On relief rallies (and dental chairs.)

Maybe you’ve had this experience: you’re in the middle of something deeply unpleasant – a dental procedure, perhaps – when the action reaches a painful crescendo, then recedes. “Whew,” you think to yourself, “at least that’s over.”

On some level you realize that you’re not quite out of the woods (after all, the dentist is still hovering over your chair wielding all sorts of sharp, medieval-looking tools), but you nonetheless allow yourself to relax a little.

It’s tempting to conclude that last week’s inflation data and the market’s reaction to it qualifies as that kind of experience. After all, both Wednesday’s consumer price index and Thursday’s producer price index were better than expected: CPI dropped from 4.0% year-over-year to “only” 3.0% on the headline, while PPI was essentially flat[1],[2]. In both cases the so-called “core” price index (which simply ignores food and energy and is therefore believed to be a more refined view of price pressures) were still a little stickier than the headline but also clearly headed in the right direction. Even better, the Fed’s focused measure for this stage in the cycle – inflation minus energy and shelter – decelerated toward 4%.

Relief on the inflation front allowed markets to relax a little. Heading into the week, futures prices were beginning imply that the Fed would boost rates twice in coming weeks to ensure that inflation was well and truly under control. Another 0.25% increase is still the overwhelming consensus for next week, but after last week’s inflation data, traders are now far less convinced that Powell & Co. will follow that up with another increase in September[3]. That allowed market-determined rates to drop, too: 10-year US treasury yields fell 0.11% after Wednesday’s CPI release and another 0.09% after Thursday’s PPI, leaving the rate on 10-year government notes once again slightly below where they began the year by Friday.

That optimism spilled over into stocks, too, with U.S. equities up more or less across the board. While “the big three” sectors (technology, telecom and consumer discretionary) once again led the gains by an almost obscene amount, every single sector of the S&P 500 Index joined in the fun (an occurrence that has been somewhat unusual as of late…) and advances led declines by a ratio of more than 4:1.

Consumers, too, seem to be feeling better about where this is all headed. On Friday, the University of Michigan released its mid-month read on consumer sentiment and the results were pretty upbeat, to say the least: the index “soared” (their word, not mine…) for a second month in a row. The index has now re-traced about half of the post-COVID drop that took it to its lowest level in the 50-year history of the survey just a few short months ago. Consumers may have been reacting to the Fed’s apparent victory over inflation and a still-durable jobs market[4] – which is really just another way to describe the “soft landing” scenario that optimists have been counting on for months. Perhaps even more surprising, small businesses – ordinarily a relatively dour group – also admitted to feeling a little better about the future than they have in the recent past[5].

But here’s the thing about relief rallies (and dental chairs): you can never be 100% sure that the pain is really over until you actually get up from the chair and walk out the door. Sure, it’s beginning to look more and more like the Fed’s inflation-fighting campaign is nearing its end, but we’re still a long way from being able to fully relax. For example, last week’s gain in consumer sentiment still leaves the index deeply depressed, and the gains were confined to high-earners: sentiment among lower-income consumers, where inflation’s bite is felt most severely, apparently didn’t improve much at all. Let’s not forget, too, that unless something changes in the very near future, the COVID-inspired student loan repayment holiday that many of these same consumers have benefited from comes to a screeching halt in October, when borrowers will once again have to begin repaying loans they took out while, uh, expanding their horizons at State U[6].

And as far as that gain in business sentiment is concerned, that index, too, remains depressed enough that the National Federation of Independent Businesses – the trade group that conducts the survey each month – still felt compelled to focus on the depressed mindset among business owners instead of the marginal improvement in attitude when it chose to use the phrase “…Great Concern For the Future…” in the title for July edition.

It’s also still prudent to ask whether we’ve really begun to pay the full price for the Fed’s apparent victory. So far, the only obvious damage done by a full 5 percentage points (and counting) of rate increases by the Fed has been a regional bank crisis that seems (for now) to have been expertly contained. Knock on wood, that might be the only thing that the Fed ends up breaking before it finally winds down its rate-raising campaign later this year. But on the other hand, there is still the very real possibility that fallout from that episode in the form of tighter lending standards and more onerous banking regulation will leave its mark by further constraining credit creation – the life’s blood of any modern economy.

