A Mid-Year Look at the Federal Reserve, the Economy, and the Markets.

Bottom Line Up Front

Fundamentally, the Federal Reserve hasn’t had the justification for rate cuts so far this year due to firmer than expected growth and a labor market that continues to add hundreds of thousands of jobs per month. That said, we have seen economic growth slow in recent months. With prices showing renewed signs of a slowdown in price increases, or disinflation, after a worrying burst in the first quarter and Chairman Powell’s improved confidence around sustainable progress towards a 2% inflation rate, the Federal Reserve likely reduces interest rates at the September meeting.

Rorschach’s Economy

It’s a confusing time in the economy and markets. While financial markets boom and the administration boasts its economic record, 55% of consumers surveyed by The Harris Poll believe the economy is currently in the midst of recession and 49% believe unemployment is at a 50-year high. Official data from the Bureau of Labor Statistics shows that the nation’s unemployment rate has been at 4.1% or lower for 32 straight months – the longest streak in 55 years. This dichotomy between soft and hard data has been emblematic of the economy so far this year – that growth has been slowing, but generally solid – while data has been noisy.

When there isn’t a clear and incontrovertible story to be found, investors tend approach the economy like a Rorschach Test – they see what they’re inclined to believe. Some see a rocketing stock market; others see a rally driven by just a handful companies. Periods of strong growth can be due to a more dynamic, less rate-sensitive economy and simultaneously explained purely by extraneous factors – demonstrated best in Summer 2023 when growth of 4.9% was widely attributed by market commentators to Taylor Swift.

With a market hyper-focused on the Federal Reserve and the timing for rate cuts, recency bias reigns supreme. This makes it important to look under the hood, examine the data in totality, and separate the noise. There are numerous examples of contradictory signals in the economy today – weakness at McDonald’s is contrasted by robust strength at Chipotle. Pool Corp recently slashed expectations for pool construction, while a record number of passengers were screened at U.S airports after the 4th of July. After 3 years of high inflation and continued high prices, consumers are still spending but have become much more price conscious. The “Any Product at Any Price” phenomenon we have seen over recent years is over, which is a major win for the Federal Reserve.

With the modest softening in economic growth we have seen over the last several months, an unemployment rate that is below the Fed’s target for the end of the year, and the early signs of a resumption in disinflation, the “full employment” side of the Federal Reserve’s dual mandate likely sees increasing importance going forward. We think the Federal Reserve likely reduces interest rates as soon as September, with another rate cut in December after the US Presidential Election. For markets, the Federal Reserve taking the long-awaited pivot towards stimulating growth likely broadens participation in a market with extremely narrow leadership through the first half of the year.

Markets

So far this year, market performance has been stellar. The S&P 500 has set 37 record closes through July 16, including the longest streak of record closes since November 2021. The performance is even more impressive considering the extreme pricing of rate cut expectations to start the year. Market expectations for rate cuts repriced from nearly seven cuts in December to just about 2 today with little to no impact on market performance. Given we had seen excessive expectations around the Federal Reserve as one of the larger risks for 2024, the digestion of “Higher for Longer” by markets has been heartening.

The largest driver in markets has been the same as 2023 – excitement around the potential for Artificial Intelligence, and the expected key roles in the transition for the “Magnificent Seven” technology companies (Microsoft, Apple, Nvidia, Meta, Alphabet, Amazon, and Tesla). Market performance has largely followed fundamentals, S&P 500 companies have largely overperformed earnings expectations set by analysts this year and earnings have been growing fastest in the mega cap technology companies. While overall S&P 500 earnings per share grew 8% compared to the year prior in the first quarter, earnings growth was negative when the “Magnificent Seven” were excluded.

With the conclusion of the second quarter, this hyper concentration in growth is set to change. As we proceed through the year, and rolling recessions turn into rolling recoveries for various industries, earnings growth is expected to broaden meaningfully and accelerate throughout the year. Given how narrow leadership has been year to date, we view this as a substantial positive. With broader earnings growth, the market has a stronger foundation as we proceed through the remainder of 2024 and into 2025. Markets are also potentially less reliant of the singular fortunes of Nvidia, which generated nearly a third of the S&P 500’s first half returns.

