Markets Remain Buoyant

As summer comes to a close, both equity and bond markets seem to reflect optimism about what is in store for the U.S. economy.  U.S. stocks are trading right near their all-time highs and bonds are also trading quite strongly, with stable Treasury yields.  In August, stocks were up for the fourth consecutive month since the April tariff announcements and bonds have also ticked up modestly so far this year.

Investors Looking on the Bright Side

While tariff uncertainties appear to be delaying companies’ decision making, the markets are taking a more sanguine view.  Stocks are trading at high price-to-earnings multiples, indicating that investors are expecting robust earnings growth to continue.  Bond prices have also increased since the beginning of the year, with the U.S. ten-year Treasury note yielding about 4.17% now, down from where it started the year at about 4.5%. (When yields go down, bond prices go up.).

Corporate Earnings Were Strong in the Second Quarter    

With the second quarter earnings season over, it is clear that business conditions have not been as difficult as expected from CEOs when they broadly watered down earnings expectations in April and May when reporting their first quarter results. For the second quarter, 81% of companies exceeded their Wall Street earnings’ estimates and 81% beat their revenue estimates.  By and large, companies set out a conservative earnings bar for themselves last quarter and then easily stepped over it. Nevertheless, it seems companies have been broadly resilient to the changing trade dynamics.  Once there is more clarity around trading rules and tariff levels, we will probably see increased corporate investment.  Wall Street remains constructive for next year as well.  Right now, analysts are expecting corporate earnings growth of 13%-14% next year, which is an above-average increase.  As the months pass, these top-down forecasts tend to be reduced somewhat, but there is no question that analysts are expecting Fed interest rate cuts to propel corporate earnings in 2026.

The Fed’s Conundrum

The dual mandate of the Federal Reserve is to maintain price stability and full employment.  Sometimes it is challenging to set monetary policy to achieve both at the same time.  Now is one such time.  There are unmistakable signs that the labor market has been weakening in recent months.  Economists largely blame the weak hiring environment on the uncertainty around tariffs and trade policy as well as artificial intelligence advances prompting many companies to cut back on new hires. But as the job market weakens, inflation has remained elevated.  The Fed’s favorite gauge of inflation, the Core Personal Consumption Expenditures Price Index (Core PCE), which excludes food and energy, has been ticking up gradually each month since April and now sits at 2.9%.  In his speech at Jackson Hole last month, Fed Chair Powell hinted that it may be time for the Fed to begin cutting interest rates to address the weakening job market.  Markets now broadly expect a rate cutting cycle, with the chances of at least a 25 basis point cut at the Fed’s upcoming meeting on September 16-17 as high as 95%, according to the CME’s FedWatch tool.

Meanwhile, many companies have said they intend to raise prices gradually to protect their margins from tariff-induced costs.  There is perhaps no better barometer of the evolving pricing in the economy than retail behemoth Walmart.  On the company’s 2Q earnings call, CEO Doug McMillon said, “As we replenish inventory at post-tariff price levels, we’ve continued to see our costs increase each week, which we expect will continue into the third and fourth quarters.”  While tariff impacts have thus far been mild, pricing pressures will be filtering into the economy over the next several quarters.  The Fed will be trying to strike a balance between supporting the labor market and restraining inflation, but at some point in the next year it may have to pick between the two.

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Photo by: Arlo