Market Update

August sees markets close strong after tough start

September 03, 2024

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A soft landing for the U.S. economy still appears to be the most likely outcome.

August brought a bit of whiplash for investors.

Markets fell at the beginning of the month, caught in the ripples of an interest rate increase in Japan disrupting a significant currency trading strategy. This led to a brief, intense global selloff.

In the U.S., the incident was aggravated by a weak jobs report with unemployment rising from 4.1% to 4.3% – which remains historically low, it’s worth noting. The report brought the U.S. into Sahm rule territory, a macroeconomic assessment which judges whether the economy is in recession based on unemployment rate increases. Additionally, several disappointing earnings releases created a sense of caution with investors over the health of the consumer.

“However, other data has been stronger, and a soft landing still appears to be the most likely outcome for the economy,” Raymond James Chief Investment Officer Larry Adam said. “For instance, retail sales for July were up a healthy 1% and the Consumer Price Index [CPI] showed that inflation is being tamed with three-month core CPI falling to an annualized rate of 1.6%. And the stage appears set for the Federal Reserve [Fed] to kick off an easing cycle, which should support broader participation and higher equity markets longer term.”

Toward the end of the month, Fed Chair Jerome Powell said “the time has come” for the Fed to adjust policy, a much-anticipated statement for those expecting interest rate cuts this year. Those remarks kicked off an equity market rally, with the S&P 500 ending the month up 2.3% and the Dow Jones Industrial Average hitting an all-time high.

We’ll dive into the details below, but first let’s look at the numbers year-to-date:

*Performance reflects index values as of market close on August 30, 2024. Bloomberg Aggregate Bond and MSCI EAFE reflect August 29, 2024, closing values.

Labor market weakens

The U.S. labor market has weakened, as suggested by data including a major revision of jobs reports spanning April 2023 to March 2024. The Bureau of Labor Statistics lowered estimates by 818,000 jobs, a 29% difference from preliminary estimates. Combined with the inflation rate continuing to decelerate, the weaker jobs numbers made the Fed’s path to lowering interest rates clearer.

S&P 500 rallies, but headwinds remain

The S&P 500 experienced a good rally – up 8% over eight days – affecting a wide range of stocks while volatility indicators remained low. This was supported by reassuring economic data, namely the third consecutive month of sub-0.2% core CPI increases and the uptick in retail sales. Headwinds remain, however, and August and September are typically the softest months of the year for stocks, so further volatility is to be expected.

An interesting dynamic developing in the S&P 500 is the subtle shift in market leadership. Defensive, interest-sensitive sectors like utilities, real estate and health care are at new highs, while the semiconductor group is down.

Treasury yields lower, rate cuts imminent

Treasurys rallied across the curve in August, bringing yields lower. One-year and two-year Treasury yields are down 35 basis points (bps) and 39 bps respectively, while the 10-year and 30-year yields are down 19 bps and 17 bps.

Fed Chair Powell’s statement from Jackson Hole indicated interest rate cuts are coming, with investors expecting two to three 25-bps cuts by the end of the year. Next year could deliver more than 200-plus bps cuts, bringing the yield curve to a more normal, upward slope.

Tech tension escalates

In its simmering trade conflict with China, the U.S. Congress is tightening control over tech exports, especially semiconductors, and seeking international support, particularly from the Netherlands and Japan. Expectations are high for new rules targeting high-performance memory chips while the Commerce Department is considering new restrictions on AI memory chips, which could impact major tech companies’ ability to sell to China.

Oil demand high, despite headwinds in China

Oil prices are down as the summer driving season comes to an end, prompting OPEC to extend production cuts. Global demand is at a record high in 2024, 3% over pre-COVID-19 levels, but is still less than oil producers hoped for early in the year. Among the reasons: China, the world’s largest oil importer, has become the first major economy where electric vehicles have reached 50% of auto sales. Meanwhile, neither the conflict in Gaza nor the one in Ukraine has had any meaningful effect on oil supply.

