Where’s The Fire?
Earlier this month, the U.S. equity markets were in a frenzy to the downside due to slightly weaker than expected earnings reports from some of the major tech leadership names, a weaker than expected jobs report for July, and a Japan currency trade unwind. But since Aug 5th equities have stabilized and rallied back strongly. We’ll take a look to see why and what it means going forward.
It’s important to note that the mega-cap tech companies’ quarterly earnings reports were decent-to-good, not great. However, when you have a market whose leadership names have high valuations and high expectations, it can lead to a strong market reaction to the downside, if those numbers don’t impress. And then we had the July jobs report show that unemployment reached its highest level (4.3%) since October 2021 and the Japanese yen carry trade disruption in early August. All of this led to a very sharp spike in volatility, as the VIX (CBOE Volatility Index) had its biggest jump since Feb-Mar 2020. This in turn led some market commentators to breathlessly call for an emergency Fed rate cut of at least 50 basis points as the S&P 500 dropped 6.1% in the first five days of August and 8.5% from its all-time high on July 16th. In other words, the news is warning us that the Fed needs to preemptively cut a lot or we risk a recession. Since then, cooler heads have prevailed.
What’s largely led to the stabilization in volatility and the equity markets has been the collective realization that inflation is moving in the right direction and the economy continues to be stable and resilient. The Atlanta Fed GDP forecast for the third quarter is now at 2.0% at an annual rate and Bloomberg’s consensus is at 1.5%. This is after GDP growth of 1.4% and 2.8% in Q1 and Q2, respectively, on a year-over-year basis. Consensus U.S. GDP for all of 2024 is at 2.3%. Unemployment is at a still low level of 4.3%. The CPI report for July showed inflation at 2.9%, while the Fed’s preferred inflation measure, the Core PCE, was at 2.6%. Both have been moving lower, but inflation remains elevated for many Americans. So, emergency rate cuts? Perhaps not.
Indeed, the ports of Los Angeles and Long Beach (together they bring in about one-third of all U.S. imports) just had their third highest volume months ever in July. This volume is somewhat seasonal due to normal pre-holiday purchase ordering, to potential new U.S. tariffs on Chinese goods, and a potential strike by American dockworkers. Nonetheless, it was a very strong month of imports and doesn’t appear to be reflective of a slowing demand environment.
As well, the most recent retail sales report (July) had its biggest increase in over a year. We’ve clearly seen consumers become more discerning in their spending over the past many months, but despite higher prices and higher interest rates, they continue to show the capacity to spend.
The market selloff of -8.5% in late July and early August (July 17 – Aug 5) was very sharp and swift and led many to question the Fed’s current interest rate policy and the timing of potential rate cuts. But since August 5th equity markets have stabilized and almost returned to their July 16th highs. This is largely based on the data above, showing that the overall economy continues to grow and inflation is moving lower. The Fed appears to be approaching its goal to cool inflation without triggering substantially higher unemployment, as Fed Chair Powell indicated in his speech on Friday at the Jackson Hole event.
It’s also worth further noting that even as the S&P 500 dropped 8.5%, the S&P 500 Equal Weight Index and the S&P 500 ex-Mag 7 were down 5.1% and 5.7%, respectively, and the Mag-7 was down 14.7%. The latter reflects the mega-cap companies’ high expectations going into this earnings season, rather than any sign of economic weakness. More importantly, all those measures of equities have largely recovered in the weeks since August 5th. Relative to that July 16th peak, the S&P 500 through August 23rd is down only 0.44%, the S&P 500 Equal Weight is up 1.51%, the S&P 500 ex-Mag 7 is up 1.43%, and the Mag-7 is down 4.84%. So, we’re essentially back to the all-time highs for equities, but now equities are rising more broadly across sectors and industries, and investors are recognizing that valuations matter.
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