Are the markets pricing in recession or simply a recalibration?
When investors turned their calendars to August, they may have flipped the narrative on the economy at the same time.
It’s been less than two weeks since the second quarter GDP report surprised to the upside, with equity markets hovering near record levels, yet there is growing sentiment is that the Fed has waited too long to cut interest rates and is now behind the curve.
While we’re not completely sold on the new narrative, the one thing that seems certain is that there is more volatility ahead.
Executive Summary
- Federal Reserve: Fed Funds Futures may have overshot once again.
- July Employment Report: Does a miss of 60K jobs really point to recession?
- Market Interest Rates: Treasury yields moving lower, forcing the Fed’s hand.
- Equity Markets: Having broken below the 50-DMA, the S&P 500®’s next support appears in the 5,250 range, representing the late-June low.
Fundamentally, we continue to look for below consensus Index profits of $237.50 this year, with a yearend fair value estimate of 5,250 for the S&P 500®.
Federal Reserve
Monetary policymakers kept interest rates steady at the conclusion of the FOMC meeting last Wednesday, though expectations changed very quickly.
While the FOMC policy decision itself was largely expected, leaving the federal funds rate at 5.25% to 5.50%, most investors were looking for signals of a rate cut at the next meeting. Fed Chairman Jerome Powell delivered, as he was slightly more dovish in his post-meeting press conference, emphasizing a greater focus on the full-employment part of the Fed’s dual mandate.
Since there had been a few small cracks evident in the employment picture in recent months, the Fed’s renewed focus on that part of their mandate was well received by investors…that is, until Friday.
The weaker than expected jobs report caused the fed funds futures market to surge, with expectations for a 50-basis point cut in September, with an additional 50-basis point reduction before year-end. See Chart: Fed Funds Futures Market Implied Rate Cuts this Year.
As the chart shows, fed funds futures are notoriously volatile and should not be viewed as definitive policy moves. To be sure, it was a little more than six months ago when traders expected up to 6-7 rate cuts, and just a few weeks ago when they priced in fewer than two cuts.
As Milton Friedman noted, monetary policy acts with long and variable lags. While we believe further data accumulation is necessary than just the recent employment report, the Fed must nonetheless begin tweaking policy lower to avert further economic and market discontent.
July Employment Report
The weaker than expected non-farm payrolls report on Friday suddenly shifted the market narrative on the U.S. economy. Confidence in a soft landing was quickly replaced by fears of recession…in just two days.
After a disappointing ISM Manufacturing report on Thursday, the July employment report revealed a few interpretation challenges for investors. See chart: Non-Farm Payrolls – Monthly Change.
For example, the economy created just 114,000 jobs last month, well below the consensus forecast for a gain of 175,000 new jobs. Though troubling at the headline level, the data may have been distorted by the effects of Hurricane Beryl, which made landfall in Texas at the beginning of the reporting period in early July.
It should also be noted that wages, which represent approximately 70.0% of business costs, moderated last month. Average hourly earnings rose just 3.6% YOY in July, the lowest reading since May 2021.
Additionally, the unemployment rate jumped to 4.3% in July, and on the surface appeared troubling, as the Sahm Rule suggests incremental jumps of 50 basis points in this measure can lead to recession. However, the climb can be attributed to more people entering the labor force, rather than an increase in the number of layoffs. Indeed, the labor force participation rate climbed to 62.7% in July, and had it held steady, the unemployment rate would have remained unchanged (4.1%) from the prior month.
Market Interest Rates
Since the Federal Reserve began its rate pause last summer, U.S. Treasury yields have traded in a volatile range, peaking last October before hitting new lows in recent weeks. The yield on the 10-year Treasury note fell 20 basis points on Friday alone and plunged ~50 basis points since July 24th, when the GDP report revealed stronger-than-expected growth in the second quarter. See chart: U.S. Treasury Note Yields.
Of course, the important question is, “what was the market’s message?” Was it predicting recession, or simply attempting to force the Fed’s hand to lower rates? We view the move of the 2-year yield, which now stands ~125-150 basis points lower than the fed funds rate, as a definitive market message that the Fed must reduce rates soon.
However, we’re not convinced recession is upon us, nor do we think an extended rate cutting cycle is looming…despite the current market panic. Instead, we think the Fed must take rates lower to align nominal GDP (real GDP plus inflation) with the overnight lending rate to improve balance in the economy.
Consequently, a move lower of this magnitude could resemble the non-recessionary rate cutting cycle of the mid-1990s, rather than the more aggressive cycles in 2000 and 2008.
In addition, despite the volatility in the U.S. Treasury market, corporate credit has remained very stable. Last Friday’s volatility notwithstanding, spread sectors typically act as signal, and we view last Friday’s moves wider as more of a reaction than signal.
Finaly, our expectations for a tweak lower in rates is also supported by our longer-term inflationary concerns. To be sure, the combination of unemployment rate below 5.0% can still be considered “full employment,” and the Fed’s balance sheet remains bloated at >$7.0 trillion, and a federal budget deficit approaching 7.0% of GDP can all be considered inflationary, limiting the Fed’s flexibility in balancing its dual mandate.
Equity Markets
After the AI-driven, large cap, growth and technology gains in the first half of the year, this summer has witnessed a transition in market leadership to beneficiaries of lower rates including small caps, value and equal-weighted index outperformance.
To be sure, valuation concerns were magnified by a thus far mixed earnings season, as massive AI spending by large cap technology companies caused investors to question the potential payoff. Investor sentiment was also frayed given the uncertain domestic political situation, as well as increasingly troubling geopolitical developments.
Therefore, we believe Friday’s jobs report and ensuing market sell-off was a perfect storm of volatility for the start of the seasonally weak, dog days of summer. Investors seemingly took the weak employment report as an indication of a material deterioration in the labor market, sparking a sharp selloff of risk assets while Treasury yields plummeted. We’re not convinced that a “miss” of 60,000 jobs portends imminent disaster for the U.S. economy.
The market’s fear gauge, the CBOE Volatility Index (VIX) surged above 20, which historically points to further volatility ahead.
Indeed, the S&P 500® Index dropped by more than 3.0% over the course of trading on Thursday and Friday last week, with futures indicating a decline of a similar magnitude early Monday morning. See chart: S&P 500® Index.
Of course, there is wisdom in price, and the market’s going to do what the market wants to do.
In what we expect to be a near-term volatile period, here a few thoughts:
- The S&P 500® closed below its 50-day moving average (DMA) of 5,450 on Friday, bringing the next technical support level of 5,250 (the late-June low) into play.
- Should that not hold, the Index’s 200-DMA of ~5,000 is the next level of support, which essentially coincides with the mid-April low. A move of this magnitude would represent a “correction” typically defined as a move of 10.0% lower from a recent market high, in this case, 5,639 in mid-July.
- Despite the volatility, more than 56.0% of companies in the S&P 500® are trading above their 50-DMA and ~70.0% > than their 200-DMA, suggesting breadth hasn’t collapsed.
- The equal-weighted S&P 500® remains above its 50-DMA and continues to hold firm against the cap-weighted Index, suggesting rotation and broader participation trends may support equities going forward.
- Fundamentally, we continue to look for below consensus Index profits of $237.50 this year, with a yearend fair value estimate of 5,250 for the S&P 500®.
We will continue to monitor all developments in the coming days and weeks.
Be well and stay safe!
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