Economic Overview
As the Federal Reserve prepares to cut short-term interest rates for the first time in four and a half years, the U.S. economy remains remarkably strong, with continued low unemployment, decent GDP growth and moderating inflation. Fed Chair Powell’s comments at the August Jackson Hole confab all but guaranteed a 25 basis point cut when the FOMC meets next on September 18th. Despite inflation still running above “target”, many economists are suggesting that current Fed policy is too restrictive and risks triggering a hard landing for the U.S. economy.
Unemployment in July edged up to 4.3%, although weekly Initial Jobless Claims held steady on the month at around 230k. Nonfarm payrolls grew by +114k in July, missing the forecast for +175k, while June’s number was revised down to +179k versus the previously reported +206k gain. Average Hourly Earnings rose +0.2% in July, and are up +3.6% YoY, while the Labor Force Participation Rate came in at 62.7%.
While the BLS’s annual jobs number revision suggested 810k fewer jobs were created over the past year, the 2nd revision to 02 GDP showed the economy grew at a better than expected 3.0% annualized rate, versus the 2.8% reported in the first reading. The U.S. consumer remains strong as July’s Retail Sales reports came in better than expected across the board, while Consumer Confidence in August rose above forecast. The housing markets remains solid with demand continuing to exceed supply.
Prices continued to moderate at both the wholesale and retail level in July. The Producer Price Index rose just +0.1% MoM (+2.2% YoY), while ex food and energy, PPI was flat for July (+2.4% YoY). At the consumer level, prices gained +0.2% MoM (+2.9% YoY), while Core CPI also gained +0.2% MoM, but rose +3.2% YoY. The PCE Price Index gained +0.2% in July, and is now up +2.5% YoY, closer to the Fed’s target of 2.0% inflation.
All of the above data, along with the belief among many that Fed policy is far too restrictive, suggest the FOMC will cut 25 bps in September, followed by another 50 basis points or so by year-end. Chair Powell recognizes the political fallout from deviating from script ahead of the November elections, so we don’t anticipate many surprises here. In our view, as long as the U.S. consumer holds up, our base case for a soft economic landing will remain intact.
U.S. equities rallied in August, with the benchmark S&P 500 Index gaining +2.4% on the month, bringing its YTD return to +19.5%. Equities overcame their largest drawdown of the year at nearly -8%, only to rally on better than expected economic data and confirmation of a change in monetary policy coming in September. Mid- and Small-Caps, as measured by the S&P 400 and 600 Indices finished the month slightly in the red, losing -0.1% and -1.4%, respectively.
While Small- and Mid-Caps collectively finished down on the month, it should be highlighted that their quarter to date performance handily outpaces that of their Large-Cap brethren. Small-Caps finished up +9.2% for the quarter, while Mid-Caps have posted gains of +5.7%, comparing favorably to the S&P 500’s +3.7% gain during the same period.
From a factor perspective, the S&P 500 Value Index (+3.0%) outpaced the S&P 500 Growth Index (+2.2%). What’s more, like the aforementioned QTD outperformance of SMID-Caps, Value (+7.9%) stocks have widely outpaced Growth (+0.9%) stocks during the same time frame, demonstrating the rotation out of Mega-Cap Technology and Growth oriented names into other parts of the market that look more attractively valued.
Low Volatility stocks, as measured by the S&P 500 Low Volatility Index, surged +5.2% during the month of August, further pointing to a rotation away from Technology and Growth oriented parts of the market. Interestingly, the largest sector representations in the S&P 500 Low Volatility Index were Financials, Consumer Staples, and Industrials at month end, collectively making up more than 50% of the Index. It’s notable that Utilities, typically considered one of the lowest volatility sectors, was a distant 12% weighting. Perhaps it’s due to recent momentum in the sector, with gains of +12.0% QTD, and a YTD gain of +22.6% (which beats the S&P 500).
At the sector level, rate sensitive sectors such as Real Estate (+5.8%) and Consumer Staples ( +5.9%) were the top performers, followed by Health Care (+5.1%) and Utilities (+4.9%), a similar but different make up than the Low Vol Index. Technology and Communication Services underperformed the market on the month, gaining +1.3% and +1.2%, respectively, while Consumer Discretionary (-1.0%) and Energy (-1.7%) were the worst performers, and the only sectors to finish the month in negative territory.
