Market Commentary: August 2024

Written as of September 10, 2024.

Highlights this Month

• Stocks showed a recovery from what seemed like a correction earlier this month.
• The market’s nervousness stems from the economy nearing a crossroads.
• Corporate optimism is likely supported by healthy earnings growth.
• While U.S. job growth is slowing, it remains positive.
• The market is eager for the Fed to cut rates.
• The upcoming Presidential election also looms large.

August in Review

The month of August concluded with several asset classes, including stocks (S&P 500), Treasuries (iShares 20+ Year Treasury ETF), corporate bonds (iShares Investment Grade Corporate Bond ETF), and high-yield bonds (iShares High Yield Bond ETF) experiencing four consecutive months of positive returns. According to Bloomberg, this four-month general rally in stocks has been the longest since March, while Treasuries marked their longest winning streak since 2021.

Stocks showed a recovery from what seemed like a correction earlier this month.

For stocks, it was a notable recovery from what initially appeared to be a material correction earlier in the month. After falling just over 6% (total return in U.S. dollars) in the first three trading sessions of August and nearly 8.5% from its July high, the S&P 500 rallied nearly 9% to end the month up 2.4%. While the S&P 500 didn’t quite reach its year-to-date high, it has recorded 38 record closes so far in 2024 and avoided a single decline of 10% or more, according to Dow Jones Market Data. Historically, the S&P 500 has averaged at least one 10% correction per year since the 1930s, as noted by Bank of America. Bloomberg highlighted that the rally in U.S. stocks has started to broaden, with the S&P 500 equally weighted index outperforming the cap-weighted index since mid-July.

However, it has been a nervous rally, with traders more jittery than usual. Scotiabank observed that globally, large-cap stocks significantly outperformed small-cap stocks in August, reversing July’s trend where small-caps had their best relative performance over large-caps since 2001. Value was the only style category where small caps outperformed large-caps, while small-cap quality was particularly weak.

In Canada, small-cap stocks underperformed large-caps, even among value names. Bloomberg reported that the rotation out of large-caps and into small-caps that began in July is evolving into a trade where investors are leaving both. Traders had hoped that a rotation out of the Magnificent 7 would free up capital for smaller-cap stocks, but by early September, they were selling both.

Amid the various market crosscurrents, the main focus appears to be the U.S. economy and the growing risk of a hard economic landing. According to a recent Bank of America Global Fund Manager survey, the top tail risk for markets in June was inflation. In July, it was geopolitical risk, and in August, fears of a U.S. recession topped the list of investor concerns. Bloomberg’s recent chart shows that markets have started treating positive economic surprises as good news, rallying when economic data exceeds expectations. Conversely, bad economic news is being treated as bad news, with stocks correcting. This is a shift from when inflation was the top concern, and positive economic news meant higher inflation and a more restrictive monetary policy by the Fed. In a slowing economy where investors worry about a recession, defensive sectors and stocks with resilient earnings and balance sheets should gain favour. According to the Bear Traps Report, this is starting to be priced into the market. However, defining what is defensive versus value or growth can be subjective, and the trend highlighted by The Bear Trap Report is still evolving.

The market’s nervousness stems from the economy nearing a crossroads.

Inflation fears have abated, but concerns over economic growth are rising. Forecasts of a soft economic landing are being overshadowed by fears that the Fed is behind the curve and the economy is tipping into recession if it hasn’t already. However, there is data to support both a soft and hard landing, leaving many investors uncertain.

Forecasting a recession is no easy task. Often, a U.S. economic recession is only evident well after the fact. According to Bloomberg, economists have consistently underestimated US economic growth lately, with median real GDP growth forecasts being revised higher throughout 2023 and 2024. Rosenberg Research believes the risk of a U.S. recession is rising, with 45% of their 20 recession indicators currently flashing red, compared to only 20% in 2022. Based on data since 1999, Rosenberg notes that the percentage of indicators being triggered has never been this high without a recession occurring. Goldman Sachs’ market-implied indicators suggest a 41% probability of a U.S. recession within 12 months and a 6% probability that a recession has already started, though they do not draw the same conclusion.

Among economists, Rosenberg is more of an outlier. Bloomberg’s forecast for a recession over the next 12 months has been trending lower since last year and is currently at only 30%. Goldman Sachs raised its recession probability from 15% to 25% in early August, only to lower it back to 20% a few weeks later. According to Peter Coy of The New York Times, the National Bureau of Economic Research relies on six economic indicators to determine whether the U.S. economy is in or near a recession. While there have been brief declines in half of them, all six continue to trend higher.

