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Market Commentary: Weak Seasonality Still in Play

The S&P 500 has pulled back almost 5% since July 31. This is not surprising considering historical data. Factoring in seasonality has worked well for investors over the last 18 months. We’ve pointed out how bear markets tend to end in October, especially in midterm election years, with the first half of pre-election years being extremely bullish. That has played out exactly as history suggested.

  • The S&P 500 has pulled back by almost 5% this month.
  • The current season is historically weak for stocks.
  • Retail sales surged in July and are up 5% over the past three months after adjusting for prices.
  • Vehicle production is now higher than it was at any point in 2019.
  • Investment spending is also rising, across high-tech, trucks, and aircrafts.
  • Long-term bond yields are pricing in stronger growth.

Our research also shows that when markets are up at least 10% by mid-year, seasonal weakness tends to follow. So, the pullback we’re seeing now shouldn’t be a shock. The good news is once this period has passed, the rest of the year is typically strong. This is how we see 2023 playing out, with the S&P 500 hitting new highs before the ball drops.

The S&P 500 recently closed below its 50-day moving average for the first time in more than four months. That got a lot of media attention, and rightfully so. However, stocks responded well. In fact, since 1990, the S&P has recovered well nearly every time it broke its moving average, up more than 14% on average one year later.

What’s interesting is that sentiment is shifting. The economy has surprised to the upside and stocks had one of their best starts to a year. As a result, several bearish analysts are changing their tunes. The Bank of America Global Fund Manager Survey surveys portfolio managers that manage hundreds of billions of dollars. Its most recent report showed that sentiment is the least bearish it has been since February 2022. Of course, one look at the chart below and it is clear there are fewer bears than before. But by no means is this what we’d call over-the-top optimism.

It’s ironic that sentiment is shifting right when stocks are experiencing seasonal weakness.

Resilient Economy May Be Accelerating

Another month, another slew of economic data that not only shows the economy is resilient, but also that it may be accelerating. Here’s a quick recap.

Retail sales and food services rose 0.7% in July. One month may be noisy, but even the three-month average shows retail sales rose 7% at an annualized pace. Inflation was up just 1.9% over this period, which means inflation-adjusted retail sales rose at a 5% annualized pace — 7% above the pre-pandemic trend. That’s incredible and indicates how strong households are.

Four positive stories on the manufacturing front are tailwinds for the economy.

Vehicle production has rebounded to the highest level it has been since 2018, which means it’s even higher than at any point in 2019. Despite that, production has yet to make up for a cumulative shortfall of 5 million vehicles due to pandemic shutdowns, which means production is likely to remain strong.

Production of medium and heavy trucks is also moving up, rising 14% this year.

The aerospace industry is also seeing a boom, with production up 4% this year.

High-tech equipment (computers, communication equipment, semiconductors) production is surging once again, rising more than 7% over the first seven months of this year for a cumulative gain of 20% since February 2020 (pre-pandemic).

Suffice to say, none of this data indicates the economy is heading into recession. These are all large investments companies must make, which signals they believe future demand will be strong.

Overall, this is positive for current activity and GDP growth near-term. But it’s also positive in two other important ways:

  • Inflationary pressure may be reduced as supply increases.
  • Productivity may rise in the future on the back of investments made today.

Housing market data show single-family construction continues to rebound. Housing starts rose almost 7% in July and are up 22% since last November. Building permits, which are a sign of future supply, rose just under 1% and are up 24% since December, indicating homebuilders view potential demand as strong, despite mortgage rates rising above 7%. This is another tailwind for GDP growth, as we wrote in our Mid-Year Outlook.

All this has sent the Atlanta Fed’s nowcast of third-quarter GDP growth to a whopping 5.8%. A month and a half ago, the median expectation for third-quarter growth was zero! That meant half of the polled economists were expecting negative growth. It’s hard to believe GDP will rise close to 4%, let alone 6%, after adjusting for inflation, and we have a long way to go before the quarter closes out. But the direction suggests much about how the economy is doing.

Higher Interest Rates for Longer, Much Longer

Equity markets have pulled back despite the run of strong economic data. Of course, this is a period that has historically been weak for equities, as noted above.

But it’s the bond market that has our attention.

Investors are not expecting the Fed to raise rates any further despite the strong economic data. So, the federal funds rate is expected to peak around 5.4%. This makes sense because inflation seems to be rolling over, and there’s potentially more disinflation in the pipeline, with vehicle and shelter inflation easing further.

Interestingly, longer-term bond yields have been surging even as short-term rates remain steady. Some of this is because of a potentially increased supply of Treasuries, as the government attempts to cover a rising deficit. But investors’ expectations of what may be coming has also changed.

Rising long-term yields mean investors expect the Fed to keep rates on the higher side long-term. The run of strong economic data, including employment, has surprised many investors. As a result, expectations for future growth are shifting higher as the economy proves its resilience in the face of an aggressive Fed and higher interest rates.

Investors expect the Fed to cut rates by about 1-1.25% in 2024, in the face of lower inflation, but not much more after that.

A month ago, they expected the Fed to keep rates around 3.2% into 2027. That’s now almost up to 4%, which is well above Fed officials’ long-run forecast of 2.5%. This long-run expectation is similar to what Fed members expected over the last decade, so they’re anchored to that.

Yet, investors see it differently. They’re saying the economy is resilient and is likely to remain that way. Either way, interest rates will have to be higher than they have been over the past decade.