Cooling Inflation Meets Hot Optimism

Jul 18, 2023

By Ben Norris, CFA, Senior Investment Strategist, Vice President
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Stocks saw broad gains last week following encouraging inflation data and a decent start to the second-quarter earnings season. All sizes and styles of stocks rose last week while each of the 11 equity sectors also saw positive performance, with Communication Services stocks leading the move higher. Bonds saw gains as U.S. Treasury yields fell and credit spreads tightened. The yield on 10-year Treasuries declined 0.23% to 3.82%, while high-yield bond spreads tightened to 379 basis points, well below their long-term average of around 500. Investors continue to push asset prices higher in hopes that inflation will finally return to normalized levels without the U.S. economy falling into a recession.

The inflation data released last week was the most encouraging set of readings since pandemic-related stimulus kicked off a cycle of rapidly rising prices over two years ago. Both the headline and core Consumer Price indices came in below expectations—the headline number saw its first reading below 4% year-over-year since the first quarter of 2021, with a 3.0% reading. While 3.0% is still above the U.S. Federal Reserve’s (Fed’s) long-term target of 2.0% annual inflation, it is a significant improvement from the prior month’s 4.0% increase and an encouraging sign for the Fed’s policymakers. The core Consumer Price Index number, which removes the effect of food and energy prices, remains elevated at 4.8% year-over-year, but is much improved from its recent high of 6.6% from September 2022. The Producer Price Index, a measure of wholesale prices, also came in better-than-expected last week with the headline number falling to 0.1% year-over-year, and a core reading of 2.4%. Finally, the Import Price Index, which measures price changes in goods or services that U.S. residents purchase from abroad and a component of the Bureau of Labor Statistics’ inflation gauge, fell to -6.1% year-over-year. Investors won’t get additional inflation data until Personal Consumption Expenditures is released on July 28, but recent trends are finally beginning to look encouraging.

I may have downplayed things a bit when I said that stocks saw broad gains last week. The S&P 500 (SPX) gained 2.4% and is now up more than 18% for the year. SPX is at its highest level since April of last year. The NASDAQ Composite (COMP) also saw impressive gains, finishing the week 3.3% higher, taking its year-to-date return to nearly 36%. We’ve recently spent a lot of time discussing the narrow nature of the current market rally. Just seven mega-cap growth stocks have accounted for nearly all the performance of SPX and COMP so far in 2023, and many small-cap and value stocks are still in negative territory year-to-date.

While it’s not unusual for a market rally to be driven by a handful of stocks, the current dispersion between these seven stocks and the rest of the market is at extreme levels. In fact, SPX’s Technology sector accounted for more than 60% of the index’s first-half move, and one stock—Apple—accounted for roughly 18%. We’ve gone on record with our worries that without participation from smaller stocks, 2023’s rally could run out of steam. With the Russell 2000’s 3.6% rally last week, markets took a step in the right direction. While small caps are showing signs of life, value stocks are still looking lethargic. The worst-performing equity style last week was large-cap value, which managed to gain just 1.9% vs. a 4% gain for small-cap growth. One of the reasons we remain hopeful for small-cap and value stocks for the rest of the year is the current valuation environment. Small-, mid- and large-cap value stocks are trading at 14-15x expected earnings, while large-cap growth stocks are trading at more than 27x. For perspective, SPX is currently trading at 19x forward earnings, which is well above its historical range. On one hand, value stocks look like a bargain at these levels; on the other, growth stocks need to come through with very impressive earnings to justify their demanding valuations.

The second-quarter earnings season kicked off with major banks reporting last week and will ramp up over the next two weeks. I’m anticipating elevated volatility around earnings results this quarter because of demanding valuations and high expectations from a handful of companies. The good news is that initial results have been strong. Reported earnings growth (just 30 of the 500 companies in SPX have reported so far) is +10%. Still, estimates have come down since the beginning of the year, and expectations are for just +0.5% earnings growth for the full year. With SPX up 18% year-to-date, and minimal earnings growth, nearly all the index’s gain has come from higher multiples—a scenario that can only be resolved in two ways. Either stocks stay where they are while earnings catch up, or stock valuations reset to a more sustainable level. The good news is that expectations for 2024 SPX earnings see +12.5% growth; the bad news is that investors will have to wait and see if those expectations are too optimistic.

The coming week will feature a relatively light slate of data with the highlight being a new reading of U.S. Leading Economic Indicators on Thursday. Wednesday, July 26, will be what most investors are focused on over the next two weeks when the Federal Open Market Committee will announce their decision on interest rates.


Date Report Previous Consensus
Monday 7/17/2023 Empire State Manufacturing Survey (July) 6.6 1.1
Tuesday 7/18/2023 U.S. Retail Sales (June) 0.3% 0.5%
Industrial Production (June) -0.2% 0.0%
Home Builder Confidence Index (July) 55 56
Wednesday 7/19/2023 Housing Starts (June) 1.63M 1.48M
Thursday 7/20/2023 Initial Jobless Claims (July 15) 237,000 231,000
Existing Home Sales (June) 4.3M 4.24M
U.S. Leading Economic Indicators (June) -0.7% -0.6%
Friday 7/21/2023


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