Fund Managers are also giving the economy the thumbs up, with August’s Bank of America Global Fund Survey showing a growing 76% in the soft-landing camp. According to Apollo, companies have been talking less about recession on earnings calls, and small business optimism is back to levels when the Fed started raising rates in March 2022.

Corporate optimism is likely supported by healthy earnings growth.

Strategas notes that while third-quarter 2024 S&P 500 earnings per share (EPS) estimates have been trending lower, forecasts for 2024 EPS growth have consistently hovered around 10% for most of the year. Estimates for 2025 EPS growth have been trending higher, with analysts currently predicting over 15% growth next year. Goldman Sachs highlights that analysts often start with overly optimistic bottom-up forecasts, leading to downward revisions. However, 2024 consensus EPS revisions have been less negative than usual, and 2025 revisions are trending higher. This optimism isn’t solely driven by AI and the Magnificent 7. Bloomberg Intelligence points out that earnings growth is broadening, which should help extend the rally beyond the top seven stocks by market cap. Ultimately, earnings drive the market long term, and economic growth drives corporate earnings.

When the economy and corporate profits come under pressure, companies typically start by hiring fewer workers, and this trend is emerging. The Bureau of Labor Statistics reported that job openings in July dropped to their lowest level since early 2021. Additionally, the Labour Department revealed that monthly payroll figures had been overstated by over 818,000 for the 12 months ending in March. Instead of adding an average of 242,000 jobs, employment growth actually averaged 174,000 per month, 28% less than initially reported. This revision, part of an annual process to reconcile monthly estimates with more accurate state unemployment records, was the largest downward adjustment since 2009 and indicates that U.S. payroll growth began to moderate earlier than previously reported.

While U.S. job growth is slowing, it remains positive.

The payroll revision aligns monthly job growth more closely with the Household Survey, which the U3 unemployment rate is based on. Apollo finds it hard to see a slowdown in the labour market, especially since companies aren’t laying off workers yet. The Bureau of Labor Statistics Job Openings and Labor Turnover Survey (JOLTS) shows that the layoffs and discharge rates remain very low, as do the Challenger, Gray & Christmas announced job cuts. Additionally, wage growth increased in August and is at pre-pandemic levels.

The strength in the labour market is reflected in the resilience of the U.S. consumer. July retail sales rose 1% from the previous month, the most since January 2023. Consumer confidence also improved, with the Conference Board’s U.S. Consumer Confidence Index reaching a six-month high in August. While real wage growth continues to help consumers regain some lost purchasing power from 2022’s inflation surge, a lower savings rate and diminished pandemic savings could hinder future spending, especially if the job market continues to slow. Goldman Sachs reports that the consumer savings rate fell to 3.5% in Q2, well below historical levels, while JP Morgan Chase Institute notes that median checking and savings account balances were $3,091 in February. For the bottom quartile of earners, the median balance fell to $1,160, compared to $8,143 for the top quartile. The U.S. consumer is still in decent shape, but the safety buffer is shrinking.

Fortunately, inflation has continued to move lower, and without needing a recession to do so. The Fed’s favourite inflation indicator, the personal consumption expenditure index (PCE), held steady in July, with headline PCE increasing by 2.5% year over year, while Core PCE increased by 2.6%. Both were 0.1% below market expectations. Even the Atlanta Fed’s Sticky CPI index continues to disinflate. Long-term inflation expectations also moved lower, with the US inflation swap forward 5yr5yr (the 5-year inflation-linked bond breakeven rate 5 years from now) at its lowest level since early 2022. This likely positions the Fed to start lowering rates, provided inflation remains well anchored.

The market is eager for the Fed to cut rates.

Historically, 2-year Treasury yields track the Fed Funds Rate, but as highlighted by MRB Partners, 2-year Treasury yields have fallen well below Fed Funds for an extended period as traders anticipate the next rate-cutting cycle. According to Bank of America’s Fund Manager Survey, expectations for lower short-term rates in the next 12 months are at a record high.

The Fed cut rates by half a percent on September 18, its first cut in four years. Futures markets are currently pricing in nearly four 25 basis point cuts by the end of 2024 and nine (a total of 2.25%) by the end of 2025. This would bring the Fed Funds rate down from 5.25-5.5% to 3.0-3.25%. As highlighted by charts from Bloomberg and SocGen, this level of rate cuts is rarely seen outside of recessions and is larger than what has been priced in at the start of previous easing cycles.

According to futures markets, the Fed Funds rate should bottom out around 3% this cycle, which, as highlighted by Bloomberg, would be the shallowest trough for an easing cycle in three decades. However, Apollo suggests that even lowering the Fed Funds rate to 3% will boost GDP by 2.2% and inflation by 1%. Given current economic conditions, this seems overly stimulative.

