Market Commentary: July 2024

Written as of August 13, 2024.

Highlights this Month

• Small-cap stocks experience notable gains in July amid shifting market sentiment.
• Are U.S. economic signals suggesting a recession?
• Weakness in the job market indicates potential consumer spending slowdown.
• Optimistic earnings reports point to job security and profit growth.
• If a recession is imminent, the corporate bond market hasn’t received the memo.
• Inflation remains the primary obstacle to a September rate cut.
• Volatility increases as investors consider potential presidential shift.
• Sentiment is shaken by Buffet’s stock sales, the yen carry trade unwind, and bond investor concerns.
• What does this mean for the rest of the year?

July in Review

Billionaire investor Stanley Druckenmiller once said, “The only good economist I have found is the stock market. People say it has predicted seven out of the last four recessions. That’s still better than most economists I know.” We agree. The market provides an unbiased view of the current and future state of the economy and the companies that depend on its growth. Unlike economists, the market doesn’t get entrenched in defending a narrative and will quickly change directions when needed. 

It’s crucial for investors to understand the message the market is sending and be prepared to adjust their views accordingly. You don’t have to agree with the market, but you should at least know what it is you disagree with. 

From the beginning of the year until July 24, the S&P 500 maintained a remarkably consistent upward trajectory, setting 38 all-time closing records. During this period, there were only 25 trading sessions where the performance swung more than 1% from the previous day’s close. Additionally, the S&P 500 went 356 sessions without a 2% drop, marking the longest streak in 17 years, according to Bloomberg.

However, on July 24th, U.S. stocks suffered their worst decline since December 2022, with the S&P 500 falling 2.3%. The tech-heavy Nasdaq did even worse, slumping 3.6%, its worst daily loss since December 2022. It was the second 2%+ loss for the Nasdaq in July and the fifth of the year. Given the torrid rally technology stocks have been on, led by the Magnificent 7 (Nvidia, Meta, Alphabet, Apple, Microsoft, Amazon, and Tesla), some pullback shouldn’t be a big surprise. But that’s not the message we think the market is sending, especially based on trading in early August. 

While we normally try to stick to “Vegas rules” when writing this monthly commentary—meaning what happens in July's commentary stays in July's commentary—market action in early August is important in helping us understand the message the market is sending. The economy is slowing and finds itself at a crossroads between a soft and hard economic landing. An unwinding of the Yen carry trade, concerns over U.S. debt levels, and even Warren Buffet’s stock sales may have contributed to recent market volatility. However, the underlying thread, in our opinion, remains whether the U.S. economy is headed for a recession and what the Federal Reserve is going to do about it. 

Small-cap stocks experience notable gains in July amid shifting market sentiment. 

Performance in July was generally quite good, with the S&P 500 gaining 1.2% (total return in U.S. dollars). However, this headline number obscures a significant rotation out of large-cap stocks and into small-cap U.S. stocks. According to Scotiabank, July saw the strongest outperformance for small caps versus large caps since October 2001. 

As highlighted recently by the Wall Street Journal, smaller stocks began heating up on July 11 after a lower-than-expected U.S. inflation rate was released. The iShares S&P Small Cap 600 Value ETF gained nearly 12% until the end of the month, compared to a 6% loss in the iShares S&P 500 Growth ETF. During the same period, the KBW Regional Banking Index gained nearly 17%, while the S&P 500 cap-weighted index lost nearly 2% and the Nasdaq fell 5.6%. 

Historically, small-cap value stocks outperform in a low-rate environment when economic growth is stable and corporate earnings are growing. Smaller companies tend to carry higher variable debt loads, which pressures earnings when rates rise. Regional banks tend to outperform when economic growth is strong and loan losses are decreasing, particularly in commercial real estate. This cycle, they also benefit from lower rates, which ease pressure on their deposit base.

Alternatively, growth stocks perform well when growth is hard to find, with investors willing to pay a premium for companies that can deliver consistent earnings growth, like the Magnificent 7. The outperformance of small caps and regional banks suggests that the market believed the Fed would start lowering rates, keeping the soft-landing narrative intact. In this environment, a rotation out of the overpriced Magnificent 7 and into the broader market seemed to be the trade of choice. 

