Daily Commentary

Providing succinct, entertaining and savvy thinking on global capital markets. Our goal is to provide discerning investors the most essential information and commentary to stay in tune with what's happening in the markets, while providing unique perspectives on essential financial issues. And just as important, Fisher Investments MarketMinder aims to help investors discern between useful information and potentially misleading hype.

Our Perspective on the Midsummer Rally

We aren’t superstitious, so here is a statement we are comfortable making: The S&P 500 closed Monday up 12.5% from its June 16 low and the MSCI World Index isn’t far behind at 10.7% since its low the following day.[i] It is impossible to know whether this is the initial upturn of a new bull market or a short-lived false dawn. But the past few weeks have much in common with a typical rebound, which we see as reason for encouragement.

No, neither index’s bounce is a symmetrical “V” off the low. The S&P 500’s closing level Monday is roughly in line with its level on June 6, a whopping seven trading days before the low. It has taken about six weeks to retrace that journey. But it is also quite a swift rise—far from an L-shaped languishing around the bottom. Tech, which got hit disproportionately on the way down, is now leading. The upturn thus far also pairs with a hefty dose of pessimism. We have seen oodles of warnings that it is a bear market rally—a temporary respite presaging deeper declines later. Seasonality chatter is returning, with some arguing the S&P 500’s weak average returns in the past 25 Augusts and Septembers point to tough times ahead. Others argue that stocks aren’t really cheap, despite the drop in P/E ratios, because earnings have much further to fall. This, they claim, points to stocks falling alongside earnings from here in order to reach truly cheap levels. And looming over everything is the constant drumbeat of recession doom.

We can’t and don’t rule out renewed declines from here. But this type of sentiment is a hallmark of young bull markets. Fisher Investments’ founder and Executive Chair Ken Fisher calls it “the pessimism of disbelief”—the tendency to ignore good news or see positives as fleeting or soon to morph into something bad. You have no doubt seen this with any good economic data that hit the wires over the past six weeks. Most coverage couches expansionary data as sure to trigger additional Fed rate hikes, implying more trouble ahead. Falling oil and gas prices hit headlines not as a relief, but as a symptom of weak demand—a dawning recession. Big eurozone economies’ Q2 GDP growth? A last gasp before natural gas shortages wreck output, according to the popular take last week.

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Hidden Storylines in Eurozone Q2 GDP

One day after the US announced Q2 GDP results, it was the eurozone’s turn Friday—and surprising many, its results were much better. Where the US contracted last quarter, eurozone GDP grew 0.7% q/q (2.8% annualized), smashing expectations for a 0.1% q/q rise.[i] That generated a heap of headlines, a few sunny on the positive result while most warned the fun won’t last now that Russia has reduced natural gas flows into the region substantially. We can’t help but wonder what all the fuss is about on both sides, considering headline eurozone GDP is next to meaningless. It is the sum of 19 individual member state GDPs, often with too many offsets among them for the total to be of much use, especially to investors looking for economic clues. This quarter’s results are a prime example.

So far, only nine eurozone member states have reported. Their results range from a -1.4% q/q contraction (Latvia) to 1.1% growth (Spain).[ii] But whenever investors look at Continental Europe, they are mainly eyeing four countries: Germany, France, Italy and Spain, the four largest economies. Of these, people view Germany as the engine, France as a ride-along and Italy and Spain as the periphery. So, if Germany is struggling, that tends to color the view of the whole and raises questions about whether other nations will soon follow.

This is the primary concern today, as German GDP was flat in Q2 (or, as Bloomberg pointed out, ever-so-slightly contractionary when you round to 2 digits versus 1).[iii] This follows 0.9% growth in Q1, which stemmed largely from post-Omicron reopening boosting the services sector, and an Omicron-related -1.4% Q4 contraction.[iv] Germany’s Federal Statistics Office doesn’t release a detailed breakdown in its first estimate, but the accompanying commentary said consumer spending rebounded while net trade detracted. Whether the latter involves rising imports, another drop in exports or a combo thereof, we will have to wait and see.

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A Look at GDP’s First-Half Dip—and Beyond

Editors’ note: The definition of a recession has become a partisan topic of late, but as political bias can lead to investing mistakes, please keep in mind MarketMinder’s GDP discussion focuses only on its potential market impact, if any.

Q2 US GDP fell -0.9% annualized, its second quarterly decline after Q1’s -1.6% dip.[i] Headlines feverishly debate whether this spells recession, with mostly partisan political implications that we won’t delve into—for investors, that debate is largely backward-looking. Months-old economic activity has little relevance for stocks, which we think have already dealt with the mild economic contraction and are looking ahead to what the next 3 to 30 months have in store relative to expectations.

