Economy Outshines ‘Uneventful Earnings’

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. Many companies exceeded expectations in the second quarter. But falling inflation and a robust economy were happening in the background. Morningstar Inc.’s chief markets editor is joining the podcast to break down the trends. this is Investing Insights.

Thanks for being here, Tom.

Tom Lauricella: Good to be here.

Earnings Season Trends

Hampton: Earnings season is wrapping up. What are the main trends that we’ve seen out there?

Lauricella: It’s been, I would actually say, a little bit of an uneventful earnings season in some ways. Earnings were solid. We saw a lot of companies beat their earnings forecasts. It’s a little bit of companies playing the game of guiding Wall Street analysts down so that it makes it easier for them to beat the numbers, but also the U.S. economy is holding up better than we had expected. So, that’s provided a pretty solid backdrop for corporate earnings. And that’s been good news for investors.

Apple and Amazon Earnings

Hampton: Big Tech names like Apple AAPL and Amazon AMZN get a lot of attention during earnings. What did we see from those companies this time?

Lauricella: These companies report early, and this time around they provided a pretty positive bias for the market in terms of their news. Google GOOG, Meta META, Amazon, all had some very nice numbers, and more importantly, they had strong guidance on the outlook. Amazon had some very good things to say about its Web Services unit, the cloud, and that was very encouraging news for the markets. The exception was Apple, which was a little softer than some people expected in terms of the outlook around its iPhones. But all in all, Big Tech had some decent numbers, and that provided us with a lift for the market back in July.

What Did We See From the Banks in Q2?

Hampton: And there was a lot of attention on the banks, the big banks in particular, and worries about a credit crunch during the first quarter. What did we see from the banks in Q2?

Lauricella: This was a little bit of the dog that didn’t bark. We had here a situation where everybody was very focused on regional banks, in particular, in the first quarter and again coming into the second quarter. And the news was actually kind of reassuring. We did see some continued roll-off of investors pulling money out of savings accounts at some of these regional banks. But it’s nothing that the banks don’t seem to be able to handle. And by the time it was all said and done, it was a little bit of a nonevent. It looked like these stocks have gotten really hammered. They’re still down for the year. But in all, there was some reassuring news and it looks like the worst of that situation has been avoided.

Key Trends and the U.S. Economy

Hampton: Looking more broadly, were there any key trends that might give clues about the economy?

Lauricella: It was interesting. So, we saw a bifurcated story out there a little bit. We had companies that are maybe a little bit more economically sensitive, especially on the industrial side, where we saw some softening. But then we saw other parts of the business world where we saw some strong activity, especially more infrastructure-type companies involved in infrastructure businesses where we’ve seen a lot of investment in terms of climate change and just general infrastructure work. So, it’s been a little bit of a split out there in terms of earnings on that level, which reflects this same picture we’re seeing in the economy, really.

Will There Be a Recession?

Hampton: Now staying on the topic of the economy, what happened to the recession that a lot of people were predicting that we were supposed to have?

Lauricella: That’s really been a big story this year that most people were pretty convinced that by now, as we’re going through the third quarter, the U.S. economy would be in a recession, that we would be seeing negative economic growth. Instead, we’re tracking GDP growth even stronger than it was at the start of the year. The reality is that this has surprised a lot of people. And the big thing here has really been the resilience of the labor market, the resilience of the consumer. We had some sectors of the economy last year, such as housing and manufacturing, that slowed down significantly, but those sectors are bouncing back pretty well this year. We’ve got housing coming back. We’ve got auto sales coming back. So, anything to do with the consumer, anything to do with the labor market is still looking really healthy. As far as where is that recession, that’s a really good question. Doesn’t mean it’s not going to happen. And, in fact, a lot of folks still think the real softness in the economy is yet to come, that we could see an actual recession as we head into next year. But as of now, as of the third quarter, the economy is looking really robust out there.

Inflation Trends

Hampton: How is that translating into what we’re seeing with inflation, with the economy being so strong?

Lauricella: This is yet another interesting part of the story, which is that we have seen continued good news on inflation. Our economist Preston Caldwell calls it the “immaculate disinflation” story, where we’re seeing inflation coming down even as the economy is remaining healthy, which is not the dynamic that you would normally expect. Normally, you would expect it would take a softening, weakening economy for inflation to come down for us to see disinflation. But yet it seems like a lot of the factors that had lifted the inflation rate to a 40-year high last year have played out. And so, as a result, the latest two CPI reports have both shown very tame numbers with most of the inflation news essentially being driven by shelter costs, rent, which move at a lag, they move very slowly. The CPI doesn’t really capture what’s happening out there in the real world. So, in essence, a lot of economists, including our own, think that the inflation picture is just going to keep getting better for now. Not clear that we’ll get to where the Fed really wants it to be yet, but we are seeing good news on inflation even as the economy is remaining pretty healthy.

Fed and Interest Rates Outlook

Hampton: How is this coming together in terms of the outlook for the Fed and interest rates?