However, this narrative changed in early August after a series of disappointing economic releases. Traders began to believe the Fed was behind the curve and that the U.S. economy was headed for a recession.

In a typical economic cycle, the impact of economic policies often starts with consumer behaviour. When consumer spending slows, it pressures corporate profits, leading to cuts in capital expenditures and layoffs. These actions, in turn, cause further declines in consumer spending, creating a self-reinforcing cycle that can cause significant economic damage.

Pinning down the catalyst, however, is tough. Does consumer spending slow because of high inflation, or do higher interest rates pressure both consumer and corporate spending? According to Goldman Sachs, various policy rules suggest that the Fed Funds rate should be closer to 4%, compared to the current 5.25% to 5.5%. The Taylor Rule, a guideline for setting interest rates based on inflation and economic output, suggests that the Fed needs to cut almost 170 basis points to achieve the desired balance between inflation and economic output. 

Perhaps the trigger will become more evident by monitoring the unemployment rate. The Sahm Rule, which indicates a recession when the three-month average unemployment rate rises more than 0.5 percentage points above its low in the past year, was triggered last month. 

Are U.S. economic signals suggesting a recession? 

It’s quite possible that the U.S. is headed for a recession, or could even be in one right now. However, the data is not entirely convincing. Second quarter GDP increased at a healthy 2.8%. While the U.S. ISM Manufacturing PMI Index fell for the fourth month in a row in July and remains firmly in contraction territory, manufacturing only accounts for roughly 30% of the U.S. economy. Services comprise the remaining 70%, and the July ISM Services Purchasing Managers Index rebounded to 51.4, well into expansion territory. 

Caution is warranted, however, as both the Conference Board Consumer Confidence Index and the University of Michigan Consumer Sentiment Index have declined, led by current/present conditions. Retail spending remains stable, but the consumer appears to be under increasing pressure. 

When trying to gauge the health of the consumer, credit has historically been a useful place to start. According to Reuters, a credit crunch is far from obvious, with only auto loan demand receding since the Fed started tightening in March 2022. However, the Federal Reserve Bank of Philadelphia’s 2024 second quarter Household Debt and Credit report paints a more pessimistic picture, with past-due credit card balances reaching levels last seen during the financial crisis. As Scotiabank points out, some perspective is required, as credit cards only account for 6% of total loans. 

While it is true that the personal savings rate for the average American is back to pre-financial crisis levels, high interest rates on savings accounts and a relatively strong stock market have helped make Americans feel wealthier. According to Apollo, a record high 30% of Americans have a stock portfolio exceeding $500,000. Additionally, 37% own a home worth $500,000.

Weakness in the job market indicates potential consumer spending slowdown. 

Lower-income consumers are likely feeling the pressure of higher prices and lower savings, but higher-income consumers still appear to have buying power. Historically, the job market rolling over is what really impacts consumer spending. July’s job report provided potential evidence of such a rollover, as nonfarm payrolls rose by a less-than-expected 114,000, with the unemployment rate rising to 4.3%. Additionally, continuing jobless claims have been on an upward trajectory all year and recently hit a 32-month high. Other bearish job market data includes long-term unemployment at the highest level since February 2022, part-time work for economic reasons at a three-year high, the private employment diffusion index at its lowest level since April 2020 (indicating fewer companies are seeing employment gains), and a consistent increase in workers holding multiple jobs while average weekly hours worked trend lower. 

We say “potential” evidence because there are some caveats. While job growth in July was disappointing, temporary layoffs largely drove the unemployment rate higher, likely due to Hurricane Beryl and other weather events. Stronger immigration has also contributed to the higher unemployment rate. As Goldman Sachs recently highlighted, the unemployment rate for recent immigrants has trended higher over the last couple of years, and their share in the U.S. labour force has risen. 

Job market tightness is still evident from the higher-than-expected job openings in June. While the four-week average of continuing jobless claims continues to rise, initial jobless claims in early August dropped by the most since last September. While job creation has slowed, especially for recent immigrants, companies don’t appear to be laying off workers, at least not yet. As highlighted recently by Apollo, the Challenger, Gray & Christmas Job Cut Index report remains at very low levels. 

