Economic Overview
The U.S. economic “soft-landing” is occurring, with employment stable, inflationary pressures at bay, and economic growth steady. Whether it can continue into year-end depends largely on an increasingly stretched consumer, grappling with higher borrowing costs and lower wage increases. Election-year noise aside, the U.S economy remains the envy of the world, with technological innovation and advances in artificial intelligence driving much of the growth.
The Federal Open Market Committee convened yesterday, July 31st, and while they held interest rates steady, Chair Powell did, in his own way, suggest that September’s meeting (there is no formal policy meeting in August), was perhaps live in terms of an interest rate cut. Despite appearances of political influence in terms of the timing, it’s important to remember that monetary policy acts with a lag, current rates are restrictive, and historically the Fed’s role has been to take away the punch bowl just as the party is getting started.
With June’s Unemployment Rate coming in at 4.1%, and with tomorrow’s reading for July expected to show no change according to Factset’s consensus forecast, the labor market has softened enough to give the Fed air cover to begin lowering rates. The Job Openings number for June has fallen to 8,184k, while Continuing Claims have ticked up to 1,877k. It’s important to remember that the Fed’s goal is not to increase unemployment, per se, but rather to reduce the demand for labor, thereby lowering wage inflation. So far, mission accomplished.
In regard to prices, the latest CPI report showed consumer prices fell -0.1% in June, while edging +3.0% higher YoY. Ex Food & Energy, prices ticked up +0.1% MoM, and are up +3.3% YoY. At the wholesale level, PPI rose +0.2% MoM and is up +2.6% YoY, while core PPI rose +0.4% in June and +3.0% YoY. Despite its stated goal of 2.0% inflation, our feeling is that the Fed may be comfortable with “2.something%” and call it a day.
Being mindful that roughly 2/3 of U.S. GDP depends on consumption, we remain wary of the increasing pressure on workers at the lower end of the wage spectrum. Inflationary pressures, along with higher borrowing costs are particularly punitive to this cohort, and cracks are forming, with a slowdown in spending, loan payments extensions and a higher default rate looming. Along with growing concern over the commercial real estate market, Chair Powell and the Fed would be wise to begin easing before too much more damage is done.
Domestic Equity
U.S. equities rallied in July, with the benchmark S&P 500 Index gaining +1.2%. The stars of the show, however, were Small- and Mid-Cap stocks, which surged on the back of a softer than expected Consumer Price Index (CPI) print for June, which caused a downshift in interest rates, and the market price in a near 100% probability of a September rate cut. Small-Caps, as measured by the S&P 600 Index, rallied +10.8% during the period, while Mid-Caps, as measured by the S&P 400 Index posted an impressive +5.8% gain.
Within the Large-Cap universe, performance “down” cap was equally impressive, with the S&P 500 Equal Weight Index posting a +4.5% return during the period. From a style perspective, Value outperformed Growth, with the S&P 500 Citi Value Index gaining +4.8%, while the S&P 500 Citi Growth Index lost -1.3% during the month. The rotation out of Growth (i.e. AI) stocks was notable, as investors questioned the price run up and considerable multiple expansion that has taken place year to date.
The aforementioned rotation can also be seen through sector performance for the month. Cyclical and rate sensitive sectors performed the best, with Real Estate (+7.2%) and Utilities (+6.8%) leading the charge. Financials (+6.5%), Industrials (+4.9%), Materials (+4.4%), and Healthcare (+2.7%) outperformed the broader market as expectations for future rate cuts from the Fed rose. Communication Services (-4.0%) and Information Technology (-2.1%) were the bottom performers on the month.
Looking ahead, we continue to believe that market concentration remains a significant risk to equity investors, and as air comes out of the AI trade, investors will rotate into more attractively valued parts of the market like the “average” stock, and most notably Mid- and Small-Caps. Whether or not July was the start of a regime change remains to be seen, but in the meantime July showed the power of rotation, and the importance of a well diversified portfolio.
International Equity
Developed (DM) and Emerging (EM) market equities posted positive performance in July; rising +3.0% and +0.4%, respectively. While EM lagged the broader market due to underperformance from China (-1.2%), DM was lifted by outperformance in Switzerland (+4.8% in USD), the UK (+4.1% in USD), and France (+2.4% in USD).
