryder with a 21% gain for the month. As we close the month, the Dow Transports index sits just 2% below its all-time high.

Still surprising

Second quarter gross domestic product caught everyone by surprise last week. Real GDP rose at an annual rate of 2.4%. First quarter was 2% and projections for the second averaged 1.5%. The acceleration in growth is impressive after a full year of Fed rate increases. “Real GDP” means economists subtract inflation from nominal dollar GDP stats. Depending on your choice of inflation measure, the actual economy rose year-over-year by about 6%. That growth rate is a long way from zero or negative growth in a recession. 

GDP is the sum of government, private investment and consumer spending, with imports and exports netted against each other. Last quarter’s foreign trade impact was small. Government spending rose at a 2.6% annual clip, inventories only 0.14% — a good sign. Another surprise was the jump in corporate capital expenditures, or capex, which contributed 0.99% of the 2.4%. That is a 7.7% growth rate and the largest in five quarters. The data series real final sales to domestic purchasers (say that real fast three times) tracks just our domestic activity in GDP. It rose a solid 2.3% last quarter. This level is below the recent average of 3%, but still above our 2% “red line” for a recession. 

Consumers continue to shift spending away from goods toward services. This makes sense after shutdowns, but we expect in the next two quarters to see spending normalize. There does appear to be some support still from shutdown stimulus. We will be watching wage growth in the coming months. Labor settlements from strike threats across several industries will add to inflation.

Yes, more coming

The FOMC resumed its rate increase program last Wednesday with another quarter-point increase in the overnight Fed Funds rate. The current target range is now 5.25% to 5.5%. The Fed started this rate increase cycle in March of last year and this is the eleventh increase in 12 meetings. Short-term rates are now their highest in 22 years. The Fed will continue to draw down its bond portfolio, which pulls excess reserves from the banking system. 

The press release did not change the key sentences: “… the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate.” In normal person-speak if GDP and job numbers continue to be strong, we will keep raising rates. 

A large contingent of Wall Street analysts and commentators believe the Fed is done or near done. From the press release: “The Committee remains highly attentive to inflation risks.” That statement suggests to us that future rate increases are more likely than not. The Fed does not want the embarrassment of raising rates, then cutting, then having to raise again because it was unsuccessful in lowering inflation. Most of the Treasury yield curve is still below median and core inflation rates. Subtracting those 2- to-30-year Treasury rates from inflation gives negative real rates or what economists call “very easy money.” What makes us uneasy is using Taylor’s Rule to measure the Fed’s progress. The nominal interest rate — right now 3.95% for the Treasury 10-year — is below core inflation of 4.8% and well below the Cleveland Fed’s median inflation measure of 6.4%. Depending on your inflation choice, the Rule suggests a Fed Funds rate somewhere between 8.25% and 9%. Ouch. 

Halfway!

After Friday’s close, 51% of the S&P 500 had reported second quarter earnings. Earnings beats are running at an 80% clip, ahead of averages. But FactSet reports that the size of those beats is below average. This season’s average earnings beat is 5.9%, just below the 10-year average of 6.4%. The big index is still on track for a year-over-year decline in earnings of about -7%. This would be the third quarter in a row for earnings declines. 

Local favorite Southwest Airlines matched estimates but said fuel costs were higher than expected. It expects a profitable third quarter based on summer vacation travel bookings but is reserving funds for unfinished labor negotiations. Intel bucked expectations of a worrisome chip outlook by raising guidance. Ford did the same. Looking through last week’s reports, we find an almost even split between companies raising earnings guidance as lowering it. That implies flat to slightly positive earnings for the rest of the year, again surprising analysts. FactSet reports that the full-year earnings growth estimate for the S&P 500 is -0.4%. Not bad for interest rates hitting 20-year highs, Fed pulling liquidity out of the banking system, a tenuous geopolitical climate and a Congress about to restart budget negotiations. 

Dow Industrial components Apple, Amgen, Caterpillar and Merck report this week. Notable Texas Capital index components reporting are Phillips 66, Service Corp,, Wingstop and McKesson. For the S&P 500, 170 names report, so by this time next week we should have a pretty good handle on the third-quarter outlook.