The Sahm Rule is based on the notion that weakness in the labour market begets further weakness due to the transmission mechanism we highlighted earlier. However, if the increase in unemployment is due to higher labour supply rather than weaker demand, is this rule still valid for forecasting a recession? Perhaps. Companies are not adding as many workers, but they aren’t laying them off either. Is this the next phase? 

Optimistic earnings reports point to job security and profit growth. 

Based on recent corporate earnings reports, it appears that workers are secure for now. According to Bloomberg, analysts are optimistic about America’s profit outlook, with Strategas forecasting second quarter earnings growth of over 12% year-over-year. Notably, earnings are expected to broaden beyond the Magnificent 7, with Bloomberg estimating that the remaining 493 S&P 500 companies experienced earnings growth in the second quarter for the first time in six quarters. Investors seem pleased with second quarter results so far, as Bloomberg Intelligence reports that earnings beats are receiving the strongest positive price reactions in five years. RBC also suggests that strong corporate profits are unlikely to lead to layoffs. 

If a recession is imminent, the corporate bond market hasn’t received the memo. 

In addition to robust earnings, companies have benefited from extremely low credit spreads. Strategas highlights that it’s difficult to be overly concerned about the falling stock market when non-investment grade credit spreads remain at rock-bottom levels. Apollo also notes that default rates have recently declined. While there was some deterioration in credit markets in early August, with spreads widening, particularly for lower-quality CCC issues, borrowing rates remain favourable for most issuers. U.S. loan prices, which have been resilient throughout the year, also fell. Although credit markets warrant monitoring, they currently show no signs of an imminent recession. 

The U.S. Treasury market and the yield curve present another area of interest. Falling short-term Treasury yields have caused the yield curve, which has been inverted for two years, to steepen and come close to un-inverting in early August. Historically, an inverted yield curve has been a recession indicator, but trouble for markets typically begins when the yield curve un-inverts. Most of the recent steepening is due to the sharp decline in the 2-year yield, which Strategas attributes to market expectations regarding the Fed Funds rate. Historically, 2-year Treasuries trade in line with Fed Funds, and Strategas points out that the current spread between 2-year Treasury yields and the Fed Funds rate is one of the largest on record. Financial markets are pricing in three 25-basis point cuts for 2024 and nearly nine by the end of 2025, though the situation remains fluid. It is widely expected that the Fed will initiate its first cut at the September FOMC meeting, lowering the Fed Funds rate by at least 25 basis points. Some have called for a 50-basis point cut, though that might seem a bit desperate. With many weeks and data points remaining before the September 18 decision date, anything is possible, including no change at all. 

When and by how much the Fed cuts rates remains a key focus for markets in the coming months. According to Bridgewater, markets have never priced in as much easing as they are now, even during recessions. The amount of easing currently being discounted is approaching the Fed’s long-term target for the Fed Funds rate, leaving little room for any setbacks in reducing inflation to the Fed’s 2% target. Bridgewater points out that past easing cycles have resulted in rate cuts exceeding the 200 basis points currently priced in over the next two years. However, it’s unprecedented for the market to start pricing in such cuts before a recession or any significant weakness has begun. A seemingly unintended consequence of the Fed’s dovish signaling is that financial conditions have tightened abruptly as equity and credit markets have corrected and the U.S. dollar has weakened. 

Inflation remains the primary obstacle to a September rate cut.  

Based on current data, the Fed appears to have a green light to start its easing cycle. The PCE, the Fed’s preferred inflation indicator, continues to trend lower, even after trimming outliers. While the PPI picked up slightly in June and CPI appears to have peaked, inflation expectations over the next five years (as reported by the University of Michigan) have increased. Any disappointment in the current disinflationary trends could complicate the Fed’s plan to ease. 

Volatility increases as investors consider potential presidential shift. 

Market volatility has increased as investors consider a potential shift in leadership, but this pales in comparison to the shifting dynamics of the 2024 U.S. Presidential election. Former President Donald Trump seemed poised for victory on November 5th, with Republicans likely to take the House and Senate, until President Biden announced on July 21 that he would not seek re-election. With Vice-President Kamala Harris now the Democratic nominee, the election is once again a dead heat. Harris and the Democrats appear to have momentum, but with approximately 100 days and three potential debates to go, both parties have a lot to play for. 

How will a shift in leadership impact the markets? 

