Will the Fed kill the stock market rebound?

The summer rebound is raising hopes that a bear market in US stocks has bottomed, but this coming week’s Federal Reserve policy makers meeting could test the nerves of the bulls.

“I expect we will continue to see market volatility until investors see more convincing evidence that this period of Fed tightening is behind us, and I don’t expect that to be the message” when central bankers wrap up a two-day meeting on July 27. Lauren Goodwin, economist and portfolio strategist at New York Life Investments, said in a phone interview.

Disappointing results from social media platform Snap Inc. SNAP,
-39.08%
The weekly rally in stocks pared Friday, but benchmark indexes still saw healthy gains. S&P 500 SPX Index,
-0.93%
It rose 2.6% last week to finish near 3,962 after rising above the 4,000 threshold early Friday for the first time since June 9.
-0.43%
posted weekly gains of 2%, while the Nasdaq Composite,
-1.87%
Advance 3.3%.

This week’s rebound lifted indices off their 2022 lows after the S&P 500 sank to 3666.67 on June 16.

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James Riley, an economist at Capital Economics, said in a note on Friday that the recovery was driven in part by a dynamism that has seen investors treat bad news on the economic front as good news for stocks.

This may sound odd, but it likely reflects, in part, a view among investors that weaker economic data will cause the Federal Reserve to raise interest rates less than previously thought, Riley wrote. He said there was evidence of this in market-based expectations of an interest rate increase, which were recently scaled back (see chart below), a development that provided support for stock valuations.

Capital Economics

The market expects the Fed to introduce a rate increase of 75 basis points on Wednesday, matching the increase seen in June, which was the largest since 2002.

Read: The Fed may get lucky or things may go wrong. A guide to where the economy can go from here

Meanwhile, last week provided plenty of evidence of slowing economic activity.

The US Services Purchasing Managers’ Index fell to a 26-month low of 47 in July from 51.6 the previous month, based on a “quick” survey from S&P Global Market Intelligence. A reading below 50 indicates decreased activity.

On Thursday, weekly jobless claims rose to the highest level since November but remained historically low, the Philadelphia Fed manufacturing index unexpectedly fell deeper into negative territory, and the Conference Board said its leading economic indicator shows the US recession at the end of the year. It is likely now as early as the next day.

US economic data due next week includes a preliminary estimate of second-quarter GDP, which is expected to show a second contraction in a row. While such an outcome is often described as a technical stagnation, the labor market remains strong and other factors make it unlikely the National Bureau of Economic Research, the official business cycle arbiter, will announce it.

Related: A “fake” stagnation? The US economy is in good shape at the moment despite the weak GDP

Riley said he doubts the slowdown in activity will slow the Fed.

“Our central expectation is that US economic growth will remain weak, but not so weak as to prevent the Federal Reserve from going strong through the remainder of this year. Such an outcome would probably mean higher discount rates and disappointing growth in corporate earnings, which would be a toxic combination to Somewhat relative to stock prices.

Many Fed watchers, including some former policymakers, see the Fed as intent on convincing market participants of its desire to stamp out inflation.

Former Richmond Federal Reserve Chairman Jeffrey Lacker said on Friday that policy makers will need to keep raising interest rates even in a recession. Letting your foot off the brakes before inflation drops” is just “a recipe for another depression ahead,” Lacker said in an interview with Bloomberg TV.

Riley argued that even if the economy slowed fast enough to force federal policy makers to pull back, it probably wouldn’t be good news for stocks. That’s because corporate profits will weaken more than the company actually anticipates, he said. It is also unlikely that supportive stocks were seen as expectations about the moderate Fed funds rate will continue to slow sharply, as history has shown that valuations tend to be lower during periods such as deteriorating risk appetite.

However, Goodwin said there is more recent flexibility for the stock market.

“The market, on average, was expecting a tougher earnings season than we’ve seen so far,” she said, while guidance was more upbeat, she said, acknowledging that it’s still in its infancy.

During Friday morning, 75.5% of the S&P 500 companies that reported beat analyst expectations for earnings per share. The average was about 4.7%, according to I/B/E/S data provided by Refinitiv. That compares with the 66% of companies that beat EPS estimates in a typical quarter since 1994, and an average winning margin of 9.5% for the previous four quarters.

On the revenue front, 68.9% of companies beat expectations by an average of about 1.3%, compared to 62% of companies that beat expectations in a typical quarter since 2002 and an average rate of beats of 3.4% in the previous four quarters.

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Goodwin said markets have been dominated by concerns about severe inflation and the threat of recession, so a “somewhat more upbeat” reading from companies so far was a dose of good news.

In fact, investors appeared to be switching between concerns about inflation and recession, market watchers said. Overheating inflation was the dominant concern as stocks tumbled and Treasury yields surged in the first half of 2022. More recently, market moves suggest that investors have focused more on the possibility of a recession as the Federal Reserve tightens sharply.

So what should investors do as the focus shifts from inflation to recession?

Goodwin said inflation will remain the primary consideration when it comes to portfolio positioning because recession-resistant assets, such as cash, Treasuries and high-quality corporate bonds that have worked in the last cycle, can create a significant drag on wealth creation.

To handle the expected volatility, New York Life moves in quality within its asset classes. For example, it is heavily weighing high-yield debt in its portfolios based on expectations that the corporate environment will remain very strong, it said, but is progressing in quality within high-yield.

If we take into account rising consumer prices, she said, that also means looking at fixed income securities and stocks that have cash flow correlated with inflation.

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