And finally, it seems entirely possible that businesses have may not yet have really felt the pinch that such a dramatic increase in rates can imply. For example, there was evidence in last week’s consumer credit release from the Federal Reserve that consumers are finally starting to balk at the record-high rates being charged for things like credit card loans, which reached an almost unbelievable 20.68% in May[7]. Consumer credit took a big leg down according to that data, with consumers borrowing less than at any point since the height of the pandemic in the spring of 2020.

That’s not necessarily a bad thing: after all, it’s entirely rational (and frankly, desirable) for individual consumers to stop buying stuff on credit when rates skyrocket. Moreover, that feedback loop is also a key part of the mechanism by which Fed rate increases work to cool the economy and rein in inflation. But if that reluctance to borrow and spend runs head-first into worsening margins wrought by still-accelerating wage bills and persistent input price inflation, then corporate earnings are clearly at risk for a deadly one-two punch of declining profitability and collapsing revenue. And that’s probably bad news regardless of whether the Fed is really done or not.

We’ll know more about how that’s all likely to play out in coming weeks as second-quarter earnings seasons heats up. But for now, it’s probably okay to relax a little and enjoy the respite – as long as you remember Dr. Doom is still hovering nearby with all those sharp, pointy things close at hand, perhaps ready to make you sweat all over again.

What to watch this week

Last week marked the unofficial beginning of second-quarter earnings season, with a number of large banks reporting results that were, on the whole, better than expectations. JPMorgan, Citigroup and Wells Fargo each beat analyst estimates by a comfortable margin and in the case of JPMorgan – who’s CEO Jamie Dimon has become a minor celebrity for his detailed views on the economy – went out of his way to give props to the U.S. consumer, who he says is well-positioned to endure a recession if one arrives[8].

But last week’s big bank reports weren’t without warts, however: all three banks also significantly boosted loan loss provisions – essentially a “rainy day fund” that banks set aside to cover anticipated losses on loans they’ve extended – and Citigroup admitted that its provisioning activity was based on the assumption that the U.S. economy will probably enter a mild recession in the near future. This week, other big lenders including Bank of America (Tuesday), Goldman Sachs, US Bank (Wednesday) and American Express (Friday) will have their chance to weigh in. Other earnings highlights include airlines (United on Wednesday and American Airlines on Thursday), who will provide more color surrounding whether or not the extremely strong travel trends that have supported consumer spending will continue, as well as transportation and logistics companies JBHunt and CSX (Tuesday and Thursday, respectively). Transport companies are always in a great position to weigh in on the overall health of the economy given that they’re responsible for moving all the stuff we buy (or don’t buy.)

Beyond earnings, we’ll get several reads into how the “smokestack economy” is performing when the first two regional Fed manufacturing reports for July drop (Empire State on Monday and Philly Fed on Thursday,) as well as industrial production on Tuesday. The goods-producing sector of the economy has been contracting for months, and this week’s reports are likely to confirm that trend. On Friday, tune in to the flash (mid-month) PMI release to see whether or not the services sector is still stubbornly avoiding that same fate.

Meanwhile, we’ll get the first installment of our monthly housing data in the form of the NAHB’s builder sentiment survey on Tuesday which, together with Wednesday’s starts and permit release, will help answer the question of whether new home sales remain on the path to recovery. Home resales, which haven’t yet seen the same momentum as new home sales given a continued lack of resale inventory, are scheduled to be released on Thursday. As we’ve said before, a sustained recovery in housing would make the case for sidestepping recession far more credible.

Finally, Tuesday’s retail sales release is probably one of the week’s can’t-miss events. Under ordinary circumstances I don’t put a ton of emphasis on that data: its lumpy, confusing, and markets don’t ordinarily move a whole lot because of it unless its wildly out-of-whack with estimates. But today, as the U.S. economy teeters back and forth between recession and a goldilocks recovery, any indication of how the consumer is behaving is critical to forming a coherent outlook. Look beyond the headline and into where people are spending their money for a deeper insight into which direction the economy might tip from here.