The implications for markets are debatable. Some trades deemed favourable to a Trump victory have trended lower, though it’s hard to isolate current polling from other market variables. As highlighted by Bloomberg, the Nasdaq 100, Gold, and the Dollar/Yen carry index have all peaked around the same time as Trump’s election odds, but this may be coincidental. Trump’s stance on trade with China could relieve some pressure on Chinese stocks at the expense of India, but there are likely bigger factors influencing Chinese investors than Trump. While Trump talks about 60% tariffs, Harris is unlikely to be much easier on China.  

The steepening of the yield curve has also been attributed to a potential Trump victory, given Trump’s affinity for deficits could see longer-term rates and inflation trend higher. However, falling short-term rates have been responsible for much of the recent steepening, and a Democrat sweep would also likely result in higher deficits. Trump’s recent affinity towards Bitcoin could be partially responsible for some recent crypto weakness, but the drivers of Bitcoin trading are complex. Perhaps the most direct market link is Trump Media & Technology Group, which trades at a highly inflated valuation but would likely profit under a Trump presidency. Caveat emptor on that one. As for the rest of the market, it’s unclear if the market will care in the short term. Wall Street likes Trump’s anti-regulation, lower tax views, but these come with some risks. Harris seems more conventional but appears to have a more progressive track record. Unless either party sweeps, the next President will have difficulty passing major legislation. There remains a lot of uncertainty about who will be running the country next year, and markets may not know how to discount it yet. 

Sentiment is shaken by Buffet’s stock sales, the yen carry trade unwind, and bond investor concerns. 

Other issues affecting market sentiment include Warren Buffet’s Berkshire Hathaway continuing to sell stocks and raise cash, the unwinding of the yen carry trade, and the potential for bond investors to go on a buying strike to protest growing U.S. debt levels. Buffet’s selling is not a positive indicator, but his cash position has been building for years. Buffet is not a market timer. The fact that he is selling and having trouble finding companies to buy suggests the market is expensive, but it has been for a while. Large leveraged trades like the yen carry trade are always at risk of unwinding when markets shift suddenly. Zero or negative interest rates in Japan and a falling yen made for great risk-adjusted returns for investors borrowing in Japan and investing in global risk assets, including U.S. stocks like the Magnificent 7. The depth of the U.S. market should help soften the blow, with most of the damage being inflicted on Japanese investors, who saw the Nikkei drop over 12% on August 5. As for the potential for bond vigilantes to demand higher yields from a growing supply of U.S. Treasury bonds issued to satisfy persistent U.S. budget deficits, it’s more of a question of when, not if. The Fed will cut rates and bond yields will fall, but the ability of markets to continue absorbing a growing pile of Treasury issuance will eventually come into question. As Bloomberg pointed out, a disappointing Treasury auction in early August exacerbated a weak market. 

What does this mean for the rest of the year?  

We believe market action in late July and early August was a wake-up call but not the start of a bear market or a signal that a recession has been triggered.  

As highlighted by Strategas, it’s rare for the market to peak in July, and it’s not uncommon for the market to experience several 1% drops during the summer. According to Ritholtz Wealth Management, the S&P 500 has historically experienced an average of seven daily drops of 1% or more in June, July, and August. As of August 12, we are at four and counting.  

The S&P 500 is down about 8.5% from its peak on July 16th, which Strategas believes is not out of the ordinary. A 5% to 10% drawdown happens in 35% of years. The U.S. economy is slowing, and cracks are forming, but Fed Funds futures are discounting more weakness than economic indicators suggest is necessary.  

Consumer spending is slowing, but most of the pain is being felt by lower-income consumers so far. Job growth is anemic, but companies aren’t laying off workers yet, likely because corporate profits remain healthy. With inflation continuing to trend lower and the economy showing some cracks, the Fed is likely to cut rates.  

As long as a recession is delayed, we believe the market rally will broaden, with small-cap stocks performing better. However, if the Fed is behind the curve and unable to prevent a recession, small-cap stocks will decline along with the rest of the market. Bond yields will also fall (leading to higher bond prices), but widening credit spreads will negatively impact corporate bond returns.

The market’s attention may be on consumer spending and the job market, but corporate earnings are the ultimate drivers of returns. Currently, it appears we are experiencing a soft landing. However, the economy must navigate through this soft landing before potentially transitioning to a hard landing.