The Bank of Japan raised its benchmark interest rate to 0.25% on the final day of the month. Kazuo Ueda, the bank’s governor, acknowledged the historically weak Yen as a possible hinderance to economic growth. The policy move was anticipated by markets, and sparked a rally in the currency from an intramonth level of 161.69 to close at 149.98. While in JPY terms the Nikkei 225 fell -1.2% for the month, the stronger Yen pushed the index up +5.5% in USD.
India has been a steady outperformer in EM. The MSCI India Index returned +4.0% in July and +21.9% YTD (both USD). India has been a beneficiary as companies re-engineer their supply chains to be less reliant on China. As an example, Apple now produces 1 in 7 iPhones in the country, double the rate from a year ago, according to Bloomberg.
China continued to lag global markets, falling -1.2% on the month and -12.0% YTD. Chinese manufacturing activity, as measured by the National Bureau of Statistics PMI, continued to deteriorate for the third straight month to 49.4 from 49.5 in June (values below 50 signal a contraction).
Information Technology was the lone ACWI ex US sector to post negative performance, falling -2.4%. Utilities (+6.4%), Healthcare (+5.0%), and Real Estate (+4.9%) led the way as investors pivoted out of growth and into more defensive positions.
Fixed Income
The Federal Reserve concluded their two day meeting yesterday, announcing that the Federal Funds Rate would remain unchanged, while opening the door for a rate cut at the September meeting. The future cut is dependent on continued supportive economic data. The recent trend of weakening employment and falling inflation seems unlikely to reverse, and with the Fed Funds markedly higher than the rate of inflation, Chairperson Powell has plenty of room to lower the rate.
The coming Presidential election does present a timing issue. While Chair Powell has clearly signaled that he is not worried about beginning what will likely be a series of rate cuts in September, traditionally, the Fed tries to avoid the appearance of a perceived conflict by pausing interest rate moves near elections. If they choose to continue this tradition, the next interest rate cut would likely occur in December, once the election has been decided.
Fixed Income performance in the month of July was unusually uniform, with most tracked indices gaining between +1.8% and +2.4%, as yields broadly declined.
Mortgage bonds are a significant exposure within the Agg Index, and have performed strongly over the past few months. When combined with the Investment Grade corporate bond component of the Agg, it led to a monthly return of +2.3% for July. This put the Agg ahead of the Government Index alone, but slightly behind the Investment Grade Index return.
Investment Grade and High Yield credit spreads tightened during the first half of the month, then widened going in to the Fed meeting. The effect on overall performance was relatively muted, with the gains primarily driven by the decline in yields, pushing bond prices higher.
Tax-free municipal bond performance trailed the taxable indices, returning +0.9% in July. Some of this underperformance developed in the final days of the month as municipal bonds failed to keep up with the rally experienced as taxable bond yields decreased. There is often a lag in the response of the municipal bond market. Next month may see tax-free bond performance catch up to the rest of the bond market.
Alternative Investments
Alternatives were mixed in July as the Bloomberg Commodity Index, which covers a broad basket of commodity futures, and WTI Crude Oil were both down on the month. Gold continued its historic run, rising over 5% in the month and over 18% year to date.
Meanwhile, as many Americans have been traveling during the summer months and exports have continued to rise, US Crude inventories have fallen each week in July as demand has been above 9 million barrels a day for four of the past five weeks. Commercial Crude oil stocks (excluding the SPR) fell by 3.4 million barrels to 43 million barrels in the last week of July, which is about 4% below the five year average for this time of year, as mentioned by the US Energy Information Administration.
Shifting gears to currency, the Japanese Yen strengthened against the Dollar over the last month. Contrary to most central banks around the world, The Bank of Japan raised its benchmark interest rates, citing concerns over the historical weakness of their currency. The Yen had fallen to its lowest levels since 1986, which imposed risks of pushing up inflation and hurting growth according to the Japanese Gov. Kazuo Ueda. The effect was a more than 6% weakening of the Dollar vs the Yen in July. Ueda has made it clear that the Bank of Japan won’t hesitate to raise rates in the future if data confirms the economy and prices are moving in line with the bank’s projections.
As mentioned above, Gold has exhibited strong performance in July and throughout 2024. This is slightly unusual given the US stock market has also had a positive year. Historically, Gold is considered a diversifying asset class in that returns are often uncorrelated with markets. In turn, Gold often works well as a hedge against falling markets. However, Gold can also rise in periods of inflation or geopolitical uncertainty. Numerous central banks worldwide have been increasing their Gold reserves in the first half of 2024, which has contributed to the rally. We will be watching Gold closely for the remainder of the year as falling rates could serve as an additional tail wind moving forward.
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