Japan's economy reveals fragility, UK's shows resilience

The benchmark Nikkei 225 index plunged after the Bank of Japan raised interest rates on July 31, demonstrating the fragility of the Japanese economy and financial markets. While the market has since rebounded, the country’s economy continues to face significant headwinds, including an aging population and low domestic demand.

Bank of Japan Governor Kazuo Ueda defended the decision to raise interest rates, saying the market turmoil had more to do with concerns about the U.S. economy than Japan’s, while Finance Minister Shun’ichi Suzuki argued that higher interest rates could be detrimental to the Japanese economy.

The UK economy is showing some resilience, with a 0.6% growth in GDP in the second quarter and a strengthened pound sterling. With inflation slightly above its 2.2% target, the Bank of England cut interest rates by 0.25% to 5.00% – the first cut since the start of the pandemic. However, Finance Minister Rachel Reeves discovered a £22 billion shortfall in next year’s budget, which, along with pressure to increase wages in the public sector, could have a negative effect on inflation and economic growth.

The bottom line

As we remain in the weakest seasonal period of the year, investors may expect to see some back-and-forth trading ahead. Economic data and actions from the Fed will remain key influences to watch.

Investing involves risk, and investors may incur a profit or a loss. All expressions of opinion reflect the judgment of the Raymond James Chief Investment Officer and are subject to change. There is no assurance the trends mentioned will continue or that the forecasts discussed will be realized. Past performance may not be indicative of future results. Economic and market conditions are subject to change. The Dow Jones Industrial Average is an unmanaged index of 30 widely held stocks. The NASDAQ Composite Index is an unmanaged index of all common stocks listed on the NASDAQ National Stock Market. The S&P 500 is an unmanaged index of 500 widely held stocks. The MSCI EAFE (Europe, Australasia and Far East) index is an unmanaged index that is generally considered representative of the international stock market. The Russell 2000 is an unmanaged index of small-cap securities. The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. An investment cannot be made in these indexes. The performance mentioned does not include fees and charges, which would reduce an investor’s returns. Investing in the energy sector involves special risks, including the potential adverse effects of state and federal regulation, and may not be suitable for all investors. A credit rating of a security is not a recommendation to buy, sell or hold the security and may be subject to review, revision, suspension, reduction or withdrawal at any time by the assigning Rating Agency. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Income from municipal bonds is not subject to federal income taxation; however, it may be subject to state and local taxes and, for certain investors, to the alternative minimum tax. Income from taxable municipal bonds is subject to federal income taxation, and it may be subject to state and local taxes. Investing in commodities is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising. International investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. The companies engaged in the communications and technology industries are subject to fierce competition and their products and services may be subject to rapid obsolescence. The Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Studies. The Leading Economic Index (LEI) provides an early indication of significant turning points in the business cycle and where the economy is heading in the near term. This is not a recommendation to purchase or sell the stocks of the companies pictured/mentioned. Investing in small-cap stocks generally involves greater risks, and therefore, may not be appropriate for every investor. The prices of small company stocks may be subject to more volatility than those of large company stocks. The Nikkei 225 is a stock market index is for the Tokyo Stock Exchange (TSE). It is the most widely quoted average of Japanese equities. Sector investments are companies engaged in business related to a specific sector. They are subject to fierce competition and their products and services may be subject to rapid obsolescence. There are additional risks associated with investing in an individual sector, including limited diversification.

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Putting the recent equity weakness into perspective

August 02, 2024

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Raymond James CIO Larry Adam reminds investors that market narratives tend to fluctuate dramatically, and to look at fundamentals in determining your economic and financial markets outlook.

To view the full article in PDF format, see the Thoughts on the Market publication linked below.

Summer volatility is not unusual, especially on summer Fridays that have major economic releases that challenge the market narrative. In this case, recent earnings and economic releases have questioned the soft landing, no recession outlook with fears of a recession becoming top of mind. Before we give you our perspective on the economy and equity market sell-off (down 6% from recent highs), we remind investors that the market narrative tends to fluctuate quite dramatically – remember in January when the market was pricing in seven Federal Reserve (Fed) rate cuts this year, and then just a few months ago, many were wondering if the Fed would cut at all this year. The point: take the market narrative with a grain of salt and look at the fundamentals in determining your outlook for the economy and financial markets. We ultimately believe this soft patch of data will prove to a be a ‘growth scare,’ not a ‘recession reality.’ Below are our thoughts:

A 'growth scare' in the making?

