Macro
This week’s macro focus was on U.S. unemployment, non-farm payrolls, and the impact of the Bank of Japan’s decision to hike rates to 0.25%, covered in the rates segment. Let’s start with the key numbers for the U.S. labour market:
- U.S. unemployment has risen significantly to 4.3%, 20 basis points (bps) above the expected rate of 4.1%.
- This sudden 20 bps increase in unemployment has triggered the Sahm Rule, historically an early indicator of a recession.
- July non-farm payrolls grew by only 114,000, well below the 175,000 estimate. This number is slightly above 100,000, considered the rough estimate of the neutral replacement rate for the U.S. economy. Additionally, June’s payroll numbers were revised downward from 206,000 to 179,000.
- JOLTS job openings moved lower but remained above expectations.
To put those numbers in context, according to the FED’s Statement of Economic Projections, the neutral employment rate is 4.1%. Given the Fed’s tight policy stance, unemployment is expected to rise above this neutral rate. This increase also pressures the Fed to take action on the employment side of its dual mandate. also pressures the Fed to take action on the employment side of their dual mandate.
FFriday’s miss in non-farm payrolls and the spike in unemployment have deepened concerns about economic growth and the risk of a recession. The higher expectations for rate cuts were insufficient to offset the negative impact of the weak jobs data, leading investors to adopt a “bad news is bad news” narrative.
Following the jobs report, investors are concerned that the Fed may be too late to cut rates, leading to anxiety about two primary risks:
- Growth scare
- Policy mistake
The Fed has observed multiple months of cooling inflation, including in the most persistent areas, such as housing and services. Now, the Fed sees signs that the labour market is also cooling, although there are fewer data points than inflation. Although the Fed has not explicitly confirmed a rate cut for September, recent meetings have been interpreted as increasingly dovish. The reasoning behind this shift is a growing focus on the employment aspect of the mandate, acknowledging recession risks, and striving for a more balanced dual-mandate approach.
As the U.S. economy cooled more than expected in July, discussions emerged about the Fed potentially being ‘behind the curve.’ On one hand, this could prompt an emergency rate cut before September or a faster pace of cuts. On the other hand, either an emergency cut or a 50 bps ‘jumbo cut’ could further increase anxiety about the strength of the U.S. economy.
Growth in nominal U.S. Core Retail Sales has decelerated from over 9% in 2022 to sluggish growth below 4%. Weakening top-line growth, combined with sticky labour costs, is starting to put pressure on retail net margins.
Investors increasingly worry that the Fed, walking a very fine line, might wait too long to implement the planned rate cut in November, potentially increasing the risk of a recession. Jerome Powell was very precise in his remarks, reading most of his statements and providing some answers from a pre-prepared script. This highlights his need to thread the needle and navigate market expectations carefully.
Although the recent GDP growth number was revised higher, it is expected to cool in the second half of the year as above-trend, credit-supported consumption slows. Thursday’s jobs report further confirmed the ongoing deterioration in economic data. Forecasted unemployment is also expected to rise, and the increase in credit card delinquencies and small business defaults raises concerns about the future economic outlook.
Rates
The U.S. rates market experienced its most significant moves this week since the SVB collapse. The 2-year yield dropped 45 basis points (bps) this week, including a 20 bps decline on Friday alone, driven by weak economic data that fueled a bond rally.
While all yields declined this week, the 2-year and 10-year spread reached its least inverted level over two years. The futures market predicts a 70% chance of a 50 bps rate cut in September. From a political perspective, there is little impact as both presidential candidates favour rate cuts. On Wall Street, the conversation has shifted from concerns about a slowdown and increased recession risks to calls for immediate action from the Fed, with widespread criticism of any delays in rate cuts. Although the Fed’s decisions are independent, they have widespread support from both the government and the markets, with nearly all participants now favouring rate cuts.
However, this week’s primary focus of the rates market was Japan’s unexpectedly high interest rate hike. The Bank of Japan (BoJ) raised rates to 0.25%, causing volatile reactions in global F.X. and equity markets. Following the BoJ’s decision, Japan’s main index, the Nikkei 225, dropped 2.5% on Thursday and 5.8% on Friday. The yen strengthened this week, pushing the dollar index down by 1%.
