Why tariff-driven inflation and a weakening labor market haven't been bad for U.S. stocks

U.S. equities are maintaining near-record highs despite a surprising 0.9% jump in July producer prices, partly tariff-driven, and signs of a weakening labor market, a counter-intuitive resilience amidst conditions often associated with stagflation. This market strength stems from robust corporate earnings, with 81% of S&P 500 companies beating Q2 EPS estimates by an aggregate 8.4%, and a significant decline in 'recession' mentions on earnings calls. This indicates that growth stocks are seen as capable of sustaining profitability even with slowing economic growth, absent an imminent recession, suggesting Wall Street's optimism is distinct from some Main Street indicators.

Analysis

U.S. equity markets are exhibiting notable resilience, with the S&P 500 and Nasdaq Composite trading near record highs despite the emergence of stagflationary economic signals. A sharper-than-expected 0.9% jump in the July producer-price index, the largest in three years and partially driven by tariffs, has coincided with a weakening labor market, evidenced by a modest 73,000 job gain in July. This counter-intuitive market strength is primarily underpinned by robust second-quarter corporate earnings. According to FactSet data, 81% of S&P 500 companies have surpassed EPS estimates, beating them by an aggregate of 8.4%, which is above the five-year average. Furthermore, corporate sentiment appears to be improving, with an 87% quarter-over-quarter decline in companies citing "recession" on earnings calls. The prevailing market thesis, as articulated by J.P. Morgan, is that equities, particularly growth stocks, can perform well in a slowing-but-positive growth environment, and that a material downturn is unlikely until the economy tips into an actual recession. This view is supported by market expectations for a continued dovish Federal Reserve, with fed-funds futures still pricing in a September rate cut, effectively discounting the recent inflationary pressure from the PPI report.

Key Decisions for Investors

• Investors should prioritize exposure to high-quality growth stocks with demonstrated earnings power, as these companies are perceived as being most resilient to a slowing macroeconomic environment.
• Monitor leading economic indicators closely, particularly forward-looking GDP and employment data, as any sign of growth turning negative would invalidate the market's current thesis and likely trigger a broad-based correction.
• Pay attention to upcoming CPI reports and Federal Reserve commentary, as a sustained rise in inflation could challenge the market's expectation for further rate cuts, removing a key pillar of support for current equity valuations.
• Given that indices are near all-time highs amidst conflicting economic signals, it may be prudent to exercise caution and ensure portfolios are not overly concentrated in cyclically-sensitive sectors that would be most vulnerable to a recession.