Late-Summer Debates

A few key issues could disrupt investors’ peace and quiet as fall approaches in the Northern Hemisphere.

Today’s CIO Weekly Perspectives comes from guest contributor Timothy F. Creedon, CFA.

The second-quarter earnings season has nearly wrapped up, with a number of retail companies this past week demonstrating ongoing resilience on the part of U.S. consumers. Overall, “resilience” has been the buzzword for the S&P 500, with nearly 80% of companies beating quarterly estimates, and results coming in a couple percentage points above what was expected at the start of 2Q. Earnings will likely decline roughly 5% for the period, but that could represent a bottom, with consensus estimates calling for flat earnings growth next quarter and then high-single-digit growth by 4Q, and an optimistic return to double-digit growth next year.

Unexpected resilience is a key reason why our Asset Allocation Committee moved to a cautiously neutral view on equities this summer, as we balanced the odds of the Federal Reserve executing a soft landing with the risk of more turbulence ahead.

The soft-landing story is more well-known now and arguably increasingly priced in the market: As the thinking goes, inflation could slow and the labor market soften just enough to temper wage inflation (with artificial intelligence potentially generating some productivity offsets), leading to potential interest rate cuts next year and a continued risk-on environment.  

That soft-landing scenario is still possible, but it requires a lot of pieces to fall in place. We see some obstacles to clear—and issues to debate—as we consider the outlook, which reinforces our cautiously neutral view on equities.

A Tight Labor Market and Potential Margin Pressures

Disinflation has started to appear in the data, but we believe this slowdown in inflation will likely be a drag on topline growth and a potential risk to operating leverage for companies, as real wages are still increasing amid a tight labor market.

Look no further than recent wage contract negotiations at the airlines and UPS, and a potentially significant United Auto Workers strike coming in September to see that labor is aiming to recapture its share of the economic pie. If labor markets remain tight and wage growth doesn’t slow, companies will likely feel pressure to pass along those costs in higher prices. That would keep inflation elevated and likely prompt the Fed to maintain a more growth-restrictive policy. Alternatively, companies may choose not to pass on higher prices, but that would lead to margin pressure and a profit squeeze. On the flip side, if unemployment does start to soften, wage pressure should abate, but attention will quickly turn to the risk of a downward spiral in economic growth, given concern that a recession has been postponed but not averted.

Interest Rate Reversion

Many have been surprised by the resilience of businesses and households in the face of the current Fed tightening cycle. While an argument can be made that many have termed out their debt, helping to mitigate the impact of rising short rates, there is risk that the government has been left holding the bag, given its significantly increased debt and refinancing risk coming out of massive spending during the COVID crisis. That risk is now starting to show up in pressure on long rates in the Treasury market, with the 10-year yield recently reaching 15-year highs. As long yields rise, this reversion of the yield curve may further test the surprising resilience to rising rates that we have seen thus far in the private sector.

The China Outlook

Finally, many eyes are fixed on the outlook for China as its rebound remains lackluster and its growth estimates have largely been downgraded, prompting questions as to whether the government will pursue a much more aggressive stimulus response (something it has thus far been reluctant to do). There are many concerns around rising debt and defaults, a lack of confidence among consumers and businesses, and escalating tension in U.S.-China relations. Chinese leaders are wrapping up their annual summer retreat and it will be important to see if any meaningful stimulus or policy change is forthcoming to address growth concerns. While significant action could help mitigate these worries, it would also likely bring potentially significant collateral effects on global inflation, as well as foreign exchange and commodity markets.

Most folks are hoping for a quiet last couple weeks of August, but these issues provide plenty to think about as we look ahead to a busy September.