Posted by Jeffrey J. Roach, PhD, Chief Economist
Thursday, September 7, 2023
Additional content provided by Kent Cullinane, Analyst
- Prices paid by purchasing managers reversed course, reverting to price levels from April.
- Yields on the 10-year Treasury temporarily spiked on the news that inflation could be stubbornly elevated throughout this year, illustrating that investors should expect a bumpy ride in the markets.
- However, business activity has been growing at a slower pace since the end of 2021 as consumers spend down their excess savings.
Bottom Line: The two big challenges facing the Fed right now are the risks that inflation could become entrenched and the possibility that the consumer could falter when excess savings dry up. Given the data, the Federal Reserve (Fed) will most likely deliver a hawkish pause at the next meeting. The hard data is not yet convincing enough to establish strong views about the subsequent meetings. Investors should still find opportunities in the market but it could be a bumpy ride.
The Institute for Supply Management (ISM) released the ISM Services Purchasing Managers’ Index (PMI) report for August, highlighting an increase for the third consecutive month. The Services PMI rose from 52.7 in July to 54.5 in August, beating consensus estimates of 52.5. As a note, a PMI above 50 represents an expansion, while a PMI below 50 represents a contraction. This marked the eighth consecutive month of the index being above 50 or in expansion territory.
While August’s aggregate 1.8 percent increase is impressive, a couple of the underlying sub-components that make up the Services PMI contributed meaningfully to the monthly increase. The New Orders Index expanded in August for the eighth consecutive month, increasing from 55.0 in July to 57.5, with 12 out of 15 industries reporting an increase in new orders. Accommodation & Food Services was the top contributor, as restaurant sales and traffic trends remain positive year over year and when compared to pre-pandemic levels.
Additionally, the Prices Index rose in August to 58.9, up 2.1 percent from the month before and marking the 75th consecutive month of price increases. Public Administration, Educational Services, and Health Care & Social Assistance were the top contributing industries to the monthly increase.
The relationship between prices and business activity has diverged, however, as the Business Activity Index, another sub-component of the broader Services PMI, added 0.2 percent, increasing less than the aggregate index. Business activity has been growing at a slower pace since the end of 2021 as consumers spend down their excess savings. Below is a chart highlighting the diverging trend between Services pricing and business activity.
Following the release of the Services PMI report, Treasury yields spiked, with the 2-year Treasury yield reaching an intraday high above 5%. At the longer end of the yield curve, the benchmark 10-year Treasury yield also increased, although to a lesser degree, reaching an intraday high of 4.30%. The probability of the Fed raising interest rates in November rose to roughly 40%, according to the CME FedWatch Tool. The probability of an interest rate hike at the Fed’s next meeting in September is still very low, with only a 7% chance of the Fed hiking again.
Despite the slowing of business activity in August, it appears companies were able to pass on rising prices to the consumers at least for the first half of this year. Second quarter earnings were much better than we had anticipated relative to consensus expectations, particularly the surprising increase in overall S&P 500 estimates during reporting season. Looking ahead, the historically close relationship between the ISM indexes and earnings suggest that either the economy will pick up (unlikely in our view) or earnings will level off (more likely).
LPL Research sees perhaps mid-single-digit earnings gains in 2024 compared to the current consensus expectation of a 12% earnings. So while we may see earnings growth in the second half of this year, analysts appear overly optimistic for 2024. Further, an earnings rebound appears priced in at current valuations and interest rate levels, consistent with the Strategic and Tactical Asset Allocation Committee’s neutral equities view.
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