August 5th, 2024
Hold on tight. If you want to enjoy the ups, you must be able to endure the downs.
We’ve enjoyed a rather glorious run over the last 18-months. Structurally, not much has changed. However, the market’s fear – domestic and abroad – is that we’re beginning to see cracks in the Federal Reserve’s (the Fed) bullet proof U.S. economy and, perhaps, the Fed will not deliver us the ‘soft landing’ we’ve all been promised as it has waited too long to cut interest rates.
Let’s review
Sticky inflation has resulted in the Fed keeping interest rates higher, for longer. This has put pressure on us all, but it’s one of the only ways the Fed possesses to combat systemic inflation. Their goal, as awful as it may be, has been to slow the jobs market – raising the unemployment rate and slowing demand for goods and services, thus, manufacturing headwinds for corporate profits and ultimately: easing inflation. Once desired inflation and economic fundamentals are achieved, they then begin a rate cutting cycle which would slowly reduce the cost of capital and gradually eliminate the ceiling currently stifling the U.S. and global economy. It’s a delicate balance to achieve without sending us all into a recession, or re-inspiring out of control inflation…
A delicate balance indeed.
Where we are now
Last week’s jobs report showed that U.S. employers slowed their hiring last month by much more than economists expected. About 37% slower. That was just the latest piece of data on the U.S. economy to come in weaker than expected over the last few weeks, which has raised fear that the Fed has pressed the brakes on rate cuts by too much, for too long.
The market sell-off is a global phenomenon, with fingers being pointed at Japan as its market has led the charge, plunging -12.4% during Monday’s trading for its worst day since 1987. As I write this, U.S. markets have seen the day down as much as -4.25% (S&P 500), but have since bounced back slightly, currently down -2.5% on the day.
What needs to happen
Rate cuts. Rate cuts. Rate cuts.
I am of the mind that this moment, in some bizarre theatrical way, is the larger economic players (hedge funds, market makers, etc.) flexing their muscle and playing chicken with the Federal Reserve. Stating loud and clear that cuts must come now.
According to CME’s FedWatch tool, a week ago there was an 88% probability we would receive a 25 basis point interest rate cut (.25%) and an 11% chance we’d receive a 50 basis point cut in September. Those probabilities have inverted, we now see a 23% chance of a 25 basis point cut and a 76% chance of a 50 basis point cut in September. Some folks are even speculating that we may see Fed Chair, Jerome Powell, announce a rate cut this month – time will tell.
Soft landing
Just a week or so ago I found myself reading articles, listening to podcasts, and hearing from peers who all believed that we had achieved the Fed’s ‘soft landing’. All that was left to do was gradually cut interest rates.
Today, that feeling seems to be slipping through our fingers. However, as I said at the beginning of this newsletter: structurally, not much has changed. The economy is robust, inflation has essentially achieved the Fed’s 2% target, corporate profits are still very strong, and unemployment is still near all-time lows. We’ve merely seen an acceleration in economic tightening, and it seems now is the time to cut rates. Not later, but now. We’ve enjoyed a pleasant 18-months of a well performing low volatility market environment. And we’ve all been waiting for a correction/contraction of some sort to balance the scales. If anything, my intuition is that now is a good time to buy. If you haven’t already begun, start reorienting your holdings toward a rate cutting cycle market environment – which is what we’ve been doing for our clients the last few months.
And now, your Monthly Market & Economic Update by the numbers.
Warmly,
Mark S Sauer
Market Update
Global Equities: Stocks continued their surged in July with small-caps out-performing all others with a monthly gain of +9.99%. The Nasdaq was on the other side of court with large out-flows as investors sought out aspects of the market with better value – Nasdaq fell -1.81%. These number seem rather irrelevant, as today we’ve seen massive sell-off’s across the board.
Economic Update
Jobs Report Miss: The July Jobs report showed a gain of just 114,000 in nonfarm payrolls, a big miss compared to the expected 180,000. The June data was also negatively revised from 206,000 to 179,000. The unemployment rate shot up to 4.3% while average hourly earnings cooled to a 0.2% monthly increase. The weak jobs data caused a market to selloff as investors fear that the Fed has waited too long on rate cuts and the odds that the Fed will force the economy into an unnecessary recession increased.
Charts of the Month
Large Vs Small-Cap
Our first chart is a daily look at year-to-date comparison of US Small Cap stocks (IWM, orange line) and Large Cap (SPY, blue line). After a stagnant first half of 2024, Small Caps surged in July to nearly catch the S&P 500 in a remarkable run up. Yet following poor manufacturing and jobs data, Small Caps have given back their gains. Investors are concerned that by foregoing rate cuts for too long, the Fed has caused structural damage to the economy and triggered an unneeded recession. Whether those fears are valid remains to be seen, but for now, investors have chosen to abandon the Small Cap rotation and flee to the safety of bonds.
Interest on Government Debt
Perhaps a factor that will finally force the Fed’s hand on interest rate cuts will be government debt, an issue that is sure to dominate headlines in the coming months as we approach the Presidential election. The Fed’s rate hikes have increased the cost of interest on federal government debt to a projected $892 billion for 2024. Interest on the federal debt burden this year will likely exceed total defense spending. Clearly, something needs to be done beyond the semi-annual debt ceiling theatrics. The longer the Fed keeps rates elevated, the louder the calls from Congress will grow to lower rates and reduce federal borrowing costs.
Fixed Income Year-to-date
For fixed income investors, the Fed’s delayed rate-cut timeline has turned 2024 into a waiting game. Active fixed income investors have attempted to get the jump on rate cuts by buying into the long-end of the yield curve, which has helped long-term Treasuries partially recover from the -10% decline that bottomed out in late April (using the iShares 20-Year+ Bond ETF, ticker TLT ). Barring a backslide in inflation data, rates have likely peaked for the cycle at prior highs of 5% for the 10-Year Treasury, so eventually long-duration bonds should have a moment of large outperformance. The challenge is timing that moment or having the patience to endure drawdowns like the initial 2024 pullback.
There is a less-than-zero probability, at this time, on the table that the Fed does not cut rates at all in 2024. This potential outcome has kept a lid on the upside for long-term bond investors. Meanwhile, the short end of the yield curve continues to offer the most attractive rates. Pairing risk-free yields of around 5.35% from short-term Treasury bills with corporate high yield bonds has been a winning strategy thus far in 2024. Both these asset classes are handily outperforming the Aggregate Bond Index and Long-Term Treasuries.
This Chart shows Year-to-date Returns of Aggregate Bond index (AGG, blue line), High Yield bond index (HYG, orange line), Long-Term Treasuries (TLT, teal line), Short-Term Treasuries (SGOV, yellow line).
Barrels of Oil Produced Per day – US, Russia, Saudi Arabia
There has been a fascinating battle between OPEC and the US over oil prices, as the former has aggressively cut production while the latter has more than made up for the output deficit. In 2023, the US produced more oil than any nation in history, averaging 12.9 million barrels per day. So far in 2024, US drillers have averaged 13.2 million barrels per day, a staggering total under a Democratic regime characterized as anti-oil. The competing forces of OPEC cuts and US drilling have kept oil prices relatively rangebound in the $70-80 a barrel range for US West Texas Intermediate. US oil independence has helped negate the usual/historical volatility from geopolitical events, and oil prices have been remarkably stable considering that there are two wars ongoing in major oil-producing regions. With global growth looking solid in the coming year, oil demand should remain robust.
