August began with a pullback in the stock market, with the S&P 500 falling over 6% in the first three trading days and the “Magnificent Seven” stocks dropping nearly 10% in the first week. The selloff was fueled by concerns that the Federal Reserve had been too slow to cut interest rates. The labor market has softened considerably with July’s nonfarm payrolls significantly missing expectations and with June’s figures also revised downward. The unemployment rate in July ticked up to 4.3%, compared to the consensus of 4.1%, sparking discussions that the economy was headed for a hard landing.

Following the July labor report, expectations for a Fed rate cut soared, with the market pricing in a high probability of a 0.5% cut in September given hard landing concerns. The market reaction was further intensified by an unwinding of the yen carry trade, given the divergence between Fed and Bank of Japan policies, after the BoJ unexpectedly raised rates at a time when the US and most other central banks are lowering them.

As we discussed last month, we believe the rise in unemployment in July was likely due to a temporary increase in the labor force and weather-related layoffs. It was therefore unsurprising when the August jobs report, released last week, showed a decrease in the unemployment rate to 4.2%. Additionally, the job market showed signs of stabilizing, with the ratio of job openings to unemployed workers falling to a healthy 1.07, in-line with the pre-pandemic average since 2004.

Last month saw the Fed release the FOMC Minutes from the July meeting which shared insight into where the Fed is most focused. Members concluded that the risks to achieving the Committee’s employment and inflation goals were becoming more balanced, though the economic outlook remained uncertain. They noted that consumer spending had slowed from the strong pace of last year, reflecting restrictive monetary policy, easing labor market conditions, and slowing income growth. Some members also pointed out that lower-and-moderate-income households were facing increasing financial pressures, as seen in rising credit card delinquency rates and a growing number of households paying the minimum due on their balances.

The equity market rebounded and erased the early-month declines as soft landing odds rose over the course of the month and the Fed essentially confirmed it would cut in September as recession risks remain low. Powell said that the upside risks to inflation have diminished, downside risks have cooled, and the Fed was committed to doing everything it could to support a strong labor market.

Skipping Stones: What are the implications of a shift in Fed policy?

We don’t know for certain how the Fed’s actions will unfold, but in his speech at Jackson Hole, Federal Chair Powell made clear that “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” We expect the initial result of a lower Fed Funds rate will be modest: a proportionate decline in the yield of money markets, savings accounts, and new Treasury Bills.

Secondary effects will likely take time to manifest. Banks will lower CD rates, and investors seeking yield may shift funds from cash and short term Treasury Bills to bonds with longer maturities which in turn puts downward pressure on yields farther along the curve. Mortgage rates and other loans, which tend to track changes in 5-Year Treasuries, have been falling, albeit slowly. The average rate on the 30-year mortgage is now at 6.7% which is below last year’s peak of 8.1%. Eventually, lower rates could provide a tailwind to consumers who face higher interest costs.

Like a stone thrown into still water, the magnitude of the secondary effects – the splash and the ripples – will be dependent on the size of each rate move and how quickly each subsequent move follows. We believe that a single 0.25% pebble or even a handful of pebbles thrown before the end of the year (such as three 0.25% cuts), would likely cause much less of a disruption than a chunky 0.75% boulder.

Capital Markets

Both equity and fixed income markets rose in August, except for U.S. Small Caps. The All-Country World Index (ACWI) rose +2.57%, the S&P 500 rose +2.43%, while the EAFE rose +3.27%. Small Caps gave back part of July’s 10% surge, falling -1.5% in August. Emerging markets finished with a gain of +1.64%. U.S. Bond prices rose +1.4% for the month.

This document contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.

U.S. stocks started July on a high note bolstered by healthy second quarter earnings. While both equity and fixed income markets rose, sentiment had begun to shift with investors rotating out of growth and stocks as the month went on.

Several recurring themes whittled away at investors’ appetite for risk:

• Companies reported investing heavily in AI without a corresponding immediate increase in revenue or earnings which called into question the timeline between capex and monetization.
•  June retail sales data remained healthy, but corporations continued to note signs of deterioration in their earnings calls.
•  Investors continued to speculate about the presidential race, given early polling suggesting President Biden’s withdrawal and VP Harris’s entrance may have made the contest more challenging for Trump. Markets and corporate boards tend to prefer landslides (more certain outcomes) vs. close calls (less certain outcomes).
  The July Fed meeting ended as expected with no change to rates. Fed Chair Powell noted at the press conference which followed that if the Fed sees the softening economic data it hopes for, a cut could be on the table in September. He acknowledged that the case for rate cuts was strengthened by some weaker labor market and manufacturing data.