The soft payroll report (114k jobs created in July) on the back of weak manufacturing data yesterday has triggered a strong market reaction (in both stocks and bonds) as the market starts to worry that the Fed is behind the curve and that a recession will result. We would caution our readers to not overly react to any one number. Yes, the labor market has clearly decelerated in recent months and consumer spending is slowing, but we have been anticipating this weakness given the Fed’s restrictive policy stance for some time. In fact, our economist has been forecasting a sharp deceleration in growth in 2H24 (Q3: 1.0%, Q4 0.8%) as the consumer slowdown and labor market normalization become a near-term drag on growth. However, we do not believe a recession is on the horizon because the job market, while weakening remains in good shape (the unemployment rate is rising because more workers are entering the labor force, not because of rising layoffs), corporate spending (i.e., tech-related spending) is healthy, and government spending (via the CHIPS/IRA Acts) should offset any slowdown we see from the consumer.

We have been calling for the Fed to start dialing back some of its policy restraint as overly restrictive policy was no longer warranted. While the Fed has been trying to thread the needle with the timing of its first rate cut and perhaps missed an opportunity to kick off its easing cycle this week, a rate cut is coming. The bond market is already doing the work for the Fed – Treasury yields are sharply lower (2Y and 10Y Treasurys are at 52-week lows) and this will drag mortgage rates and small business borrowing rates lower as well – providing much needed relief to the sectors of the economy that are hurting.

The market has quickly moved to pricing in over four rate cuts by year end, signaling to the Fed that they need to move policy rates lower or risk a recession. While the Fed does not like to surprise the market and policymakers have suggested it needs to see ‘more good data’, we still believe the Fed will do what it takes to avoid a recession (i.e., the ‘Fed Put’). Our economist’s base case is two cuts – in September and November, but he believes the Fed is flexible. Two other scenarios are: if next month’s jobs numbers come in weak, it could cut 50 bps at the September meeting. If economic data deteriorates further sooner, it would not be unprecedented to see the Fed move intermeeting if the data warrants.

Putting the recent equity weakness into perspective

Pullbacks in the market are never comfortable. But this current drawdown is part of a normal functioning market. As the S&P 500 moved above our year- end target of 5,400 we had turned more cautious. Our concerns were driven by five key factors:

1. Bad news would become bad news | While 2Q GDP figures suggested that economic growth was healthy, forward-looking indicators (e.g., labor market softness, companies highlighting a slowing consumer, housing weakness) suggested that the economy was weakening. A slowing economy would likely lead to downside for earnings estimates and forward-looking guidance. We have seen that occur with earnings disappointments from McDonald’s, Procter & Gamble, and Wayfair.
2. Valuations | A lot of good news was priced into the market, with the S&P 500’s trailing P/E trading in the 93rd percentile. Any economic or earnings disappointment would likely lead to increased volatility. We have seen that with both economic and earnings releases, particularly this week.
3. Investor over optimism | Investors had gotten overly complacent. The % of bullish investors rose above 50%, a level that has historically led to negative short-term future performance.
4. Historical precedent | The market typically experiences 3-4 5% pullbacks on average and a max intra-year drawdown of 13%. Up until this most recent pullback, the market had only experienced one pullback year-to-date with a max drawdown of ~5%. Greater volatility is not unusual.
5. Negative seasonality | While the S&P 500 has been up each of the last 10 Julys, August and September have been the two worst-performing months on average. The open election (two non- incumbent candidates) provides an additional wrinkle to this, as the S&P 500 has been down on average in the 100 days leading up to election date.

What is the equity price action telling us?

Currently, the equity market is acting as expected with a ‘growth scare’ serving as the catalyst for the drawdown.

