This week marks the start of Q2 earnings season with major banks like JPMorgan Chase (JPM), Goldman Sachs (GS), and Wells Fargo (WFC) kicking things off for the S&P 500 index heavyweights. The second quarter will shine a light on how tough the macro environment has been on companies’ bottom line, as they faced increased labor costs and materials costs amid a still-tight supply chain. Despite the headwinds, earnings estimates for S&P 500 companies show earnings growth of 4.3% year-over-year for the second quarter. This is a sharp difference in what market indices have done in the second quarter as the image below shows – earnings forecasts in blue remain near peak levels while index prices falling have created a gap. Other challenges for S&P companies remain, such as the Fed’s ongoing battle with inflation and still-tight labor market.

Last week brought fresh jobs data which continued to point to a tight labor market – read: plenty of jobs but no one to hire. Nonfarm payrolls beat analyst expectations that called for 268k jobs to be added, or a roughly 3% drop versus the 25% drop expected from the previous month’s figures. Instead, the economy added 372k jobs in June. The unemployment rate also held steady at 3.6%, but the underemployment rate (workers not using their full skills or can take a full-time job) hit a new low which points to further tightness in the labor market. The latest jobs data, and the image below, highlights that the labor market still has room to come down a healthy amount if the economy enters a slowdown and solidified the expectation of a 0.75% interest rate hike during this month’s Federal Open Market Committee’s (FOMC) meeting.

This week will bring in new inflation data via the Consumer Price Index (CPI). Analysts expect headline inflation, which includes energy and food prices, to edge up from May’s 8.6% reading, but see core inflation ticking down slightly from the 6.0% reported for May. Needless to say, inflation is under close watch from the Federal Reserve as they look to dial in their dual mandate of stable prices and maximum employment. Although three rate hikes are expected at next month’s FOMC meeting (0.75%), and interest rate hikes take several months to work themselves through the economy, investor’s inflation expectations in the near-term are already falling from the highs seen back in late March of this year. The image below shows the five-year inflation breakeven rate near 2.5%. In other words, investors believe that inflation will continue to fall to an average of 2.5% over the next five years.

The headwinds seen at the start of the year continue to carry into the year, mainly inflation concerns, the labor market recovery, and easing supply chain pressures. While we have seen very small changes in the economic data for the labor market and inflation expectations that the Federal Reserve wants to see, keep in mind that these trends will occur over a stretched period of time. I would like to point out that not all companies will be affected the same. Among companies with elevated earnings expectations, there will be a high hurdle to jump to justify the price investors pay for shares going forward. In the labor market, the Fed is willing to tolerate a weaker job market in order to cool inflation. Not all industries will see an even dispersion of jobs lost – see the recent headlines from several tech companies. On prices, the reality of our current environment is that even the best estimates will be hard to show what the average consumer is experiencing. What is clear though is that we are slowly making our way to a more normal economic environment. As we navigate to normalcy, keeping your investments aligned within your financial plan will be key to avoid any unnecessary shortfalls in your portfolio.

Jose Rendon
Senior Portfolio Administrator

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All charts and data from Bloomberg unless otherwise indicated.

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