August 2023

Labor markets are starting to cool, but Q2 GDP exceeds expectations!

The July employment report came in slightly below expectations with 187,000 new jobs added to the economy versus the 200,000 estimate. The unemployment rate unexpectedly fell 0.1% to 3.5% and average hourly earnings came in above expectations at an annualized rate of 4.4%. The broader U6 unemployment rate fell from 6.9% in June to 6.7% in July. The U.S. labor market remains in solid shape despite some slowing job growth over the past few months. Unemployment is still very low, and while wage growth has come down, it is still higher than the Federal Reserve would prefer. There were no changes to the market’s policy expectations for the remainder of 2023.

The U.S. economy grew at a faster than expected clip in Q2 as GDP increased 2.4% year-over-year (Y/Y), well ahead of the 2.0% estimate and Q1’s 2.0% reading. Consumer spending rose 1.6% last quarter which was better than expected, but below the 4.2% increase in Q1. Gross private domestic investment increased by 5.7% and government spending increased 2.6%. Business investment was one of the major highlights in the report, rebounding from Q1. Inflation was held in check during Q2 with the PCE index increasing 2.6%, down from 4.1% in Q1.

Inflation ticks higher after hitting a 2-year low; Fed likely to hold steady rather than cut rates

After trending lower for the last year, CPI inflation rose on a month-over-month (M/M) basis in July. Headline CPI rose 0.2% M/M or 3.2% Y/Y last month, slightly ahead of expectations and June’s 3.0% rate. Core CPI also increased 0.2% M/M, matching the estimate and equating to a 12-month rate of 4.7%, the lowest since October 2021. The annual rate for core CPI also was slightly below the 4.8% expectation. Almost all of July’s inflation increase came from shelter costs, which rose 0.4% M/M or 7.7% Y/Y. Falling inflation has allowed the Fed to pause rate hikes, but inflation remains high enough to prevent any discussion of interest rate cuts.

In July, the Fed raised rates for an 11th time to the highest level in 22 years (5.25% – 5.50%). Markets are no longer pricing in any additional rate hikes for this year and the storyline has shifted from future rate cuts to how long the Fed will hold rates steady. Economic growth remains resilient and better than expected, which may lead the Fed to maintain current policy levels. Any economic weakness may bring monetary easing back into the forefront.

Source: U.S. Bureau of Labor Statistics via FRED

Manufacturing & services weaken in July, Fitch cuts the U.S. AAA credit rating

The ISM Manufacturing PMI improved slightly in July but remained well in contraction territory. The July reading of 46.4 was up from 46.0 in June and slight improvements were seen in new orders and production. Employment contracted at a faster clip in July. The ISM Services PMI weakened last month due to softness in new orders, production and employment. The July services reading of 52.7 was down from 53.9 in June.

On 8/2, Fitch cut the U.S. credit rating by one notch from AAA to AA+. Fitch cited the country’s deteriorating finances and expressed major doubts about the government’s ability to tackle the growing debt burden because of sharp political divisions, exemplified by the brinkmanship over the debt ceiling. Fitch also cited poor governance in the country and challenges facing Social Security and Medicare. Treasury yields moved slightly higher on the news, but little impact is expected as the U.S. dollar is still the reserve currency of the world and Treasuries are still considered the safest securities in the world.

Did earnings bottom in Q2? Amazon drives Q2 beat

Through 84% of the S&P 500 Q2 earnings season, the blended Y/Y earnings decline has been 5.2%, ahead of the –7.0% forecast at the start of Q2. 65% of companies have beaten on the top line and 79% have beaten on the bottom line.  Most of the outperformance has come from the consumer discretionary, communication services, and industrials sectors, while energy and healthcare companies have missed forecasts. The strong U.S. dollar has played a role in Q2 earnings as U.S. centric businesses have posted positive earnings versus more global oriented ones that have posted an aggregate 18.7% decline. Earnings are projected to be flat in Q3 and grow 0.8% for all of 2023. Markets have been very macro driven since COVID, but stock returns may finally be explained more by company specific factors.

Eurozone returns to growth in Q2, PMIs point to weakness in Q3

After nearly posting consecutive negative quarters of growth, the eurozone finally posted positive GDP growth in Q2. The eurozone economy grew 0.3% quarter-over-quarter (Q/Q) in Q2, slightly ahead of expectations. France (+0.5%) and Ireland (+3.3%) helped European GDP growth during the quarter, while most of the other countries in the economic block posted disappointing growth readings.  With the eurozone Composite PMI hitting an eight-month low in July and the manufacturing PMI hitting a 38-month low, risks to the European economy are to the downside with a recession likely. Headline inflation in the eurozone was 5.3% in July, lower than the 5.5% reading registered in June.  Core inflation remained steady at 5.5% in July with food, alcohol, and tobacco once again driving increases (prices rose by 10.8%).  To combat sticky inflation, the ECB has raised rates over the past year to the current level of 3.75%.

Source: Goldman Sachs, as of 7/31/23

Japan’s GDP surges! BOJ removes the lid on rates

Japan topped growth estimates in Q2, reporting a surge of 6.0% in GDP. The Q2 reading was ahead of estimates and the 2.7% Y/Y growth reported in Q1. Exports rebounded 3.2% Q/Q, largely driven by a spike in car shipments. While the headline number is impressive, the underlying details show weakness. Most of the upside came from net trade while private consumption fell 0.5%, signaling soft domestic demand. The BOJ took steps last month to allow long-term interest rates to rise, a move seen as the beginning of a gradual shift away from massive monetary stimulus.

China’s COVID reopening surge has stalled; PBOC needs to pursue more stimulus measures

China’s economy grew 6.3% Y/Y in Q2, below expectations but higher than Q1’s 4.5% reading. The Q2 data showed a clear slowdown in consumer spending and faltering business confidence, reinforcing the idea that growth has stalled.  China continues to face significant headwinds, such as consumers who are wary of spending, businesses that are hesitant to hire and invest, a property market dealing with its worst downturn on record, and a weak global economy that is stifling external demand.  The PBOC may need to consider additional stimulus measures beyond interest rate cuts and tax breaks. Policy support measures have been somewhat restrained so far and any impact to economic growth is likely to only be modest.

PMIs contracting & credit bubble may be bursting

China’s factory activity contracted for a fourth consecutive month in July, while non-manufacturing activity slowed to its weakest this year as the world’s second-largest economy struggles to revive growth momentum in the wake of soft global demand. China’s exports fell by a reported 14.5% Y/Y in July, while imports dropped 12.4%. CPI and PPI are now both negative. Country Gardens Holdings Co., the largest property developer with ~$194B of debt, missed a coupon payment and sparked concerns of default. China is attempting to restimulate the economy, but with high debt loads and the housing market continuing to fall, consumer confidence has fallen with deposits at banks rising rapidly.

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