Lauricella: The inflation outlook is really key, for now anyway. At this point, it’s seeming like the Fed has at most one more small interest-rate increase up its sleeve, perhaps in November, at least that’s what the markets are saying. It’s very widely expected that when the Fed next meets in September that they’re going to hold rates steady, that one additional rate cut is really the unknown at this point. Markets are giving it a slight chance of happening. More so, investors seem to think that the Fed is done. And from there, what’s even more interesting is that despite the strength in the economy, the markets are saying that the Fed is going to cut interest rates pretty aggressively next year. Five interest-rate cuts are currently priced into the bond market. That’s a pretty significant move given how strong the economy is right now and given the fact that inflation is not yet down at the Fed’s 2% target. But, for now at least, most people in the market seem to think the Fed is almost done, albeit going to hold at higher interest-rate levels at least through the end of the year.

Stock Market Outlook

Hampton: If folks are thinking that the Fed is done or almost done with raising interest rates, what does that mean for the stock market?

Lauricella: This has been good news for the stock markets. It’s part of the reason that we’re up 20% or so this year. It was those expectations that the Fed would be winding down its rate hikes along with some better earnings news that has contributed to that rally that we’ve seen. Essentially this removes one of the headwinds from the market. And that’s part of what we saw in terms of the improved sentiment. It’s allowed the market to hold on to these gains. We’re technically out of the bear market at this stage, and the fact that the Fed seems to be done is what’s enabling markets to sustain this bounce. Perhaps we’ve seen the worst, we’ve seen the end of the bear market. Seems that way anyway.

Near-Term Stock Outlook

Hampton: What are analysts saying about the near-term outlook with stocks having experienced that big rally?

Lauricella: That’s in the rearview mirror at this point. That 20% gain it’s, sort of, “Now what?” Things are a little bit choppier now. Valuations are not attractive to the degree that they were at the beginning of the year. Some of the stocks that led the rally, like these Big Tech names, they are definitely on the pricier side again. A lot of folks are thinking that we’re going to consolidate, as I they in Wall Street jargon, that the overall market might not move much higher or lower. And we have some other things to contend with. There’s still the lagged impact of the Fed rate hikes. As I said, the possibility of a recession is still out there. A lot of economists believe the economy will start to slow. We have other factors kicking in this fall, such as the resumption of student loan payments. That’s a lot of money that has been in a lot of folks’ pockets that they’re going to have to start paying out again. There are a number of issues out there that could create some new headwinds even as this big one of Fed rate hikes seems to be off the table.

What Headwinds Could the Stock Market Face?

Hampton: And what other headwinds could the stock market face?

Lauricella: There is this question of will earnings continue to be as solid as they’ve been. One of the interesting things about the strong labor market is that we’re seeing wage hikes being baked into union contracts. Eventually, companies start running into profit margin constriction. That’s not so good for the stock market. We’re also seeing the significant slowdown in the economy in China. When you add that up, plus the potential for some slowing of the economy, there could be a few speed bumps in the road for the stock market as we head through the rest of the year, even though the overall outlook seems OK.

Takeaways For 2023

Hampton: Tom, can you share a couple of takeaways for investors for the second half of this year? I can’t believe 2023 is almost over.

Lauricella: We’re getting there. The main thing at this point is that we have seen this big rally. And at this point, certain corners of the market, the valuations are stretched. However, the interesting thing about this rally, because it was so concentrated, there are big sectors that were left behind and valuations are still attractive. Dividend stocks did not really participate this year. There are other sectors out there, other names where investors can find some opportunities. It’s really a time for folks to be looking at the valuations and considering that in terms of any adjustments that they might make in their portfolios. And of course, on the interest-rate side, as we’ve written about many times, we do have much higher yields here in the bond market. You can earn 5% on a very safe U.S. government-bond-backed mutual fund, et cetera. That’s a pretty attractive proposition with inflation below 3%. You’re making money there for the first time in years. So, there are opportunities out there for investors.

Hampton: Well, thanks, Tom, for your time today.

Lauricella: Glad to be here. Thanks for having me.

Hampton: Subscribe to the Smart Investor newsletter. Tom shares his must-read market commentary every week. Thanks for checking out Investing Insights. We appreciate you. And I’m thanking lead technical producer Scott Halver and video producer Daryl Lannert. Subscribe to Morningstar’s YouTube channel to see new videos, and you can hear market trends and analyst insights from Morningstar on your Alexa devices; say “Play Morningstar.” I’m Ivanna Hampton, your host and a senior multimedia editor here at Morningstar. Take care.

Read About Topics From This Episode

July Jobs Report Suggests Economy on Track for ‘Immaculate Disinflation’

Markets Brief: Is the Stock Rally Broadening?

July CPI Report Cements Improved Inflation Picture

5 Stocks To Buy as Q2 Earnings Season Wraps Up

The Stock Market Is Now Fairly Valued. Here’s What to Do Next.

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