Retail sales jumped in July, rising 0.7% from the previous month. Economists has been expecting a rise of 0.4%. BlackRock Head of iShares Investment Strategy Gargi Chaudhuri tells Yahoo Finance Live that there are three key takeaways from this data. First, Chaudhuri points out that "we're seeing strength across categories" in the retail sales data. Second is that "despite the 525 basis points of rate rises that we have seen over the last year and a half, I think it is fair to say that the consumer remains on very strong footing," Chaudhuri said. Given that, Chaudhri says, "perhaps we have to re-think how strong this economy is and is going to be for the remainder of this year and perhaps, to a certain extent, for the first half of next year as well."

Video Transcript

- Let's broaden it out, shall we? Because interest rates have risen steadily over the last 18 months. What does this mean for your portfolio? Our next guest says quality is king, and urges investors to look to the corners of the market still catching up to the market rally.

Joining us now is Gargi Chaudhuri, BlackRock Head of iShares Investment Strategy. Gargi, I do want to start on the retail sales number, because that really was a bit of an eye popping moment this morning coming in so much stronger than estimated. What does that tell you? I mean, that feels like more than consumer resilience when you see a number like that.

GARGI CHAUDHURI: Good morning, Julie. It's so great to be here. And absolutely as I was sort of getting ready to appear on your show, I was looking through the retail sales number. Absolutely eye popping is a good word.

A couple of things that it tells me. When I look at the breadth of where the strength came from, it's easy to chalk it down to just Amazon Prime, but it isn't. If you look at apparel, if you look at building materials, if you look at just the different categories, I think we're seeing bars, restaurants, we're seeing strength across categories. And I think that is meaningful.

The second thing that I think this is telling us is that despite the 525 basis points of rate rises that we have seen over the last year and a half, I think it's fair to say that the consumer remains on very strong footing. This is a consumption-based economy, 70% as we know.

And that I think has us considering, what are the risks of recession, if any? Perhaps we all have to rethink how strong this economy is and is going to be for the remainder of this year, and perhaps to a certain extent for the first half of next year as well.

So I think this is one number by itself is not a lot. But I think this number, in addition to so many other stronger than expected data points that we have seen just shows us that the US economy is in a really strong place, and consumers are doing very well, despite the rate rises that we have seen.

- What does this report tell you about the dynamic right now that we've witnessed in terms of the shift in purchasing from goods to services, and how that has continued as a broader trend?

GARGI CHAUDHURI: Yeah. So I think a lot of the goods to services dynamic is just the post-pandemic world, right? We all remember what 2020 and 2021 was like with the goods consumption. And it is but normal to see some of that normalization, I guess, to happen in services. I think retail sales is much more of a goods-- much more of that is goods-based.

But even when we look at a few of the services categories, such as the spending in restaurants and bars, that remains robust. And I think the more that we move away from the goods spending into the services spending, the more that we see influence of that in the data, I think it points to a number of things. First of all, normalization of supply chains that's happening, that will keep happening.

Hopefully, that means pressure on goods inflation continues to dissipate. And I also think that at the end of the day, that services spending to the extent that, that continues will have massive ramifications for next quarter's GDP. And I think people will already start revising that higher based on what we saw this morning.

- Gargi, does-- I know it's just one number. But given the strength of this number, does this virtually guarantee that the Fed will raise rates at its September meeting?

GARGI CHAUDHURI: Great question. And I don't think-- it is one number, but I think there's just a trend of stronger than expected growth data. And so far, at least two months of weaker than expected inflation data.

But what does that mean for the Fed? I think that the Fed has been very clear that when they think about raising rates, it's not so much about the growth dynamics as it is about the inflation dynamics. That has been the question that they have been trying to answer for reporters.

And I think that less-- there'll be less of a focus on the strength of manufacturing or the strength of retail sales and more of a focus on how much further weakening or at least moderation perhaps we get on the inflation front.

So we've seen two months of point or a little less than 0.2, about 0.16 on the core CPI. If we see another month of that, I don't really think there's a need for the fed to necessarily raise rates. It's not growth that they're trying to tame.