Stocks move ahead of economic activity, and bear markets often precede recessions as stocks discount the likely decline in investment and corporate earnings. This year’s shallow (to date) bear market would be pretty consistent with a shallow recession. But whether or not one is underway is questionable. The National Bureau of Economic Research (NBER), which is the official arbiter, doesn’t define a recession as two sequential GDP contractions. Rather, it defines it as a “significant decline in economic activity that is spread across the economy and lasts more than a few months.” Diving under the hood of Q2’s GDP report, there are reasons to question whether the US economy meets that threshold.

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On the Senate’s Busy Week

Where did gridlock go? That is the question many are asking after a flurry of Senate activity this week. On Tuesday, a bipartisan majority passed the Chips and Science Act, a $280 billion package pitched as a solution for the semiconductor shortage and concerns about China’s potential influence over global chip supply—which the House passed and sent on to President Joe Biden’s desk on Thursday. Separately, on Wednesday, the budget reconciliation bill once known as Build Back Better returned from the dead, slimmed down and renamed the Inflation Reduction Act.[i] It hasn’t yet passed and may not, but we see this as a textbook case of how markets and politics typically intersect in the first half or so of a midterm election year—and we think it points further toward a late-year rally as midterm results zap lingering fears of big legislation.

Exhibit 1 shows a high-level look at what is in each bill at the moment, pending committee and both chambers’ votes and possible reconciliation on the Inflation Reduction Act. The provisions could change, but for now, here is how things stand.

Exhibit 1: New Legislation at a Glance

Source: United States Senate, Reuters and The Washington Post, as of 7/28/2022.

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Are July’s Business Surveys Normal?

Has a summertime swoon arrived? July business activity contracted in major developed economies, including the US and eurozone, per the latest surveys. We aren’t Pollyanna about today’s global headwinds, but it is critical to ask whether any of this information is surprising to markets—and in our view, the answer is no. Despite all the headline handwringing, July’s purchasing managers’ indexes (PMIs) don’t reveal much new on the economic data front—stocks likely reflect this weakness to a large extent already.

As Exhibit 1 shows, S&P Global’s July “flash” PMIs weakened across the board from June and missed expectations.

Exhibit 1: The Latest PMIs<

Source: FactSet, as of 7/22/2022.

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Another Fed 75

The Fed announced another 0.75 percentage point (ppt) interest rate hike Wednesday, as widely expected, lifting the fed-funds target range to 2.25 – 2.50%. Stocks didn’t mind, with the S&P 500 rising after the announcement and finishing the day up 2.6%.[i] Bond markets didn’t do a whole lot, with 10-year yields flattish at 2.79%, as we write, and 3-month yields down a whisker to 2.37%.[ii] That shouldn’t shock, considering—as we showed last week—bond markets appeared to have priced this well-telegraphed move in advance. As ever, what matters is what happens from here, as the Fed is on the verge of inverting the yield curve—a matter worth watching, but not obsessing over.

Inversion isn’t guaranteed to happen, mind you, and it will probably rest on how markets interpret the Fed’s guidance. On that front, Fed head Jerome Powell wasn’t terribly helpful when addressing future moves at the post-meeting press conference. He told reporters a third 0.75 ppt hike in September could be warranted and that he sees the fed-funds range’s upper bound being between 3.0% and 3.5% by year end. But he also said the Fed couldn’t give “clear guidance” anymore and that future moves would be data-dependent. Soooooo. Seemingly clear guidance, alongside a disavowal of clear guidance. Try figuring that one out.

If recent history is a reliable guide, markets will spend the next several weeks trying to suss this out, parsing all Fedspeak and incoming data. Observers will likely hyperventilate over central bankers getting together at the Kansas City Fed’s annual big bash in Jackson Hole, Wyoming—this time centering on “Reassessing Constraints on the Economy and Policy.” So expect that now. If investors broadly expect the Fed to keep hiking, then 3-month yields will probably rise. If inflation expectations continue moderating, 10-year yields could continue their drift lower. We aren’t saying either is highly probable, mind you—we are just pointing out possibilities, specifically, the possibility of that 0.42 ppt gap between 3-month and 10-year yields closing.

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The EU’s Holey Natural Gas Conservation Plan

Here are two things that seem related but—on a closer look—aren’t: Tuesday, the IMF sounded the global recession alert, citing the potential for a severe winter energy shortage in Europe. Also Tuesday, the European Commission agreed on a natural gas conservation plan for EU member states.

The IMF’s latest projection may or may not prove correct about those shortages, but in our view, that is less important than the fact that it echoes the past several weeks’ worth of fearful headlines, which stocks have already moved on. Therefore, what matters from here is how reality evolves compared to baked-in expectations. That is where the EU’s move comes in. Read the finer points, and we think it becomes evident the conservation plan mostly kicks the can and doesn’t automatically tee up tough cuts that would take German industry offline and guarantee a eurozone recession.

