SPXN - Can Markets Continue To Rally? Why Inflation Remains Key

2023-07-25 00:52:00 ET

Summary

• Why markets may continue to rally but at a slower pace.
• The U.S. economy continues to send mixed signals to investors.
• Why we may be in an earnings recession.

Equity markets have performed better than expected so far this year. But can that trend continue through the second half? John Eade, President of Argus Research, breaks down the various scenarios that could impact market direction and explains why inflation remains a central theme.

Anthony Okolie: Markets have held up better than expected so far this year. But will that trend continue? Joining us now to discuss is John Eade, President of Argus Research. John, thanks for joining us.

John Eade Well, thank you, Anthony, for having me on the program today. I'm honored to be here.

Anthony Okolie: Okay, so let's start maybe with a look back at what we've seen so far this year from your initial forecast. What has played out and what has surprised you so far?

John Eade: Well, so Anthony, we started the year here at Argus a bit contrarian. We were one of the few research shops that was actually predicting a good year for stocks. Everybody was, here in the US, still thinking about the 19% decline in the S&P 500 last year and really forecasting that trend forward, just continued challenges for stocks.

We've looked at the stock returns going back years and years and have found that it's very rare, Anthony, that you have two negative years in US stocks in a row. So we thought that this year would actually be a more normal year. Not a great year, not 20% up, but maybe 8%, 10%, 12%, which is your average year here in US stocks. And we thought that would be driven by the Federal Reserve moving to the sidelines after its rate hike campaign, inflation trending downward from the peaks of 9% last summer, an economy that stayed in a growth mode.

And so far, we've hit on all of those outlooks. And then the fourth factor is the corporate earnings. And you mention in your introductory remarks that we're in the second quarter earnings period here, and so far, so good. We've had two negative earnings quarters in a row here in the US. That's an earnings recession. But we may be ready to leave that earnings recession here in this second quarter. Or if not the second quarter, then I would think almost for certain the third quarter.

Anthony Okolie: As you mentioned, we're early into the second quarter earnings. So far, so good. We have more to come.

But let's go through some potential scenarios for the markets going forward. And you have three different outcomes for us. Talk to us about your base case for the markets for the rest of this year, to start.

John Eade: OK, so let's start out and say that the first half returns, let's call it 15% for the S&P 500. So what we've found is when the US stocks increase at a double digit rate in the first half of the year, they tend to go on and continue the rally in the second half as well. In fact, the fourth quarter is usually the strongest quarter that we see in all of the quarters in the US.

So our base case is that the bull market continues, but we don't rise at the same pace that we did in the first half. Maybe the market adds another 5% and ends up for the year 18%, 19%, 20%, which is an awesome year for stocks, but a stronger first half than the second half. And that would depend on things like maybe GDP growth slows a little bit in the second half. Perhaps the Federal Reserve hikes rates not just one more time, but a couple more times.

And we've already seen some real good news on CPI. We had thought that the core CPI could fall to 5% by the end of the year. It's already at 4.8%. So we've beaten that expectation. And that 4.8% is down from, like I said earlier, almost 9% this time a year ago.

So that's been a very sharp decline in inflation. And while we expect inflation to moderate looking ahead, we don't think it's going to decline at that same rate over these next few months.

So those are some of the things that we're thinking about and looking for as we think about our base case for stocks for the second half of the year.

Anthony Okolie: OK, so that--

John Eade: In a--

Anthony Okolie: Go ahead?

John Eade: In a bullish case, maybe inflation does continue to decline faster than expected, these earnings come in better than Wall Street analysts are expecting, and we get to the point where the US has entered a bull market again. It's up 20% from its bear market lows, but it hasn't yet reached the previous peak, the peak that we had in, I guess, it was January, 2022.

So in the bullish scenario, we see maybe a 25% gain in stocks, again, driven by low inflation, lower interest rates, and better earnings and we reach an all-time high in the S&P 500. That would be a bullish case, we think, in the US for the second half.

Anthony Okolie: Okay, so you've got the bullish case. Talk to us about the bearish scenario.

John Eade: Okay. Yeah, got to cover all the ground, Anthony, for sure. So again, going back to that study we did on the returns in the market, remember the first half returns were up 15%. Never in the second half of a year when the market has been this strong have we ended up with a full year negative return.

So I think returns overall for the year are going to be positive for the S&P 500 in 2023. But there's a chance that we pull back from these current levels where we are, maybe give back 10% of the gains or so. And what would cause that?

Well, maybe inflation stabilizes here and transportation costs don't fall, shelter costs don't fall, food costs stay high, so you get a leveling off of inflation instead of a decline in inflation. Or in even a worst case scenario, maybe inflation picks back up again.

The Federal Reserve met a month ago. And while they didn't hike rates at that meeting, they indicated that they plan on hiking rates up to two more times here in 2023. So they've got a meeting at the end of this month. We think there's going to be one hike. And then we don't think that they're going to hike twice, but the Fed's notes from the meeting indicated that they're willing to go at least two more times.

So two more rate hikes, a negative impact on the consumer sector of the economy. We've seen the rate hikes have an impact on the housing market. We've seen the rate hikes have an impact on the manufacturing market. We've seen the rate hikes have an impact on the export market. They haven't yet had an impact on the consumer sector, which is the biggest part of the US economy.

Well, okay, maybe two more rate hikes do have that impact on the consumer sector and unemployment heads back up toward 5%. The economy dips into a recession. Those are some of the bearish case scenarios. Not entirely likely, but, again, the Federal Reserve has said they're not done raising interest rates. And that could still have a negative impact on the consumer sector of the economy.

Anthony Okolie: And when you talk about inflation remaining sticky, talk to us about wage gains, because wages have been coming down, but they haven't been coming down as quickly as possible. What are your thoughts there as well?

John Eade: So that's a great point, Anthony. Let's go back maybe 8 or 10 years, when there was really almost no wage growth at all. Maybe 1%, 2% year-over-year wage growth, barely ahead of inflation, which at that time was very low. And then you contrast that to the period right after the pandemic, when people were bringing employees back on, a lot of employees didn't want to go back to work, so companies had to pay employees more. We started to see 5%, almost 6% year-over-year wage growth for a period of time in 2021 and into early 2022.

So that's cooled off a little bit. The numbers now are around 4.1%, 4.2%. That's well ahead of what the Fed would like to see. The Fed would like to see all measures of inflation down at 2%. But 4% is better for the economy and for inflation than 6% was a year ago. And we do expect that trend to move toward 3% perhaps by the end of next year. So wage growth is moderating but is still a little bit higher than what the Federal Reserve would like to see.

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