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4785455 - 6/15/2023
Get insights directly from Merrill’s Chief Investment Officer on market volatility, and why it might be here for some time.
Get insights directly from Merrill’s Chief Investment Officer on market volatility, and why it might be here for some time.
Niladri Mukherjee: This is Neel Mukherjee, Head of Portfolio Strategy for the Chief Investment Office, with the August 8th market update. I’ll go over recent key developments, our portfolio strategy advice, and what to look for in the coming weeks. On Friday the employment report for the month of July far exceeded investor expectations. It showed that the US economy added a robust 528,000 jobs, recouping the 22 million jobs lost early in the pandemic. The unemployment rate dropped to 3.5%, a half a century low also seen just before the pandemic and average hourly earnings - a measure of wages - also came in stronger than anticipated rising 5.2% in July from a year earlier; a slight acceleration over the prior month. The labor force participation rate or the share of adults working or seeking a job ticked down to 62.1% in July from 62.2% a month earlier. This exceptionally strong labor report is good news for the economy and indicates that the US consumer can potentially remain resilient amid higher prices to the benefit of companies and their profitability. On the other hand, it shows that the Federal Reserve is still way behind the curve in controlling inflation and therefore may have to be more aggressive in tightening monetary policy to bring down core inflation. The Fed would welcome some easing of the labor market especially wages, but they got the opposite of that with a three month average for job growth increasing to 437,000 jobs in July compared to three month average in June at 384,000. Last week bond yields rose meaningfully on this news. The front end treasury yields rose with a two year rate climbing as much as 20 basis points on Friday to 3.24%. In total, the two year yield rose 35 basis points last week as several Fed officials reaffirmed an ongoing resolutely hawkish stance on inflation and interest rates, challenging the view that July’s FOMC meeting marked a dovish pivot. Rates from the long end, recognizing that inflation is proving sticky, also rose with the 10 year treasury yield rising 14 basis points on Friday and a total of 18 basis points for the week to 2.82% and the twos tens yield curve further inverted by 18 basis points last week to a -43 basis points currently. The strong jobs report validates the Fed’s view of a resilient economy that can, at least in the near term, withstand additional interest rate hikes. The market has now recalibrated expectations for Fed policy with a 75 basis point hike as more likely scenario at the September meeting, but the data dependent Fed will have two CPI reports and one more employment report to consider before that meeting. Our economics team now believes that the Fed will have to raise the fed funds rate to a range of 3.5% - 3.75% by year end from the current range of 2.25% - 2.5%, meaning an additional 125 basis points of hiking over the remaining three meetings this year on September 21st, November 2nd, and December 14th. Despite July’s strong labor report on Friday, there were other reports during last week that indicate that there are early signs that the labor market is easing. Jobless claims have risen by 94,000 since mid-March to 260,000. Also, US job openings fell in June to a nine month low as the number of available positions decreased to 10.7 million in June from an upwardly revised 11.3 million in May. Beyond the bond markets last week, we saw the dollar strengthen further and is now hired by 11% this year. Oil prices fell below $90.00 a barrel and it’s now down 25% from the peak in June. The average price of gas at the pump is lower by $0.90 during this time in what is surely going to be a relief for consumers. Equities have generally been quite resilient and higher bond deals have not hurt sentiment for equity investors much with the S&P 500 ending the week roughly flat, but since the lows in June, the S&P 500 is up 13%, narrowing the year to date losses to only 13%. The rally since June has been led by sectors that had taken the brunt of the sell off in the first six months of the year such as consumer discretionary and technology. For the S&P 500 index valuations have expanded somewhat, the indexes forward PE which started the year at 21.4 bottomed at 15.3 on June 16th and is back up to 17.5, a level slightly above its long term average. Better than expected corporate earnings for the second quarter has been one major reason for this equity bounce with most of the S&P 500 companies reporting both top and bottom line have beaten consensus expectations by roughly 3% - 4% each. The year over year blended growth rate for revenues this quarter is around 13% and for earnings it is around 7%. However, we are seeing analysts begin to trim their estimates for the second-half of the year and for 2023 and we think that as economic growth further moderates, there could be more downside to these earnings estimates. Looking forward, during the week of August 8 there were two important data points that investors will be looking towards. The July Consumer Price Index will be released on August 10th where investors will look for signs of cooling prices given the recent decline in oil and other commodities and the University of Michigan’s Consumer Sentiment Index will be closely followed on August 12th to gauge the state of the consumer and their expectation for inflation going forward.
Now moving from macro to politics, there’s a lot that transpired with Washington fiscal policy recently. First, Congress passed the CHIPS and Science Act, which provides semiconductor companies $52 billion to encourage them to develop and research chips in the US. It creates a 25% investment tax credit for companies that invest in semiconductor manufacturing to further incentivize US companies. Additionally, the legislation authorizes roughly $200 billion in science and technology research funding for the coming years. The package overall is aimed at improving US’ ability to compete in future technologies amidst efforts by other nations to boost chip manufacturing and industry increasingly seen as key to economic and military security. President Biden is expected to sign it into law on August 9th. Secondly, this weekend the senate democrats passed the Inflation Reduction Act, their signature climate act and healthcare package. The core of the legislation includes lowering some prescription drug prices, providing more than $300 billion for climate change and clean energy, and imposing a 15% minimum tax on large corporations plus a 1% excise tax on stock buybacks. The bill also increases IRS enforcement and extends Affordable Care Act subsidies through the 2024 elections. The bill is likely to pass when it is taken up by the House on Friday. Both these bills have been significant legislative victories for the democrats and is likely to help their chances in the midterm elections but current consensus is still with republicans making meaningful gains especially in the House.
To end today’s segment, here’s how we are thinking about portfolio positioning. Broadly, our view remains for more volatility ahead for the equity and bond markets. The Fed’s posture of being more data dependent while downplaying forward guidance is an admission of the uncertain outlook on inflation and growth. This widens the range within which asset prices will perform especially in the next six months. However, the Fed is likely to keep tightening policy through higher rates and balance sheet runoff into a slowing economy until they see inflation come down to a more acceptable level. Our investment strategy recommendation is to remain disciplined and stay invested in a broadly diversified multi asset portfolio, utilizing alternative investments and real assets if appropriate. We have a neutral tactical tilt on global equities and prefer US over international equities, large over small caps, and recommend a high quality bias. While higher bond yields have led us to add to bonds recently, we still maintain a slight underweight to fixed income. In the next six to 12 months we anticipate opportunities to add to equities in a disciplined manner as corporate earnings picture for next year gets reset lower and the Fed signals a pivot to a less hawkish monetary policy environment. That will do it for the Aug 8th market update. Thank you for listening.
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