The EU’s plan is not energy or electricity rationing. Heck, it isn’t even rationing. It is a loose agreement for most member states to voluntarily reduce natural gas consumption by -15% from the average amount each used over the past five years. It won’t apply to islands (Ireland, Cyprus and Malta), which are disconnected from Continental supply lines. It doesn’t have a clear enforcement mechanism, which is jargon for a clear answer to “or what?” It doesn’t mandate how to curb consumption. It leaves loopholes for countries that have full gas reserves, “are heavily dependent on gas as a feedstock for critical industries,” or have sharply raised consumption over the past year (exposing them to severe hardship if they go -15% below the prior average).[i] It also offers exemptions for countries that don’t draw much gas from Continental pipelines and feed gas into the system for their neighbors. And while it leaves room for the cuts to become mandatory if the European Commission declares a “Union alert,” details on what would trigger that aren’t sketched out yet (beyond a request from five member states to do so).

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Adjusting for Swings With Constant Currencies

Q2 earnings season is in full swing, and there is a new buzzword in town: constant-currency. As in, Widgets “R” Us reports earnings grew 4%, or 7% on a constant-currency basis. What is this, and what should we make of it? Read on.

Simply, constant-currency earnings aim to strip out skew from big currency swings in order to zero in on how the core business is faring. As you have no doubt seen headlines railing about, the dollar is near an all-time high relative to a broad basket of currencies, which has implications globally. When the dollar strengthens, it can hurt US companies’ overseas sales. If they don’t raise prices and transaction volumes stay constant, their revenue in dollars drops—the same amount of sales in euros, pounds or yen converts to fewer dollars. Or, if US companies raise prices in hopes of keeping dollar-denominated revenues firm, they risk losing market share. This dilemma often gets at least a partial offset from overseas costs being cheaper when the dollar is strong, but it isn’t always a wash. This is why you will have seen oodles of American companies blaming the strong dollar for disappointing earnings—and oodles of articles arguing it is a huge problem markets are egregiously ignoring.

Meanwhile, companies based abroad have the opposite problem. When their home currencies are weak relative to the dollar, they have to pay more in their local currency for parts, labor and energy sourced overseas and priced in dollars. They can get an offset from overseas sales, though. If they want to, they can cut prices overseas to gain market share without taking a big hit once they reconvert to totals to their own currency. Or, they can keep prices overseas steady and earn big fat profits from currency conversion.

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Italy Can Still Service Its Debts Easily

Editors’ note: MarketMinder is nonpartisan, preferring no party nor any politician. Our analysis aims solely to assess political developments’ potential market impact.

It was supposedly a double whammy for Italian bond markets Thursday after (now caretaker) Prime Minister Mario Draghi resigned and the ECB hiked rates half a percentage point (ppt). Italy’s 10-year yield rose 0.22 ppt on the day to 3.58%—its highest since summer 2020, when credit spreads spiked during initial pandemic lockdowns, before falling back Friday. (Exhibit 1) Pundits now say a financial crisis is brewing, but we don’t think one looks any more likely than last month.

Exhibit 1: The 10-Year Italian-US Credit Spread Widened Some

Source: FactSet, as of 7/25/2022. 10-year Italian BTP yield minus 10-year US Treasury yield, 1/1/2010 – 7/25/2022.

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Our July Fed Meeting Preview

The next Fed meeting is less than a week away, and most analysts are penciling in another steep rate hike. Almost no one expects this to do anything about inflation, given the Fed can’t refine petroleum into gasoline, increase the grain harvest, staff airlines or unload container ships, all of which have fueled accelerating inflation even as money supply has started rolling over. But there is mounting fear that even one more big rate hike could be overshooting and kneecapping the economy, especially given how much the yield curve has flattened in recent weeks. In our view, there is some risk of the yield curve inverting, but it isn’t a given—and even a mild inversion isn’t an automatic recession trigger.

Now, when we look at the yield curve, we don’t use the 2-to-10 year segment that gets most pundits’ attention of late. We think the yield curve’s importance comes from its relationship with banks’ funding costs (short-term rates) and loan revenues (long-term rates), with the spread between them influencing banks’ potential profit margins on new loans—which drives loan growth. Generally, a wide spread means big profits and aggressive lending, while a deeply negative spread can signal a credit crunch. Banks don’t get much funding through 2-year CDs. They fund primarily through retail deposits and interbank markets, which are much shorter-term. We think the 3-month Treasury yield is a better approximation, so we use the 3-month to 10-year yield spread. That spread, as Exhibit 1 shows, has narrowed sharply since early May, from over two full percentage points (a multiyear high) to roughly half a point as of Tuesday’s close.

Exhibit 1: The Rapidly Shrinking Yield Curve Spread

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