This morning, the attention of Wall Street is on the U.S. inflation situation and the unofficial start of second-quarter earnings season. At 8:30 A.M. (EDT), the Labor Department reported that the Producer Price Index (PPI) jumped 1.1% on a month-to-month basis, a worrisome reading notwithstanding that the “core” PPI, which excludes the more-volatile food and energy components, showed a more moderate rise of 0.4%. Likewise, producer (wholesale) prices were up 11.3% over the last 12 months. This reading, along with yesterday’s companion report showing the biggest year-over-year rise in consumer prices (+9.1%) since 1981, do not quell the concerns about inflation and the impact higher prices are having on the economy. Meantime, initial jobless claims for the week ending July 9th rose by 9,000, to 244,000. The equity futures, which were lower heading into the inflation data, are still indicating a weak opening to the trading day stateside.
On the corporate front, the big news was the release of latest results from banking giant JPMorgan Chase (JPM) before the opening bell. That report showed that revenue fell $1.2 billion short of expectations on weaker-than-expected loan growth of just 7% and a drop in investment banking activity. On the bottom line, earnings of $2.76 a share came in below the consensus forecast of $2.88. The investment community also did not like that the bank has temporarily suspended share buybacks to conserve more capital for loan loss reserves and possible cloudy days ahead. Likewise, fellow banking behemoth Morgan Stanley (MS) delivered disappointing quarterly results, with revenues and earnings missing expectations on weaker investment banking results.
In general, banking sector earnings are likely to be down, as many of the banks have increased their loan-loss provisions in anticipation that a slowing U.S. economy may lead to a spike in loan delinquencies in the coming quarters. Shares of the aforementioned banks are lower in pre-market action and, along with the inflation concerns, are weighing on the performance of the overall equity market.
The continued high inflation readings, along with last week’s better-than-expected report on jobs creation, will likely not change the Federal Reserve’s near-term stance on tightening the monetary reins. The expectation is that the central bank will raise the benchmark short-term interest rate by 0.75% when the Federal Open Market Committee (FOMC) meets the last week of July. There is even chatter that a full percentage-point increase can’t be completely ruled out for this month’s FOMC meeting. The resultant higher borrowing costs will likely continue to weigh on the housing market and other economic sectors. Too, a rising rate environment is not a good backdrop for the technology companies, especially the less profitable entities that are valued on future cash flow potential. Theory says that higher discount rates lower a company’s intrinsic value, which measures the value of an investment based on its cash flows.
The more-restrictive stance of the Federal Reserve at a time when the economy looks to be slowing is raising the odds of a recession or at the very least a period of stagflation – low growth with continuing inflation. The aforementioned banking industry results have added to those worries, as JPMorgan results, in particular, are seen as a barometer for the overall health of the U.S. economy. The continued inversion of the yield curve (this occurs when yields on shorter-term Treasury note yields are higher than those of longer-duration bonds) bears watching, as such an occurrence has historically preceded the economy falling into a recession. This phenomenon also does not help the performance of the banks, which tend to borrow short and lend long. In addition, the inflation—and resultant higher borrowing costs—are taking a toll on housing demand. Data released yesterday showed a sharp drop in the average size of loan originations (from $460,000 to $415,000).
So what is an investor to do with so many questions, especially with regard to inflation and second-quarter earnings season, yet to be answered? This creates uncertainty, which investors typically don’t like. In this environment, we continue to recommend that investors target the stocks of high-quality companies that have strong balance sheets, a history of delivering steady earnings growth, and have shown an ability to generate ample cash flow. They may be best positioned to weather a period of slow economic growth. Keeping a healthy level of cash in one’s portfolio also is recommended. That said…
Investors should be wary of some of the multinational companies that do a large portion of business overseas. The strength of the U.S. dollar, which is now on parity with the euro, will reduce foreign earnings for many companies when translated back into the dollar. This may pressure the bottom lines of the multinational companies and could be frowned on by Wall Street in the coming weeks.
– William G. Ferguson
At the time of this article’s writing, the author held positions in one or more of the companies mentioned.
