Key Points:
- Stocks had their best month of the year despite the Fed aggressively raising rates to tackle inflation.
- The US entered a technical recession after GDP declined for the second consecutive quarter in Q2.
- Bonds also had their best month of 2022 with long-term rates declining as investors hedged a potential slowdown in the US economy.
Sometimes good economic news is bad and bad economic news is good for financial markets. US stocks rallied in July with the S&P500 gaining 9.22% despite the Federal Reserve raising interest rates to combat inflation. With inflation reaching a 40-year high of 9.1%, the Fed raised the Fed Funds Rate 75 basis points for the second straight meeting, bringing its range to 2.25%-2.5%. The US economy entered a technical recession a few days later, defined as two consecutive quarters of negative GDP growth. Second quarter GDP contracted by 0.9%, after a first quarter drop of 1.6%. Conventional wisdom might suggest that stocks should go down on bad economic news. However, it is important to remember that stocks are forward-looking. April and June saw big market drawdowns of over 8% per month where investors seemed to have priced in these outcomes. While the US economy is most certainly slowing and has challenges ahead, the Fed has confidence that it can handle higher rates. The labor market continues to be strong adding 372,000 jobs in June, keeping the unemployment rate at 3.6%. Average hourly earnings have also been robust as there are more job openings than job seekers. Higher rates will likely cause that gap to narrow in quarters to come.
All sectors of the US stock market were positive for the month. The best performing sectors were those that had been hit hard for the first half of the year: consumer discretionary (+18.94%) and technology (13.54%). Energy (+9.72%) came back into favor as a heat wave in the US sent natural gas prices swiftly higher. Small cap stocks rallied over 10% in July, while international returns were more muted. Concerns over energy supplies in Europe heading into the winter are causing economists to adjust growth estimates lower. The MSCI EAFE Index gained 4.98% for the month while emerging market equities were flat. The strong US dollar continues to weigh on international returns for US investors.
Fixed income markets saw the best month of the year for the Bloomberg US Aggregate Bond Index, moving 2.44% higher in July. Intermediate and long-term Treasury yields dipped as investors hedged for a recession, following the Fed’s hawkish policy of higher rates and balance sheet reduction. While inflation may be close to peaking as gasoline and other commodity prices have fallen, the Fed is a long way from its 2% target. Additional rate hikes seem probable and may continue to slow economic activity. Looking ahead to the rest of the year, earnings uncertainty from higher borrowing costs and the slowing US economy may continue to cause volatility in stocks and risk assets. However, staying invested through tougher economic periods paid off for long-term investors in July.
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