Hedgie's Market Edge - August 11, 2025

🦔 Welcome back! Markets rebounded strongly this week with the S&P 500 up 2.4% to 6,389 and NASDAQ surging 3.9% to 21,450 as corporate earnings season delivered solid beats. But while headlines celebrate the earnings strength, I'm tracking some concerning undercurrents that suggest this rally might be masking deeper structural problems.

Here's what everyone's missing. Corporate earnings are masking economic stress signals, private credit defaults just hit record highs, and we're seeing the classic late-cycle pattern where financial engineering keeps markets moving higher even as fundamental risks build in the shadows.

The Earnings Story Everyone's Celebrating

With 90% of S&P 500 companies reporting, 82% beat analyst estimates with an average upside surprise of 8.5%. This drove earnings growth forecasts sharply higher to 9.7% from just 3.8% at quarter-end. Technology and communications sectors led with over 20% year-over-year growth, while even consumer names like Disney and McDonald's beat expectations.

But here's the context. This earnings strength is happening while private sector job growth sits at just 1.1% annually, services sector readings diverge sharply, and companies continue passing tariff costs to customers. Strong earnings during economic deceleration usually means margin expansion through cost-cutting rather than organic growth.

THREE FORCES RESHAPING MARKETS

1. Private Credit Cracks Are Showing

While everyone celebrated equity earnings, I've been tracking alarming developments in the $1 trillion private credit market. Fitch data shows defaults jumped to 5.5% in Q2 from 4.5% in Q1, with the smallest companies hitting a record 9.5% default rate.

Here's why this matters. Private credit has grown from $46 billion in 2000 to $1 trillion today, and it's interconnected with the banking system through credit lines and funding arrangements. When defaults spike in floating-rate loans during a high-rate environment, it creates stress that can ripple through the entire financial system.

The warning signs are clear. Eight new defaults in Q2 (double Q1's four), new issuance down 16% as "tariff volatility and deteriorating economic outlook" dampen lending, and maturity extensions becoming common as companies struggle with higher borrowing costs.

2. Services Sector Sends Mixed Signals

The services sector (71% of GDP) remains in expansion but with concerning divergence. S&P Services PMI hit a yearly high of 55.7, driven by tech demand and financial services activity. But ISM Services PMI fell to 50.1, missing estimates as business activity slowed and trade disruptions weighed on imports/exports.

The key insight here. Companies are successfully passing tariff-related cost increases to customers, with output prices rising across services despite tariffs not directly applying. This suggests inflationary pressure is building even as economic activity shows stress.

3. Labor Productivity Provides Inflation Buffer

Second-quarter productivity rose 2.4% annualized, helping offset 4.2% year-over-year wage gains to keep unit labor costs contained at 1.6%. This is genuinely good news because modest unit labor cost growth could help counteract tariff impacts on inflation.

With wages growing above the 2.7% inflation rate, consumers are receiving positive real wage gains that should support spending. But the productivity gains need to continue as tariff costs work through the system.

TARIFF REALITY BITES

Higher tariff rates took effect this week as the August 7 pause expired. Most trading partners now face rates in the 10-20% range, up from the 10% baseline. The 100% semiconductor tariffs announced include generous exemptions for companies with US production, significantly reducing effective rates.

But here's the thing about that gold tariff chaos I covered earlier. When a Swiss refiner can't get a straight answer from customs officials about basic trade rules, it shows how policy confusion creates real economic costs beyond the tariffs themselves.

BOND MARKETS SIGNAL FED PIVOT

Treasury yields rose to 4.28% despite weaker auction demand as bond markets price in Fed rate cuts resuming in September. The recent softer jobs data gives the Fed room to move to a less restrictive stance, with the fed funds rate near 4.3% and inflation at 2.6%.

The constraint here. Rising deficit concerns could limit how much yields can fall even with Fed cuts, keeping financing costs elevated and creating headwinds for highly leveraged borrowers (like those private credit companies I mentioned).

SECTOR POSITIONING FOR WHAT'S AHEAD

Positioned for Outperformance

• Financials benefit from higher-for-longer rates and potential private credit stress creating opportunities

• Healthcare offers defensive characteristics with reasonable valuations

• Large-Cap Quality provides balance sheet strength that matters more as credit conditions tighten

Potential Headwinds

• Small-Cap Cyclicals face the most exposure to private credit funding and economic slowdown

• Consumer Discretionary shows strong earnings but faces margin pressure from tariffs

• Highly Leveraged Sectors discover that floating-rate debt becomes expensive quickly

MY TAKE: THE EARNINGS VS. REALITY DISCONNECT

We're seeing a classic late-cycle pattern where corporate earnings mask underlying stress. Strong productivity gains and successful cost pass-through create near-term profit strength, but the foundation is shakier than it appears.

The Real Concerns

Private Credit Systemic Risk creates vulnerabilities through a $1 trillion market with record defaults, floating-rate structures, and bank interconnections during a high-rate environment that most investors don't understand.

Policy Through Confusion happens when customs agencies give conflicting interpretations of trade rules, creating economic costs beyond the tariffs themselves through business uncertainty and supply chain disruption.

Margin Sustainability depends on companies passing costs to consumers now, but consumer spending resilience requires continued real wage gains. If productivity growth slows or tariff costs accelerate, margins get squeezed from both ends.

Credit Conditions Tightening emerges from rising private credit defaults combined with deficit concerns limiting Fed flexibility, creating a tightening credit environment just as highly leveraged companies need refinancing.

THE WEEK AHEAD

This week brings crucial inflation data, retail sales, and consumer sentiment that will test whether the consumer resilience story holds against rising costs. I'll be watching private credit spreads, small business confidence, and any signs that the services sector divergence is resolving in either direction.

Key Data Points

• CPI and Core CPI (Tuesday)

• Retail Sales (Wednesday)

• Consumer Sentiment (Friday)

• Corporate earnings from Home Depot, Walmart, Target

Weekly Market Stats

The key insight here. Strong earnings during economic deceleration usually signals late-cycle conditions where financial engineering and cost management drive profits rather than organic growth. Pay attention to credit conditions, margin sustainability, and policy clarity because those will determine whether this earnings strength can continue.

Until next week,

🦔 Hedgie

^{DISCLAIMER For educational purposes only. I'm a hedgehog who types with tiny paws, not a licensed financial advisor. Taking investment advice from woodland creatures, no matter how financially literate, is generally not recommended by the SEC or any self-respecting burrow inspector.}