The upcoming Presidential election also looms large.

It’s too close to call, but a Republican sweep enabling Trump to move forward on his platform of lower taxes, less immigration, and tariffs could be somewhat inflationary. Markets might react positively in the short term, as evidenced by the S&P 500 rally after the 2017 Trump tax cuts. However, Nomura Global Economics highlights that most market participants expect CPI to increase under a Trump presidency.

What could this mean for investors? Stocks have generally been a positive investment and could continue to trend higher, especially if the Fed cuts rates and successfully engineers a soft landing. However, it might also be time to start looking for greener pastures. According to a recent chart by Jefferies Fear & Greed, stock prices have decoupled from bond yields. This can happen for a period, but eventually, bond yields need to rise to reflect the economic environment that stock prices are already discounting, or vice versa.

We believe the Fed is preparing to start cutting rates, and the yield curve is close to uninverting. As of September 9th, the 2-year versus 10-year yield curve has turned positive. Goldman Sachs highlights that the path forward for stocks historically depends on the economy after both events. If the US slips into recession within 12 months of the first Fed rate cut, the S&P 500 has historically drifted lower. If a recession is avoided, stocks have continued to move higher after the first Fed rate cut. Once the yield curve uninverts and starts to steepen, stocks do well if a recession is avoided within the next 12 months.

The key question remains whether the U.S. can avoid a recession, and the data is anything but definitive. We don’t think the U.S. is in a recession right now, but cracks are forming, and the trend is not favourable. Even worse, the market is not priced for a recession. Based on the Fed Model, which subtracts the 10-year Treasury yield from the S&P 500 earnings yield, stocks look expensive. As depicted in a recent Morgan Stanley cartoon, investors looking for safe passive income can earn a decent return holding bonds. A recent Financial Times article argued that bonds provide similar 10-year returns as stocks with less volatility in high-rate environments, which they (and we) argue we are in. The one caveat is that bonds might not be as good of a portfolio diversifier going forward, especially if inflation reasserts itself. In a high or rising rate environment, bond returns benefit from higher coupon returns, not capital gains generated from falling rates. A recent Wall Street Journal article concedes that bond yields above 3% and an uninverting yield curve have historically delivered equity-like 10-year returns, but bonds don’t cushion equity routs if the rout is caused by higher inflation and/or higher rates.

If you seek to safeguard against equity downturns and ensure peace of mind, short-term bonds or cash may offer the most security. As Jeffrey Gundlach of DoubleLine, often referred to as the “Bond King,” advises, “T-bill and chill.” While 5% T-Bill yields are likely temporary with the Fed poised to cut rates, 10-year Treasury bonds have significantly outperformed T-Bills since 10-year yields reached 5% last October. However, the extent and speed of the Fed’s rate cuts remain uncertain, and 10-year rates have already seen substantial rallies.

Even when the Fed begins cutting rates, banks have historically lagged in adjusting their savings account rates, as highlighted by Barron’s. Banks were slow to raise rates, which negatively impacted their deposit base, so they may be even more cautious in lowering rates this cycle. Investors seem to be responding accordingly, with Bloomberg reporting that $6.24 trillion is currently parked in money market funds.

For taxable Canadian investors, quality dividend-paying stocks may be a sensible choice as central banks cut rates. According to BMO, yield sectors typically deliver solid returns during rate easing environments, and CIBC highlights that dividend yields in Canada are higher than in the U.S. Quality dividend payers also tend to be defensive, which is attractive in a slowing economic environment. 

Timing recessions is challenging. U.S. economic growth is slowing, and cracks are forming, but declaring a recession imminent is difficult. Yet, financial markets seem to be anticipating one by discounting up to four 25 basis point cuts in the Fed Funds rate by the end of 2024, and another five next year. Stocks aren’t pricing in a recession, and according to Bloomberg, neither are credit markets. Markets are focused on the job market, believing it will determine if a recession occurs. Job growth is stalling, but companies appear reluctant to cut jobs, especially given that earnings remain healthy. 

If we had to choose, we suspect the Fed easing cycle will unfold slower than the market expects. The Fed will likely cut rates in September, but only by 25 basis points. The job market will need to continue deteriorating to compel the Fed to cut by 50 basis points. We see rates bottoming at a higher level than in previous cycles, as a higher-for-longer rate environment continues. Bonds can be an attractive investment in this environment, but cash can also provide security. Quality dividend-paying stocks, of which Canada has an abundance, also make sense. It’s no time to be a hero. Let’s be safe out there.