THIS WEEK WITH SADIQ

A Fed Divided?

July 31 to August 4, 2023

THIS WEEK WITH SADIQ

A Fed Divided?

July 31 to August 4, 2023

Commentary

Market Recap

  • Equity markets rallied this week on signs that the economy is holding firm despite ongoing rate hikes, while inflation continues to ebb. The S&P 500 gained 1.0%, with telecom services charging ahead almost 7%. Defensives and rate-sensitives lagged the pack.
  • While the Fed raised rates as expected, the Bank of Japan’s tweak to yield curve control lifted bond yields, while the European Central Bank also raised rates.
  • The Nikkei and major European/U.K. indices were all higher on the week. The TSX, however, lagged with a 0.1% decline, as telecom, consumer staples and utilities were all lower.

The Fed

Last week, the U.S. Federal Reserve (Fed) raised interest rates by 25 basis points, as was widely expected. Perhaps the bigger story, however, is increasing internal disagreements at the Fed, leaving it unclear whether another rate hike can be expected later in the year. The Fed’s next meeting isn’t until September, meaning that there will be plenty of time for economic data to show which way the wind is blowing—and as Chairman Powell has repeatedly said, the Fed’s decisions are data-dependent. At this stage, however, we’re not convinced it makes much difference whether there is one or zero rate hikes left. Markets continue to believe that we’re nearing a terminal rate, but they’re also begun to realize that rate cuts should not be expected in the near term. With the most optimistic outcomes out of mind, one additional rate hike—or a decision to forgo a final increase and pause—likely won’t do much to alter investors’ expectations. On the question of whether one more hike should be expected, we’d lean toward yes, but it could go either way. The important question is—are we on a downward slope or not? At present, the economy is holding up well, which presents a case for another 25 bps hike. But if softer economic data comes through over the next two months, leading the Fed to believe that a decline is underway, then they’d likely stay put. Recent declines in inflation have given the Fed the luxury to be a bit more cautious, and as they highlighted in their press conference, the effects of previous rate hikes are still filtering through the economy.

Bottom Line: It won’t make a significant difference whether there is one more rate hike or not, because either way, the Fed is likely to pause afterwards.

Earnings

Earnings season is back, and some winners and losers are already apparent, with Meta showing strong growth while Shell saw an implosion in profits. Is this a function of industry difference, or is it a Quality-related divide? For an answer, let’s look at each company’s situation. Tech was hit hardest last year—they were the first to fall victim to the earnings decline story. Now, they appear to be the first ones coming out of that dip as well. In general, their products are less impacted by inflation than the retail world, for instance. The question for Tech companies like Meta (yes, I am calling Meta a tech company) is—will consumers continue to spend whether we’re approaching a recession or not? So far, the answer has been yes. Meta showed higher ad revenue in their recent earnings, meaning that spending is continuing despite a higher interest rate environment; Alphabet (Google) reported the same thing the day before. Meta is also focusing on areas of growth, including the recent launch of Threads, which stormed to over 100 million users in only three days and aims to take advantage of weakness at Twitter (or X, as Elon Musk seems intent on rebranding it). Markets reacted positively to Meta and Google’s good news. On the Energy front, the bar was set much higher after a strong 2022, and Shell’s weak earnings meant that they were unable to clear it. Overall, despite differences in industries, we believe it’s a company-by-company story.

Bottom Line: Meta has a great story with earnings to back it up, while Shell fell short of loftier expectations.

Consumers

Despite expectations of a recession, there are no signs of the consumer being weak just yet. Yes, one can make the case that the consumer is weakening, but that isn’t the same thing as being weak; we’d characterize the shift in consumer health as being from great to merely very good. That’s enough to keep people spending, markets chugging along, and companies doing better than expected on the earnings front. The bears continue to point to declining numbers, but so far, they haven’t translated into headline figures; the latest U.S. GDP number, for instance, was strong. Overall, we see little evidence of a bad economic outcome in the near future. Our analysis still shows an 86% chance of a recession, but that’s over the next 12 months. We’re still leaning toward a downturn in Q1 of 2024, but that could get pushed out even further if the consumer stays strong. This begs the question: if the consumer is still spending, why is inflation declining? We see three main reasons. First, supply chains are improving. Second, there’s no further need to bid up the prices on certain goods that were in high demand during COVID—with the economy reopened, no one needs to keep 10 of anything on hand anymore. And third, people are now more cognizant of their spending patterns, which is why hotel and airline spending has plateaued even as overall expenditure has remained robust.

Bottom Line: There is little reason to be pessimistic about the economic outlook in the near term, and we expect the consumer to continue to hold up well.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled Staying the Course Through Choppy Waters.

Disclosures:

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