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Markets race past dropping GDP and higher inflation

By some accounts, the U.S. economy is officially in a recession, though investors largely discounted that analysis and have rallied to end the week on a positive note.

MANHATTAN (CN) — Investors got some bad news this week, as the U.S. economy shrunk for the second quarter in a row, inflation continued to rise, and interest rates were hiked again. But they rallied anyway.

Besides a slight dip on Tuesday, indices marked gains each day this week, with the Dow Jones Industrial Average gaining 947 points since last Friday, the S&P 500 netting 169 points, and the Nasdaq increasing 556 points.

The gains were partly surprising given news on Thursday that gross domestic product decreased for the second consecutive quarter — by some measures the definition of a recession. The 0.9% drop during the second quarter follows the 1.6% decrease from the first quarter in this year.

Whether the U.S. is currently in a recession is being hotly debated on both Capitol Hill and among economists, with some saying consumer spending has been too strong, and the labor market too tight, for the drop in GDP to constitute a recession.

According to Josh Bivens, director of research at the Economic Policy Institute, two straight quarters of negative GDP growth is a rough rule of thumb. “We’re very likely not in a recession currently,” Bivens said, noting that more accurate measures of an economy — unemployment and employment growth — are still “quite strong.”

The other major economic news this week also did not affect equities, as the Federal Reserve on Wednesday raised interest rates for the fourth time this year in a bid to smother inflation. The 0.75% increase brought the federal funds interest rate to 2.25% to 2.5%, its highest since 2018, though it is likely the rate will hit 3% by the year’s end after the Fed increases rates during its next three meetings.

Wednesday’s rate hike was unanimous by members of the Federal Open Markets Committee, signaling a unified approach to curbing inflation as quickly as possible, particularly since the FOMC noted in its statement that “recent indications of spending and production have softened.”

The central bank likely will wait until inflation has begun to noticeably drop before backing off rate hikes, though it is unclear whether the next FOMC meeting in September will mark another 75-basis point increase, a steeper 1% increase, or something more dovish given the recent drop in GDP.

“The speed limit has been set at 75 basis points,” said Charlie Ripley, senior investment strategist at Allianz Investment Management, after the rate hike was announced. “The Fed has already reached the peak policy rate from the previous cycle in a relatively short period and the timing between now and the next meeting will allow the Fed to become more data dependent from here on rather than letting the market guide their decision from a rate-hike perspective.”

Part of the reason the Fed’s aggressive stance on interest rate hikes hasn’t dented markets could be that investors want the central bank to get inflation in check. So far, thiugh, the rate hikes haven’t had that impact.

On Friday, the U.S. Bureau of Economic Analysis reported that inflation — measured here in personal consumption expenditures — increased by 1% last month. Personal income inched higher than experts predicted it would, gaining 0.6% in June compared with the consensus forecast 0.5%. After inflation and taxes, however, personal income actually cropped by 0.3%.

The PCE data are closely watched by the Fed and may portend continued aggressive rate hikes to come, but some analysts say the June inflation data shouldn’t count for much anymore.

“This inflation metric is for June, and we know much has changed since then, especially gas prices, so investors should put this inflation report into historical context,” said Jeffrey Roach, chief economist at LPL Financial. “Looking ahead, July inflation rates will ease a bit from the previous month as food and energy costs should wane in July.”

A slew of corporate earnings this week from Big Tech should have diminished markets somewhat, but the misses did not translate to a drop in equities. Alphabet, the parent company of Google, announced in its earnings report that its revenue during the second quarter of 2022 rose to $69 billion from $61 billion a year ago. Its net income dropped, however, from $18 billion during the second quarter of 2021 to $16 billion during the second quarter of this year.

Another company that slightly missed analyst expectations was Microsoft, which posted a 12% year-over-year increase in revenue despite only a 2% increase in net income during that same period. The computing company said it predicts double-digit revenue in 2023 based on the strength of the company’s cloud revenue, which grew by 28% last quarter.

Other companies able to weather the recent economic downturn included Boeing and Apple, the latter of which saw a 2% increase in quarterly revenue compared with its third quarter of 2021. “We set a June quarter revenue record, and our installed base of active devices reached an all-time high in every geographic segment and product category,” CFO Luca Maestri said in the earnings report.

Consumer sentiment also has improved slightly but remains historically low. The final July reading from the University of Michigan’s consumer sentiment index gained 1.5 points but still hovers around 50 points, the weakest it has been since 1980.  

“Robust consumer spending had been supported by strong labor markets and the expectation of growing incomes, but with persistently high prices eroding those incomes, consumers are adjusting their spending habits to cope,” survey Chief Economist Joanne Hsu said in a statement. “With emerging concerns that rising unemployment could be on the horizon, this pullback in consumer spending is likely to be amplified if their concerns over the future path of the labor market continue to grow.”

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