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Investment Commentary

The economy zigs, markets zag

By Kelsey Ellsworth | Johnson Financial Group • August 25, 2022

4 minute read time

Most mornings I begin my day by walking the dog. Pippa is an energetic lab mix and not the best of walkers. At the beginning of our journey, she zigs and zags to sniff everything along the way. As much as I try to keep her in a straight line, she has a mind (and nose) of her own. Toward the end, we begin to find our rhythm as Pippa begins to relax and walks alongside me.

In the language of markets, one might say that by the end of our walks, Pippa and I start to “trend together” …unless she spots a rabbit, of course.

We see a similar “trending together” relationship between the markets and the economy. Though we tend to talk about the two collectively, they are not one and the same. However, directionally, and especially over longer time frames, the two tend to trend together.

Markets vs. economy as seen in goods vs. services

Markets can be volatile as they constantly digest new information, while changes to the economy can be slower but steady.

Stocks have rallied since mid-June as markets believe inflation is peaking and the Fed will slow rate hikes. The S&P 500 Index posted one of the best July returns in history, up over 9%. Most companies have reported second-quarter earnings. Reports were in line with expectations, but many companies reported that bloated inventory weighed on profits.

The chart below shows the difference in the breakdown in goods and services for S&P 500 earnings versus the breakdown for U.S. GDP. Consumer spending is the biggest driver of both categories, so let’s think in those terms. For S&P 500 companies, most of the earnings are attributable to the sale of goods. But for U.S. GDP, most of spending goes toward services.

Demand for goods has been weakening as consumer spending shifts towards services—having been more focused on goods earlier in the pandemic. Now many companies are behind that consumer trend. But remember, plenty of S&P 500 companies sell services…so there’s potential for their earnings to climb even as goods sellers struggle.

The economy zigs the markets zag

The overall markets vs. economy picture

The shift towards services influences S&P 500 earnings (and by extension the markets) and the economy differently. Inflation is taking its toll on consumers’ ability to spend—affecting markets negatively. However, job growth, wage growth, and savings have been encouraging—pointing to a solid foundation for the economy.

Still, for the economy, we expect a period of slower economic growth numbers due to difficult comparisons (i.e., last year’s rocketing growth) and the impact of high inflation.

While our base case is that we will not see a recession in the coming months, we recognize that the economy and the stock market don’t always move in close tandem. Therefore, it is important to have a disciplined rebalancing policy. As Brian Andrew mentioned in his commentary last week, we added to equities in June after a decline of more than 20% and recently removed some of what we added.

We’ll be closely monitoring job growth, inflation, and consumer spending as indicators of economic strength. Assuming that strength holds up, we anticipate the remainder of the year to be far better than the first half with respect to market results. That said, markets can be volatile anytime…just as Pippa will lunge for a rabbit even when tired at the end of a long walk.


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