Labor Report Startles Investors but it’s Premature to Declare a Recession

The Bureau of Labor Statistics announced that nonfarm payrolls rose 114,00 in July vs. the consensus estimate of 175,000. That shortfall coupled with slight downward revisions to job growth numbers for May and June suggests the economy grew at a slower pace than expected. Of note, a shortfall in payroll growth is not the same as a contraction in payrolls, but nonetheless this spooked investors. In addition, the unemployment rate rose from 4.1% to a still low 4.3%, whereas expectations were for the rate to remain unchanged. While the three-month average of payroll gains was virtually unchanged at 170,000, this was overshadowed by the July headline.

As a result, some economists were quick to claim that based on the July unemployment data the U.S. is already in a recession, pointing to the “Sahm rule”, named after former Fed economist Claudia Sahm. The rule suggests the economy is already in a recession if the three-month average of the unemployment rate rises 0.5% or more above the prior 12-month low of that average.

This speculation propelled an already anxious market into a bout of volatility, particularly in the tech space. Tech leaders like Nvidia which have propelled the market higher by rising over 170% YTD fell over 6% in one day. Likewise, semiconductor stocks like Broadcom, AMD, Qualcomm, Intel and others saw similar drops.

While the Sahm rule does have a strong historical record, Dr. Sahm stated in an interview with CNBC on August 2nd “We are not in a recession now – contrary the historical signal from the Sahm rule – but the momentum is in that direction. A recession is not inevitable and there is substantial scope to reduce interest rates.” She elaborated, saying “The Fed has a big lever still to pull, they have a lot of interest rate cuts they could go through if they need to.” She added “This economy is in a good place – it just needs some pressure taken off it.”.

What Might be Skewing the Numbers?

Workers on temporary layoffs accounted for a startling 70% of the increase in the number of unemployed in July. Yardeni Research Inc points out that according to the Bureau of Labor Statistics household employment survey, 1.54 million workers were either not working or had only part-time employment specifically due to weather in July, a vast increase compared to the 280,000 figure in June. In fact, the July figure was so large that it is one of the top five monthly readings for workers impacted by weather since 2018.

Another factor in the labor data is a surge of individuals joining the work force. Nancy Vanden Houten, Lead U.S. Economist at Oxford Economics states that it’s unlikely we’re in a recession currently as the labor force participation rate among prime age workers increased in July hitting 84% – the highest rate since 2001. This is a sign of strength rather than weakness. She noted “In a recession, individuals are more apt to get discouraged and leave the labor force.”

The Fed has repeatedly stressed that they are watching the data closely and focus on trends, rather than a single data point. This is necessary because monthly data is calculated and then subject to two further revisions while also being subject to wide margins of error. For instance, according to the Bureau of Labor Statistics, from 2021-2023 the Nonfarm Payroll monthly numbers were subject to a total of 108 revisions with 107 of those reviews resulting in different final numbers.

Chicago Fed President Austan Goolsbee pointed out in a CNBC interview on August 5th that the jobs growth number came in 61,000 short of expectations but noted “The payroll jobs number is plus or minus 100,000 a month so be a little careful over-concluding about things in the margin of error.”

What This Means for Investors

We believe the US economy is slowing but this is to be expected and is not a cause for alarm. The decline in the inflation rate as well as the softening labor market both support the case that the Fed is likely to cut rates in the months to come. It’s impossible to predict the pace or exact timing of cuts, however equity markets have historically risen in their wake, thus staying invested remains the best course of action.

 

Capital Markets

Both equity and fixed income markets rose in July. The All-Country World Index (ACWI) rose +1.6%, the S&P 500 rose +1.2%, while the EAFE rose +2.9%. As we noted last month, there continues to be a wide dispersion both in valuation and performance between large and small cap stocks. Small Caps saw a notable gain, rising +10.2% for the month on hopes for Fed rate cuts to come soon. Emerging markets were the slowest to rise, finishing with a slight gain of +0.4%. U.S. Bond prices rose +2.3% for the month.