Some stock investors see a silver lining in negative GDP report, and they could be wrong

Published Thu, Jul 28 202212:13 PM EDTUpdated Thu, Jul 28 20221:10 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

With clear signs the economy is slowing, some investors believe the Federal Reserve will have to be less aggressive about raising interest rates — a potential positive for stocks. But with the unemployment rate at a low 3.6% and consumer inflation running at a hot 9.1%, other strategists do not believe the Fed will easily back down from its vow to fight inflation. In the second quarter, the economy contracted by 0.9% as spending and investment slowed. It was the second negative quarterly report for gross domestic product in a row, a signal that technically the economy could be in a recession. Fed Chair Jerome Powell said Wednesday the economy was not in recession, when asked several times by reporters at his post-meeting press briefing. Economists were quick to dismiss the idea of recession just yet, since the labor market remains so strong. But they do note if the slowdown continues into the third quarter, there could be a recession. Others say the labor market is often a lagging indicator. "The cracks in the foundation of the recovery are starting to form," said Diane Swonk, chief economist at KPMG. She noted nonresidential business investment was flat. "The unwillingness of businesses to bet on the future is worrisome." Stock futures initially rose after the 8:30 a.m. ET GDP report, but then the market headed lower before turning higher again. Stocks had surged Wednesday , following the Fed's meeting and its 0.75 percentage point interest rate hike. Bond yields, which move opposite to price, turned lower after the Fed meeting Wednesday and continued to decline Thursday. The closely watched 10-year Treasury yield was at 2.66%. "People are saying the drop in rates means the Fed's going to stop hiking soon. It's the mentality we've generated after all these years. No matter what dark cloud is above us, the Fed is going to be there to clear them," said Peter Boockvar, chief investment officer at Bleakley Advisory Group. The economy's contraction in the second quarter follows a 1.6% decline in the first quarter. The National Bureau of Economic Research, the arbiter of recessions, is not expected to declare one because it weighs many factors. But some economists see the warning signs of a real recession. "We do think this is a stagflationary environment, and I define it as very low growth and high inflation. And that's certainly what we're seeing in the GDP data and inflation data," Conference Board economist Dana Peterson told CNBC. Peterson said the economy probably is entering a recession in the middle of this year, not back in the first quarter when GDP was distorted by trade and inventories. That makes it tough for the central bank, which is attempting to rein in inflation while also trying to engineer a soft landing and avoid a deep recession. Some market pros said the stock market took the Fed comments as dovish Wednesday, since the central bank acknowledged that the economy was slowing — meaning it may ease back on its tighter monetary policy campaign. Mohamed El-Erian, Allianz's chief economic advisor, said the Fed needs to focus on putting the "inflation genie" back in the bottle. "I think the worst outcome is next year we are in a recession and inflation has proven very sticky. That's the worst outcome," he told CNBC. "I don't think the Fed can take its eye off the ball in terms of bringing inflation down." Powell did say Wednesday that policymakers were neutral in lifting interest rates, and at some point could slow the size of its rate hikes. The market also embraced Powell's comments that the fed funds rate could be at 3.25 to 3.5% at the end of this year. Powell was referring to the Fed's forecast from June for its fed funds target. The market, however, does not expect the it to move beyond that level. If anything, fed funds futures have been pricing in rate cuts for next year, and traders expect the funds rate to stand at 2.65% at the end of 2023. The Fed's forecast puts that target rate at 3.8% at the end of next year. Scott Redler, partner with T3live.com, said the negative GDP report is being taken as a sign the Fed is doing its job. "They slowed down the economy and we're probably at peak inflation so it seems like we're through peak hawkishness and maybe the market will act a bit better if the economy doesn't get much worse," he said. "The market is taking a half-full approach." Other strategists say Powell's message Wednesday was not the positive one that the equity market believed it to be. "I don't think it was dovish at all," said Jim Caron, head of macro strategies for global fixed income at Morgan Stanley Investment Management. "The Fed had this GDP number going into this meeting. What they highlighted was that the job market is strong. That's a veiled way of saying we're not in a recession." He said that in itself is hawkish. "If the Fed says we're not in a recession and why are we focused on a recession; what they're telling you is even though we have two quarters of negative growth, we're still hiking," he said. Boockvar said the employment data, which is a lagging indicator, will give policymakers cover to raise rates for awhile. "I think the Fed is more focused on where the unemployment rate goes than where GDP goes," he said. "They're going to rely on the most lagging of indicators for policy. That's the danger zone we've entered and now we got the fed funds rate to 2.5% , and likely 3% in September. The pace of these rate hikes are somewhat jolting for an economy that has been so dependent on easy money for so long." Boockvar said the second-quarter GDP report sent a warning about further slowing as inflation continues to burn hot. "If you take out inventories and you take out trade, real final sales for domestic purchases was zero. If you take out inventories, growth was stagnant," he said.

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