Weekly Thoughts: September 16, 2024
Markets had the strongest week for equites in 2024 as investors shook off the on again off again growth concerns and continued to climb the proverbial “wall of worry.” With the ultra-focus on the upcoming FOMC meeting and the expert predictions ping-ponging between a 25 or 50bp cut, US investors should note that the European Central Bank cut rates for the second time last week as Euro Zone growth is much slower than the US. Our Fed’s internal struggle about the size of the first move is not doubt that the cut cycle is in order, but a sliver of worry that the last vestiges of inflation still hang over the economy. No Fed wants to ever reignite the economic harm caused by inflation.
The S&P’s bull move, leaving aside an intraday 90-point drop after core CPI was +.01% higher than expected, yet reversed to close +50, shutting the door quickly on another bearish move. The market was up +4.02% and closed within 1% of July’s all-time high of 5669. The Nasdaq was even hotter as the recovery from last week’s semi-conductor decline led the index to a +5.95% rally. The R2000 had a nice recovery as well, rallying +4.36% over the 5 trading sessions. The 10-year treasury bounced between 3.60 & 3.70%, ending Friday at a 3.657% yield. The 2-year sent a bigger signal, as it closed at 3.587% [note the 2/10 spread is no longer inverted] and as the week progressed, markets were increasing the odds of 50bps instead of 25bps by the Fed but the 2-year is a better indicator of where markets think the Fed’s destination is over the next two full years while the Fed Fund futures contract is where we look for the market prediction for a single meeting. In short, while your team at Empire believes it will be 25bps, the markets are close to a jump ball at week’s end instead of a lean to 25 it had at the start of last week.
The increase of the 50bp probability came about on Thursday after articles in the Wall Street Journal and the Financial Times about the challenging decision the Fed faces. The 50bp odds increasing are based on the theory—with some merit—that the Fed often gets their thoughts “out there” through the media, so it is Fed insiders who revived the 50bp talk. While unknowable, if this is the case and they do not deliver on 50bps, markets may well trade lower. If they make the larger cut, there will be a knee jerk move higher, but we could make a case in the short run, this meeting may fall into a “sell the news” event as we are near highs after a volatile two month period and economic direction and investor emotions in front of a contentious election may deliver more of the same back and forth movements.
We stated in our last note that while important, the angst and fretting over the size of the first move is overdone. Proponents of 50bps say it will lesson the odds that the Fed is behind the curve while those in the 25bps camp believe the economy is not on the precipice of a fast growth decline and it is too soon to be sanguine that inflation is completely put to bed. That debate will only have a certain winner down the round with perfect hindsight. Therefore, it is much ado about nothing. If growth plummets in the next few months, it will happen regardless of the size of this cut as the ‘long and variable lags’ of monetary policy work both ways. Stating more clearly, if the slowing picks up pace quickly, it will be clear they were late but 25 or 50 next week would not have changed things. If that scenario plays out, they will do larger cuts soon. The data and forecast state that the Fed should start the cycle and then adapt as needed with authority if necessary.
That hypothetical scenario is not our base case. We expect the economy to slow further but not hit a cliff for the remainder of the year. There is still plenty of liquidity in the system and longer rates are supportive of the large parts of economic activity outside of consumer spending—housing and autos. While housing remains largely unaffordable for many, mortgage rates in the low 6s is great improvement from the peak of 8% and should help the poor supply of existing homes on the market as the buyer pool will increase with lower funding costs.
The improvement on the inflation front has continued and while economists correctly point to the lagging nature of the shelter costs component showing that inflation is lower than stated now and thus will continue to fall, another source of disinflation has been the abject failure to have a solid recovery from China, the world’s second largest economy.? When China struggles, it lessens commodity demand. The Bloomberg Commodity Index is only up 1.09% YTD, due to a three month drop of -5.02%. Softness in oil, when logic would say the unrest involving Russia and the Mideast should put upward pressure is due to strong US production---and weak China demand.
While investors tend to focus on labor and inflation when exploring macro factors that drive the markets, equity managers also follow a forward indicator that tracks default rates in corporate America. In fact, we often see a rise in those rates in front of significant slowing of growth and in markets, high yield bond indices start to decline as credit spreads widen. Thus far, we are not experiencing those phenomena. The Morningstar/LSTA Leveraged Loan Index Default Rates have been declining during 2024.? Moreover, consumer spending somehow remains solid, and the Atlanta Fed GDPnow currently estimates Q3 growth at 2.5%. ?
As investors that garner more salient information from what markets tell us then prognosticators, the major concern for us is the treasury market which has rallied, thus lowering rates. Fed cuts will flatten the curve but as we mentioned, the 2-year has already caught up to the 10-year highlighting markets appear to want Fed cuts as well. That said, the potential concern is treasury rallies are often a harbinger of slowing growth and even recession. The positive data we have quoted can lead to a conclusion that the Fed may not be late, but it is time, and investors should not get too euphoric that the ship has been steered through the stormy post-pandemic period.
The coming week has a modest economic data calendar outside of the FOMC meeting. Retail Sales is expected to be flat for August after a robust 1% gain a month ago. Close attention is paid for any signs of consumer weakness. Additionally, housing starts, industrial production, initial claims and the Empire Manufacturing survey are a few of the highlights. The rate decision on Wednesday and of course, Chair Powell’s post meeting presser will capture the attention of investors and provide a bevy of strategists and economists interpretation of both the FOMC action and the Fed’s future path.