After July rebound, market outlook is still uncertain

Equities and bond markets rallied last month as positive earnings and lower expectations for rate hikes offered some reprieve after an awful first half for investors.

The monthly gains came after a week in which the Federal Reserve raised its key rate by 75 basis points and the U.S. recorded its second consecutive quarter of negative growth.

“For markets that have been under heavy pressure this year, largely because of higher rates and weakening growth, this might rightfully seem a tad counterintuitive,” a report from BMO Economics said.

The S&P 500 index finished July 9.1% higher, though still down by 13.3% for the year. The S&P/TSX Composite gained about 4% last month to end July down by 7.21% for the year, while the hard-hit Nasdaq gained 12.4% in July.

Bonds also rebounded from a historically bad start to the year as yields dropped on recession fears. The 10-year U.S. Treasury yield fell 83 basis points from its mid-June peak of 3.48%.

Most government and corporate bonds rebounded in July, with high-yield the top performers, a report from FTSE Russell said. U.S. high-yield bonds gained 6.2% for the month while European high-yield was up by 5%.

As a report from Purpose Investments put it: “While many have complained of the positive correlation between equities and bonds this year, temporarily reducing the efficacy of portfolio construction, positive correlation is rather nice when everything goes up.”

BMO attributed the rally to a combination of extreme bearish sentiment and a perceived Fed pivot, with the market pricing in rate cuts next year.

“[T]hat seems to have been enough to trigger a rally in beaten-down risk assets, including higher-beta stocks, even if it effectively means more pain in the interim,” the report said.

The FTSE Russell report noted that tech and discretionary names led the rebound. “In a sharp reversal from first-half trends, tech and other growth stocks outperformed commodity-driven and defensive peers,” it said.

Meanwhile, about three-quarters of S&P 500 companies have topped earnings expectations so far for the second quarter, though energy companies have skewed average earnings growth data, BMO said. It also warned that forward guidance becomes more important at economic turning points, and since early July, “downward revisions have been outpacing upward revisions by a two-to-one margin.”

The Purpose report attributed the latest market swing to continued effects from the Covid-19 pandemic.

The U.S. economy had to adjust to an extra trillion dollars spent on goods during the worst of the pandemic, sending corporate profits soaring. Now, as service spending surges and goods purchases drop, the Purpose report said, there could be a recession — or an “earnings recession” — while employment continues to rise.

“The pandemic was an exogenous shock to the entire system — it changed behaviours, economic relationships, moods, etc.,” the report said. “Now things will return to normal, but the impacts will continue to reverberate through the system for years, likely with a diminishing magnitude.”

The second half “will not be smooth sailing,” Purpose said, but it forecast positive returns for equities and bonds over the next five months.

If the global economy is entering a recession, BMO warned, stocks rarely bottom out without a negative payroll print and a Fed rate cut.

“Both of those circumstances argue for more tough slogging ahead,” the report said. However, it also noted that periods where core inflation falls back toward 3% are traditionally strong for equities. “Any relief on that front would almost certainly be welcomed by a wave of buying this time around too,” it said.