In fact, they want growth to be stronger. They want to-- as we know, they did tell us that they now think that they're not as close to a recession. They're not forecasting a recession anymore. I don't think that their intent is to tamp down growth. Their intent is on the inflation front.

So if they have this environment where growth is still robust and inflation is coming down, which again, it's a little bit too early to say that. But we have seen two strong or two good months of weak inflation. If that continues to be the case, I don't think they need to raise rates any further. I think they can pause and see what happens in the fall, and then perhaps determine in November if that is another-- if that is time to raise or not.

- So Gargi, let's then circle it back around to rates, right? And rates here not what the Fed is doing, but what we're seeing in the market. We are seeing rates move higher this morning. We're seeing the 10-year Treasury go higher-- yield go higher. How problematic are yields at this level going to continue to be for stocks?

I mean, we've sort of started to see a little bit of that impact. And I know we're showing nominal yields right now. But what I think equity markets have historically cared more about is the trajectory of real rates. So adjusted for inflation. What are rates doing? And real rates have also moved significantly higher.

So there are two things. One is just the level, and the other is the rate of change. And right now, both have been a little problematic, which is obviously why we've seen equity markets come under a little bit of pressure. I think going forward, there's going to be two dynamics that are going to have an impact on equity markets.

Number one, are we going to see a continuation of the growth story? Are we all going to realize that not only have we soft landed, but a recession is far away from our investable horizons, or at least it's not upon us anytime soon. That will probably be beneficial for certain parts of the equity market. Those that are not so reliant upon negative real rates.

The second is going to be how quickly do rates keep rising? So we've seen this move over the last month and a half or so ever since we heard from Fitch and Bank of Japan and the Treasury supply. All of those were big drivers, I would say, of the steepening that we've seen.

If we continue to see the move that we've seen over the last call it month or so, I think that does begin to serve a little bit of a problem, so that we have to balance both. Is the good news on growth going to be driving equity markets or is it the bad news of real rates, and especially real rates in the longer end of the curve?

So balancing that, I would say equity investors should focus on areas of the market that are showing profitability. And we call this quality companies. Quality companies that have ability to have strong margins that have stable ROE, and really looking at those companies in a higher rate environment make a lot of sense.

- OK. So that started to answer my question of what are the defining parameters of those quality companies? So even as you think further to how companies can continue to display that, even as many of them have kind of moved through periods of either looking at their own guidance and trying to figure out a way that they could sandbag it in entirety, but ensuring that it wasn't so high as to make a marker that would be unattainable and risk missing then some of that guidance, which could seem far more detrimental.

GARGI CHAUDHURI: Yeah. I think that we have to recognize that there has been a slight shift in the markets, right? So where we were thinking about 2023 six weeks ago versus where we are today has changed. The growth has been meaningfully stronger. Earnings, to your point Brad, have been meaningfully agreed that the bar was low. But we have still beat.

And what we found is even though we've sort of sales numbers haven't beat as much as we had expected, there's still been overall earnings growth being stronger than what the market had expected. And to a certain extent, the companies that do have better margins have outperformed, have done better.

So when we look at our own quality ticker QUAL, we look at how that has performed through this earnings cycle. And we see that outperformance coming because of that margin resiliency. So going forward, I think that there can be periods of volatility in the market, especially going back to my point that I was making with Julie earlier, if we see this rapid rising in real rates continue, I think there can be periods of volatility.

Looking at minimum volatility strategies might make some sense. Another area that we are really telling investors to focus on is looking at these equal weighted baskets. So obviously, we know the technology has done very well.

But now what about focusing on those areas of the market that haven't done as well? So that catch up trade, looking at something like EUSA that gives you an equal weighted exposure to the markets. And I think that is something that could have a little bit of a catch up trade.

But let's be clear. I think a little bit of volatility, especially if interest rates and especially the long end of interest rates continue to move higher, a little bit of volatility in the markets is to be expected.

- Gargi, always a pleasure to get some time with you. Gargi Chaudhuri who is the BlackRock head of iShares Investment Strategy. Thanks so much for taking the time this morning.

GARGI CHAUDHURI: Absolutely.