We continue to be favorable towards AI and think owning exposure around the supply chain of Artificial Intelligence is important. That said, after nearly 2 years of extremely concentrated returns we believe that broadening exposure outside of the “Magnificent Seven” is wise. There are plenty of discounts under the surface of the S&P 500, and multiples are skewed heavily by the weights and premiums of just a couple companies. Additionally, over longer time horizons there has been historically little to no difference in returns between the Market Cap Weighted S&P 500 and its Equal Weight counterpart. While performance can vary significantly on a year-to-year basis, both indices have returned roughly 10% per year on average since 1990. Given the last 2 years of outperformance has largely been driven by substantial weighting differences in 8 key names, the Federal Reserve’s likely pivot towards supporting economic growth makes a rotation towards the more cyclical, rate-sensitive laggards highly plausible in our view. This provides a favorable setup for the S&P 493 and small caps, which still trade at large discounts to the overall S&P 500.

Economy, Inflation, and the Federal Reserve

For a data dependent Federal Reserve looking for the next move in rates to be down, data has moved convincingly in their favor after a burst in the first quarter. Core inflation has moderated significantly from the levels seen in the first three months of the year, and there are early signs that the services sector has entered a more sustainable path of disinflation. For the labor market, the ratio of job openings to unemployed workers has fallen from 2x in March 2022 to 1.2x in May 2024, the same ratio seen in February 2020. On the growth side, nominal economic growth has normalized towards the average rate of growth seen in the 5 years before the pandemic.

That said, we do not think a material slowdown or recession is imminent in the US economy. The US jobs market continues to add hundreds of thousands of jobs per month with over 1.3 million job additions to date – just 100,000 jobs shy of the job additions at this point in 2018. For layoffs, the story is similar. Non-seasonally adjusted, initial filings for unemployment are exactly in line with the average levels of 2017, 2018, 2019, and 2023. While the economy has slowed from its white-hot pace after the reopening from COVID-19, it has mostly returned to a level more consistent with the economy seen in the years pre-pandemic.

With the normalization seen within the economy, the Federal Reserve has a much better justification to begin the normalization of monetary policy. The economy no longer needs interest rates at 5.50% when growth is around trend, alongside a balanced labor market and a declining rate of inflation. The Fed likely has the data it needs to reduce interest rates as soon as September and we think market pricing for at least 2 cuts through December is about right.

That’s not to say we should expect a return to the zero-bound on interest rates seen in the 14 years after the 2008 Great Financial Crisis (GFC). Unlike that period, the global economy is amid an era of fragmentation and conflict – with a prioritization of domestic resiliency over cheaper prices – while certain areas of domestic consumer spending are in a period of structurally higher inflation. Housing services is grappling with a national shortage of 4.5 million homes, while automotive services such as insurance and car repair are dealing with an industry in transition. Modern cars are more expensive and increasingly complicated with about 40% of the cost of a new car related to electronics, compared to less than 20% in 2000. The transition towards electric vehicles adds another layer of expense to the national vehicle fleet given their unique complexity, cost to repair, and growing share of new vehicle sales. In response, insurance companies continue to raise rates meaningfully, dealing with a more expensive fleet that costs more to repair alongside a US driver population that is crashing more often and with greater severity. Nearly 41,000 people died in US traffic crashes last year, up 13% from 2019, according to the National Highway Traffic Safety Administration, with 289,000 injuries due to distracted driving. While the inflation rate for both insurance and housing should moderate from here, they likely remain elevated given these structural phenomena.

There are also notable differences in the structure of the economy today compared to both the post-GFC period and previous rate hike cycles. Today, more than two-thirds of GDP and 4 in 5 private sector jobs in the United States are related to services which are inherently less sensitive to interest rates and less prone to the boom-bust cycles seen in manufacturing. The Institute for Supply Management’s Purchasing Manager Indices (PMI’s) for manufacturing and services display this clearly. The services survey has been in contraction for just 3 out of the 28 months since the Federal Reserve first raised interest rates, while the manufacturing survey has been in contraction for 19, including a 16 consecutive month contraction – the longest streak since 2001. On the income side, the economy isn’t as reliant on the strength of the labor market to support growth. Less than half of the $24 trillion in total personal income now comes from wages and salaries as the share of interest income, dividends, and transfer payments such as Social Security has doubled from just 15% in 1959 to 31% in December 2023. While a strong labor market remains a key ingredient for robust growth, in the modern economy, incomes and spending aren’t as purely dependent on wage income as in the past.