Investors are carefully watching the rates market’s reaction to the BoJ’s decision, as this could have implications for the unwinding of the yen carry trade and potential ripple effects in other markets.
Credit
Market turbulence has also added to perceived risk in the credit market. Spreads remain historically high, but the average blue-chip credit spread has widened by 7 bps to the highest level since November. History suggests that this reflects some adjustments and an increased probability of economic slowdown, but it’s far from pricing any significant probability of recession. Some of the stress might be seen in junk bonds, where the sensitivity of spreads to trading volume has increased. Based on little change in trading patterns in the U.S. credit market, the market does not seem to flag any financial stability issues.
The bankruptcy costs have increased significantly, and companies frequently look for alternatives. What helps them are weak covenant protections, especially in the leveraged loan market, which is now over 90% ‘covenant-lite’. This results in more companies taking advantage of the lax loan documentation and restructuring debt through LMEs (Liability Management Exercise) rather than going bankrupt. Estimates suggest that the default rate would double if we added distressed LMEs with the number of defaults.
In the private credit space, the ‘capital solutions’ strategies are gaining momentum. These strategies rely on a deep understanding of the legal landscape, aggressive negotiation tactics, and a willingness to take on significant risks. As these manoeuvres often lead to legal battles, funds applying these strategies understand how to restructure a company’s debt to favour their position.
Equities
Thursday’s release of the jobs data has led to a sharp decline in stock prices. Unique for this week was the systematic pressure and technical impact on the selloff coming from the unwinding of the yen carry trade.
The NASDAQ 100 faced the biggest reversal since the start of 2022 and dropped 3.4% to below the 18,500 level this week and 10.8% since the peak on July 10 close. The Broader NASDAQ Composite Index fell 3.4% this week, just over 10% from its peak, putting it in correction territory. Equally Weighted S&P outperformed the Market Cap weighted version.
U.S. mega-cap tech was mostly lower following weak earnings from Amazon (8% decline despite positive AWS results) and Microsoft (3.9% decline). Meta was the only cohort member reporting an increase in net income by 4.8% on the back of an A.I. tailwind as its early move of Capex from Metaverse to A.I. started paying off. From a Sector perspective, we had outperformance of Utilities(4.29%), Real Estate (+2.78%) and Communication Services (+1.26%), and underperformance of Consumers discretionary (-4.28%, Technology (-4.03%) and Energy (-3.75%).
The decline in stock prices and yields signifies that fears of recession outweigh the benefits of expected rate cuts. In other words, bad news for the economy is now bad news for the markets. U.S. aggregate investable funds (households and investment firms) as a percentage of U.S. Equity and Bond Market Value has now declined to a record low. Only a little ‘dry powder’ is left to buy equities. This is despite the low opportunity costs, as money-market funds until last week offered above 4% rates.
S&P is also coming down from historically extended momentum levels. Historically, a decline in extreme momentum reading tends to swing from one extreme to another. While the U.S. stock market is coming off its highs amid the weakening labour market, the S&P 500 still looks expensive based on P.E. ratios, equity risk premiums or discounted future earnings. Some calculate that the S&P 500 has come off the highest premium to its NPV (Net Present Value) since 2020. The Buffet Indicator is also running hot, as the total market capitalization of the U.S. equity market is now at 185%, which is lower than in 2021 when it almost reached 200%.
We are now through two-thirds of the earnings cycle. 75% of companies have already reported this earning season and took the S&P 500 blended YoY earnings growth rate to 11.5%. However, the proportion of companies that beat revenue estimates has been the lowest since 2019. Many disappointing earnings announcements from this week were explained by pointing to the weak consumer. Another interesting finding from the earnings calls is that we recorded the highest number of “The FED” mentions this quarter. This means that companies are worrying about restrictive monetary policy. Also, this highlights companies’ fear that the FED might be behind the curve again (they were late to hike in 2020, and now they are late to cut).