CIO View

Waiting for U.S. PCE data, and looking forward to next week’s FOMC meeting

Last week had some highly interesting lessons to offer. Friday’s computer outage has caused significant economic damage, with a clear picture only to emerge over the next weeks, while it also demonstrated how dependent the globe has become on a few lines of program code. One can expect frantic efforts to make such events less likely in the future. Hence, it’s well possible that last week’s short-term pain might carry some long-term gain, similar to a virus infection: as long as it doesn’t get too severe, a virus trains the immune system and can ultimately have positive long-term effects despite all the short-term inconveniences. Alongside some first attempts to assess the potential damage, one could read plenty of jokes, with a satirical magazine reassuring that despite the global computer failure, fax machines in German public administration kept working flawlessly.(1)

Last week’s most spectacular event was likely the dramatic rotation in the stock market. Various metrics were discussed, from how-many-sigma an event the Russell 2000’s outperformance of large caps or tech stocks was, to the sudden drop in the correlation between market segments, which in some cases almost reached zero.

Our equity strategist lists two main causes for the strong comeback of U.S. small and mid-caps. First, there’s the prospect that the U.S. Federal Reserve will follow its peers and cut interest rates. A weakening economy, along with, after a pause in the first quarter, again-declining inflation rates, supported by more moderate tones from central bank officials, suggests that the first-rate cut should happen soon. And never forget, ‘the first cut is the deepest,’ as Rod Stewart and others have sung before! As we pointed out a few weeks ago, some brave souls out there are expecting the cut to materialize already at next week’s July Federal Open Market Committee (FOMC) meeting. Last Thursday, these expectations were fueled by a Greg Ip article in The Wall Street Journal.(2) ‘Inflation […] has fallen from 4.3% [a year ago] to an estimated 2.6% now, the steepest decline since 1984, and within shouting distance of the Fed’s 2% target,’ Ip wrote. The economy has cooled down, and the unemployment rate has risen from 3.4% to 4.1% recently. Given that “[h]istorically, when unemployment rises this much, it tends to keep going up”, the question comes up: why wait any longer?

Whenever Greg Ip writes an article shortly before a FOMC meeting, we recommend paying close attention. Nevertheless, we would not expect an interest rate hike for next week. As usual, it’s not our job to say what should happen or what we would like to see (admittedly, we originally expected the first rate cut already for June), but rather what is likely to happen. Listening closely to the Fed, we do not get the impression that Powell & Co. have prepared markets for a July cut. They probably would have given a few vague hints by now. However, it is quite possible that these hints will be delivered next week, or later at the Jackson Hole event in August. Markets are priced for more than two cuts this year.

The second reason for the comeback of small and midcaps is the change in probabilities for the outcome of the U.S. election. Like AI algorithms, traders take a look at their training data, identify November 2016 as a suitable period of reference, finding that the Russell 2000 made 17?% after the election, which corresponds to an outperformance of 8?% compared to the S&P 500. Based on this, they draw their analogies. Why wait until November 2024 to set up the same trade again? The historical pattern is complemented by some fundamental explanations, such as the prospect that companies operating in the domestic market should benefit particularly from trade barriers and import tariffs likely to be implemented by a second Trump presidency. Add the expectation of further declining corporate taxes, and there we go! However, President Biden’s announcement not to seek re-election reminds us that the election is not over yet.

Despite all the SMC euphoria, the question remains about the overall direction of the market. Much will depend on how the tech giants will report during the current earnings season. If they consistently excel in terms of revenues, profits, and guidance, as they did in previous quarters, the market may still have potential. The hurdle however is likely to be high. Two “Magnificent-7” companies will report their results this week.

In terms of economic data, the first series of preliminary July purchasing managers’ indexes (PMI) will be due on Wednesday, and Germany’s IFO Index will be published on Thursday. The data will be scrutinized for clues as to whether the modest rebound in the global manufacturing cycle remains on track, and how the U.S. service sector develops given last month's sharp drop in the service ISM. U.S. durable goods orders and first Q2 U.S. GDP numbers will be released on Thursday, too. Market consensus expects a 1.9% annualized growth rate, up from 1.4% in Q1. Finally, on Friday U.S. June personal consumption expenditure (PCE) data will be released, including the much-watched core deflator. Markets go for another 0.1% monthly increase, which would bring the annual rate to 2.5% after 2.6%. The outcome will shape expectations for next week’s FOMC meeting.

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1. Source: Der Postillon, July 17, 2024.

2. Source: The Wall Street Journal, July 18, 2024.

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Forecasts are based on assumptions, estimates, views and hypothetical models or analyses, which might prove inaccurate or incorrect. Past performance is not a reliable indicator of future returns. Source: DWS Investment GmbH as of 7/22/24.

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