International Equity
International equity performed fairly well in the month of August, as each sector in the MSCI ACWI ex U.S. index experienced a gain, led by health care, real estate and utilities as interest rate sensitive sectors have started to flourish as the majority of GlO central banks have either started or are poised to begin cutting rates.
Developed markets exhibited a positive month, as the MSCI EAFE Index was up 3.3% in August, placing gains at 12.5% YTD. Japan, although relatively flat in August, has helped fuel developed markets this year as the Nikkei 225 Index is up 16.7% YTD and makes up almost one fourth of the MSCI EAFE index.
Fixed Income
Jerome Powell’s recent Jackson Hole speech painted a picture of a Federal Reserve that is ready to begin lowering short-term interest rates. The real discussion has shifted from whether rates will go up or down, to the magnitude by which rates will ultimately be decreased by. Chairperson Powell made it clear that the Fed did not want employment to weaken further than it already has, perhaps somewhat concerned by the Sahm Rule (when the 3-month moving average of the unemployment rate is 0.5% higher than the lowest 3-month moving average of the preceding 12 months, a recession has begun) nearing levels that historically are associated with economic slowdowns.
The market is convinced that the Fed will reduce the Fed Funds rate at the September meeting. We agree that this is as close as you can come to a sure thing. The Fed wants to take the first step in changing the interest rate narrative. They spent a long time raising rates, and have now spent a long time paused at peak interest rates. The narrative will now progress to falling interest rates, with the speed of the rate cuts driven by incoming economic data.
Across the Treasury yield curve, interest rates moved lower in August, most significantly at the front-end of the curve. One-year and two-year maturity Treasury note yields declined by over 20 basis points. Maturities longer than 7-years saw their yields decline by closer to 5 basis points. This move lower in rates helped raise the price of bonds in August, with all indices tracked reporting positive performance.
Investment Grade (IG) corporate bonds outperformed Government Bonds due to their higher yields. In the month of August there was some credit spread widening, but this widening reversed course prior to month-end, with spreads finishing the month almost exactly where they started it.
High Yield (HY) corporate bonds also saw significant spread widening (negative for price performance) intra-month, followed by swift tightening, actually ending the month at tighter levels than it began. This was beneficial to price performance, and when combined with the higher yield on the index, HY bonds were able to turn in the highest performance of the domestic indices tracked, and retain their performance lead over most time periods tracked.
Alternative Investments
Alternative investments had mixed results in the month of August. Broad commodities, as measured by the Bloomberg Commodity index, returned -0.4% for the month and are down -2.6% YTD. The increased likelihood of falling interest rates factored into the performance of numerous alternative investments, from the U.S. Dollar declining to real estate prices benefitting.
The U.S. Dollar weakened during the month, falling -1.6% versus a basket of major currencies. The U.S. Dollar fell as revised BLS job data and Fed Chair Powell’s speech at Jackson Hole caused the market to price in a rate cut at the Fed’s September meeting to greater certainty. Focusing on a specific currency pair, the Japanese Yen strengthened versus the U.S. Dollar in a continuation of a recent trend and is now up roughly 10% compared to the U.S. Dollar to start Q3. Following the Bank of Japan’s (BOJ) interest rate hike in July, Governor Kazuo Ueda reiterated that the central bank would continue to raise interest rates if inflation and the economy performed as policymakers forecast. This recent hawkish narrative caused a quick unwind of many yen carry trades (borrowing in Japan’s currency to invest in higher yielding assets) and could have an influence on the flow of future global capital.
Oil prices fell -5.6% during August and WTI Crude Oil closed the month at $73.55 per barrel. The country of Libya appears to be nearing an agreement between rival political factions to restore crude oil supplies, potentially bringing more than half a million barrels of oil a day back to the market after a disruption earlier this month.
This is happening as OPEC+ is due to gradually start adding oil production back to the market in October. In addition, economic concerns affecting global oil consumption have increased, particularly from key oil consuming countries such as China. A fourth straight contraction in factory activity and a slump in the value of new home sales show signs that China may struggle to meet their 5% annual economic growth target, which could reduce global oil demand.
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