We think this diversification of income and the growing portion of the US economy claiming Social Security benefits are significant contributors to the resilience we have seen over this cycle and good reason to see the likelihood of recession as low. Between 2021 and 2024, Social Security payments have grown faster than inflation while Real Average Hourly Earnings have fallen 2.5% over that same period. 2023 saw 70.6 million Social Security recipients, roughly 22% of the US adult population, receive an 8.7% Cost of Living Adjustment (COLA) – the equivalent of the largest annual increase in Average Hourly Earnings since 1982. Bank of America’s June 2023 Consumer Checkpoint release found that while Generation X and younger had meaningfully curtailed spending, older generations were largely keeping overall consumer spending afloat.

We expect this trend to continue. In a move that is largely attributed to financial market performance, there are now more than 2.7 million excess retirements – retirements above a trend level expected given an aging population – relative to expectations in a model maintained by the St. Louis Federal Reserve. The result is a population of 71.7 million people receiving Social Security or Supplemental Security Income in January 2024 – just 6 million fewer than the number of workers over 16 that were paid at hourly rates in 2022. Effectively, annual Social Security COLAs now have a similar – if not larger – impact to aggregate consumer income than any potential increase to the Federal Minimum Wage. This gives the economy a better ballast in the event of weakness but limits the magnitude of what the Fed can do in terms of rate reductions.

Conclusion

Since the Federal Reserve first raised interest rates in March 2022, markets have been through two distinct phases: “How High?” as the Fed embarked on one of the fastest rate hiking cycles in history, and “How Long?” after the Fed went on pause. With data once again providing confidence of a more sustainable path towards 2%, markets can now proceed into Phase Three of this cycle: “How Low, and How Fast?”

For now, two cuts this year and 3-4 cuts in 2024 – as guided in the Fed’s June Summary of Economic Projections – seems like a reasonable baseline. However, with low unemployment claims, expansionary fiscal deficits, an aging population that is actively dis-saving, and a stabilization of nominal growth above Pre- Pandemic levels, the Federal Reserve continues to have the luxury of patience. In the post-2009 world of forward guidance by central banks, shifts to rate policy tend to be absorbed quicker by markets – as evidenced by the takeoff in markets when Powell signaled a coming pivot in the fourth quarter of 2023. The Federal Reserve is also likely contending with a neutral rate that is higher today than it was in the post-GFC economy that was starved for growth.

The question for next year is how many times the Federal Reserve cuts, rather than if they will cut at all. This is a meaningful difference when analyzing the outlook for markets over the next 12 to 18 months. A Federal Reserve that pivots towards incrementally supporting growth is a significant boon for numerous industries in the US economy, many of which have had close to no contribution to the returns we have seen over the last 18 months. A return to broad-based earnings growth across the S&P 500 is a great step for a more fundamental foundation for markets, although the simultaneous slowdown in growth at the “Magnificent Seven” could be a challenge for indices where the mega-cap technology companies hold extreme weights.

Ultimately, the noise we have experienced over the last 6 months is unlikely to dissipate materially. The US economy isn’t growing at the pace we saw in the years immediately after the COVID-19 reopening, but slowing from that rate does not mean a slow economy. As we enter the US Presidential election, markets could be volatile as they examine any potential changes to policy and the likely beneficiaries under a Democratic or Republican presidency in a contest that remains highly in flux. While the candidates differ on many issues, neither is likely to reduce fiscal spending in a way that materially hurts growth. In the end, the market and the economy are likely on a good footing for continued and stable growth regardless of the day-to-day noise on the Federal Reserve or the elections.

For our clients with Strategic Asset Management (SAM) accounts where we manage with full discretion. Depending on your individual situation, objectives, and type of accounts, we may own a larger number of individual securities to take advantage of potentially broader market participation and lean towards building higher cash positions for opportunistic purchases as we proceed towards the US Presidential election. Cash will be deployed as we evaluate both volatility and values in line with our current outlook. This will give us an opportunity to mitigate volatility and take advantage of opportunities of what we expect to be a positive but choppy year.

For our clients who hold brokarage accounts, if you are interested in a similar fee-based strategy, please contact your advisor.

If you are not yet and are interested in learning more about our services, please contact our team at (949)660-8777 or [email protected] to schedule an appointment.