GDP report jolts Fed soft-landing hopes

The Federal Reserve's effort to bring the economy to a 'soft landing' that tames inflation while avoiding recession received a massive boost Thursday from data that continues to defy forecasts and could stabilize the current market slump.

The economy grew at a 2.8% clip over the three months ending in June, the Commerce Department reported, a tally that was both firmly ahead of economists' forecast and well above the 1.4% pace recorded over the first three months of the year.

Consumer spending largely powered the stronger-than-expected advance, rising 2.3% in the quarter, while business investment rose to the highest levels in a year, and government spending surged by 3.6%.

The stronger-than-expected tally also extends one of the longest runs of quarterly expansion on record for the U.S. economy, which has grown at an averaged annualized rate of 4.5% since the post-pandemic rebound began in the spring of 2020.

Inflation pressures were modestly firmer than forecasts, with the core PCE index for the quarter up 2.9%. However, that is still a big decline from the 3.7% pace measured over the first quarter, and it dovetails with the Fed's recent messaging that prices are starting to decline towards its preferred 2% target.

'Soft landing' in focus

Still, weekly jobless claims data still surprised the upside, as 10,000 fewer Americans filed for unemployment benefits during the week ending July 20. The broader economy looks well on its way to the kind of soft landing Fed officials have been orchestrating for more than a year.

"While this print will be subject to revisions, it was a reassuring sigh of relief to see a better-than-expected result and perhaps increases the odds that the Fed can achieve a soft landing after all," said Brent Kenwell, U.S. investment analyst at eToro.

"As long as the labor market doesn’t experience too much stress, the US economy can continue to defy its critics and chug higher," he added.

Related: Former Fed official changes tune on what's next for interest rates

Stocks pared their premarket declines on the back of the data release, with the S&P 500 little-changed from last night's close, which was the lowest since early June following the biggest single-day slump in nearly two years.

Meanwhile, The Nasdaq, hammered by big declines for megacap tech names, was last seen 0.37% lower in the session.

Benchmark 10-year Treasury note yields were holding around 4.225%, with 2-year notes trading at 4.401%, following the Commerce Department's GDP data and the Labor Department's weekly claims update.

Rate traders continue to bet that the Fed will begin the first of at least two rate cuts this year in the autumn, with bets on a quarter-point reduction in September pegged at 85.5%.

No 'July surprise' interest rate cut

The odds of a 'July surprise,' however, have fallen to around 7% even after a series of commentators, including former New York Fed President William Dudley, warned that waiting until September could trigger recession risks.

"Certainly no signs of imminent recession from this morning’s data," said Chris Larkin, managing director for trading and investing at E*Trade from Morgan Stanley. "For now, the markets are still looking at a first rate cut in September.

"The US economy is much stronger than people realize and to the extent that markets were worried about a growth slowdown, they should breathe a sigh of relief after this morning’s GDP number," said Chris Zaccarelli, chief investment officer at the Independent Advisor Alliance in Charlotte.

Related: Stocks face summer slump as tech rally fades, political risks rise

"More volatility is to be expected – especially as we get closer to the election – and as long as the economy avoids a recession, then this bull market will continue through 2024 and well into 2025, so we would take advantage of any pullbacks along the way," he added.

Yung-Yu Ma, chief investment officer at BMO Wealth Management, sees the Fed's rate-cutting cycle and the resilience of the domestic economy supporting the ongoing rotation into small-cap stocks.

Small stocks, big gains

The Russel 2000, up 7.2% for the month against a 0.61% decline for the S&P 500 and a 2.2% slump for the Nasdaq, should be the principal beneficiary.

"The catch-up trade in smaller stocks should still have room to run," he said, noting that the combination of "political and economic uncertainty, coupled with specific concerns about the durability of AI-related spending," continues to cloud mega-cap tech stocks.

"Earnings growth among smaller companies is set to improve by year end, and the Fed will soon begin a year-long rate-cutting campaign which will disproportionately benefit smaller companies," he added.

Related: CPI inflation report fuels Fed interest rate cut bets

Markets now face another series of near-term tests, with PCE inflation data for the month of June slated for release on Friday, July 26, and the Labor Department's non-farm payroll report due the following week.

Apple ( AAPL ) , Amazon ( AMZN ) , Meta Platforms ( META ) and Microsoft MSFT will all publish June quarter earnings next week, as well. Investors looking for the larger Magnificent 7 peers to offset disappointing updates from Alphabet ( GOOGL ) and Tesla ( TSLA ) .

"The health of earnings season should prevent the market from falling into a full-blown 10% correction," said BMO's Yung-Yu Ma. "But the market is looking for something more –especially from AI-related plays. A lot is already priced-in to the megacap technology stocks, and it may take a bit of time or strengthening of trends to grow into current valuations."

Related: Veteran fund manager sees world of pain coming for stocks