• Volatility has increased, but there has not been any panic-driven broad-based selling.
• At this juncture, defensive sectors (e.g., Consumer Staples, Health Care, Utilities) are outperforming whereas some of the more cyclical sectors are feeling more pressure.
• Consumer Discretionary, which is now negative year-to-date, has seen downward pressure which is consistent with the weakness seen in consumer-related economic data.
• Small-cap equities, which are levered to domestic economic growth have had a bigger decline than large-cap (S&P 500) stocks.
• Energy stocks have sold off as oil prices have fallen toward $73/barrel as growth concerns mount.

As a result, much of this market reaction is consistent with a slowing economy and it is not disorderly. That is why we view this pullback as a normal reaction and consistent with our economic forecast (i.e., weak 3Q & 4Q GDP) and year-end S&P 500 target (5,400).

So where do we go from here?

We use our equity target as a guiding light for the direction of the market. When the market moved above our 5,400 price target, we turned more cautious. From a technical perspective, when the market is in an up-trend and breaks through its 50-day moving average to the downside, it tests its 100-day moving average 77% of the time (currently 5,308) and 200-day 44% of the time (currently 5,008). Interestingly, the S&P 500’s 100-day moving average has been a key level of support in recent years and will be a level many technicians will focus on in the near term. Going forward, we expect the recent weakness to continue as the market digests the slowing economic activity and the impact on earnings. Keep in mind, the average max intra-year drawdown (13%) would bring the S&P 500 down to around the 200-day moving average of ~5,000. While we may not get to that point, we do expect uncertainty around the economy, earnings, and the upcoming election to lead to further volatility – consistent with seasonal patterns exhibited over the last 50 years. However, we reiterate our year-end target of 5,400 and would get progressively more positive on the equity market if we see more downward pressure (Read: Buying opportunity). The reason: we do not expect a recession, just a soft patch in the economy. Assuming that is the case, earnings should continue to move higher into next year and this young bull market should continue its path higher.

For fixed income, with the 10-year Treasury yield below our 4.0% year-end target, we would be cautious to extend duration here given the sharp rally that we’ve seen in recent weeks (particularly with yields in overbought territory) and the exuberance priced into the Fed’s expected interest rate path given this recent growth scare. We have been on this roller coaster ride before, and the market could be getting ahead of itself given the outsized moves we’ve seen this week with yields. However, we would look for opportunities to deploy cash and cash equivalents as the timing of the Fed’s rate cut nears.

Read the fullThoughts on the Market

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Small-cap stocks bolstered by possibility of interest rate cuts

July 31, 2024

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While election news dominated July's headlines, small-cap stocks had their best monthly performance relative to large-cap stocks since December 2000.

Election news dominated headlines through July and culminated in President Joe Biden declining to seek a second term, instead endorsing Vice President Kamala Harris as the Democratic Party’s candidate. The markets don’t particularly like uncertainty, but the turbulence that followed this commotion is not likely to linger as more fundamental market forces play out.

“Politics is only one of ten factors in our equity outlook framework and in fact, it ranks pretty far down the list,” said Raymond James Chief Investment Officer Larry Adam. “Macro factors and fundamentals are much more important in determining the market’s direction.”

The market’s expectations have been on a rollercoaster regarding the Federal Reserve (Fed) cutting interest rates this year, but with inflation receding and consumer spending beginning to slow, lower rates seem finally in sight. This has bolstered small-cap stocks, which had their best monthly performance in July relative to large-cap stocks since December 2000*.  

Historically, small caps outperform in anticipation of and following a first rate cut, and this rally is supported by improvements to corporate earnings. Earnings are on track to rise 10% year over year, turning in the best quarter since the fourth quarter of 2021. Real estate and utilities were the best performing sectors. Tech-related sectors underperformed.

Bond yields were lower across the board, led by shorter-term securities, as markets priced in the likelihood of a rate cut.

Employment remained strong in June, with the establishment employment survey showing jobs increasing by 206,000, but the unemployment rate – which comes from the household survey – inched up to 4.1% from 4.0%.

We’ll dig into the details below, but first we’ll look at the numbers year-to-date: