Macro
This week, we had normalization of the macro numbers, with GDP revised upward, an uptick in consumer sentiment alongside a slight rise in the Personal Consumption Expenditures (PCE) index. This week’s key economic releases included:
- US GDP (Q2): Revised upward to 3.0% (annualized rate) from a prior estimate of 2.8%. The upward revision was mainly driven by stronger consumption, revised up to 2.9% from 2.2%.
- PCE Inflation (July): The market’s attention shifted to consumer spending, which increased by 0.5%, while the personal saving rate dipped to 2.9%. Core PCE came in slightly below expectations at 2.6% year-over-year (y/y). This is after a 0.2% month-over-month (m/m) increase.
- Weekly Jobless Claims: Remained low at 231k, indicating ongoing labour market strength.
- Conference Board Consumer Confidence (August): Expectations rose to the highest level in a year, signalling improved sentiment.
The GDP growth estimate for Q2 nearly doubled the Q1 estimate. This strength was primarily driven by consumer spending and business investments, which continued to show momentum. On the other hand, GDI only increased by 0.31% in the same period, signalling that income growth (wages, profits, and other earnings) hasn’t kept pace with output and that economic expansion hasn’t directly translated into worker benefits.
Regarding consumer spending, real spending in the U.S. increased by 0.4% in July, while real disposable income grew by only 0.1%. The personal savings rate has fallen to less than half of its 2019 level, with pandemic-era savings nearly depleted and consumer loan delinquencies on the rise. This situation suggests that the savings rate will need to increase, causing consumption growth to lag behind income growth. Compounding this is the slowdown in wage growth and the expectation that employment growth will weaken further, potentially pushing the economy toward “stall speed” more rapidly than anticipated.
Although there is resilient spending in some sectors like travel and entertainment, consumer-facing companies voiced their concerns about the strength of the consumer during the last earnings season calls. The key issue was affordability with the demand shift towards value-focused offerings. As inflation-elevated prices are challenging households, there is a notable division between higher—and lower-income cohorts, with the latter facing more significant financial strain.
The recent job market data, including payroll figures, the unemployment rate, and various surveys, indicate a softening labour market. The unemployment rate is a mean-reverting indicator, meaning that once it begins to rise, it often escalates rapidly. In nearly every instance, a sharp increase in the unemployment rate has coincided with a recession. The unemployment rate has never spiked so rapidly without the economy entering a recession. Although unemployment soared to trigger the “Sahm rule“, the recent increase in unemployment is partly inflated by the influx of new entrants and re-entrants into the labour force.
The upcoming U.S. jobs report (Nonfarm Payrolls, released next Friday, 06/09/2024) will be a key input for the FED decision and the most important economic data release ahead of the FED’s September meeting. Current expectations are that unemployment will drop from 4.3% to 4.2%, and job gains will rebound from 114k for July to 165k for August.
| Prior | Estimate | |
| Nonfarm Payrolls | 114k | 165k |
| Unemployment Rate | 4.3% | 4.2% |
| Hourly Earnings MoM | 0.2% | 0.3% |
| Hourly Earnings YoY | 3.6% | 3.7% |
Rates
Despite recent macroeconomic data suggesting that the U.S. economy is holding steady, the market is pricing in over three rate cuts for the remainder of this year, equivalent to around 75 bps. Current projections suggest that the Fed funds rate could fall 200 bps to 3% by the end of 2025. This prices a lot of cuts. However, the historical average reduction during past economic downturns is 400 bps. This week, the 2-year Treasury yield declined 10 basis points (bps). However, we’ve seen some increases on the longer end of the curve.
The Treasury’s role is to minimize debt payments for taxpayers, and it is now responding to a massive demand for short-term debt by issuing more Treasury bills (T-bills). Demand is coming from various places. First of all, institutional investors, including banks, insurance companies, and pension funds, are heavily purchasing T-bills as part of their liquidity management strategies. Second, corporations park cash safely while earning the highest returns in 20 years. Third, there is demand from governments and central banks as a part of reserve management. Fourth, recent high yields have increased the share of T-bills bought by retail investors, who now have easier access to T-bills via new fintech initiatives. Finally, the elephant in the room – Money Market Funds. These funds are among the largest buyers of T-bills. Due to regulatory requirements, such as the SEC’s Rule 2a-7, money market funds are required to hold high-quality, short-term debt instruments, making T-bills an ideal fit. Record inflows into money market funds, driven by investors seeking safety and liquidity, have significantly boosted demand for T-bills.
Heavy demand for short-term Treasuries is absorbing much of the supply that the Treasury issues. As a result, yields on these short-term securities are expected to continue declining. This could eventually weaken demand, prompting the Treasury to shift more of its issuance to the longer end of the curve, where issuance has been relatively light but well-absorbed by investors.
This week, the Treasury auctioned $183 billion in 2-, 5-, and 7-year notes, achieving an average bid-to-cover ratio of 2.53 and the lowest yields seen this year. Despite limited long-term issuance, buyers have readily absorbed these auctions.
The FED is behind the curve and already decided on rate cuts. Furthermore, the economic slowdown is in motion, and regardless of the election results, we will see weaker growth numbers early next year. This, in turn, should prompt the FED to make further cuts. As the short-term rate declines, investors may eventually shift away from T-bills in search of higher returns elsewhere, leading to adjustments in Treasury issuance and further impacts on the bond market.
Credit
The issuance of investment-grade (IG) bonds has been relatively low compared to the strong demand from investors looking to lock in higher yields. For September, IG bond issuance is expected to reach $125 billion, consistent with last year’s levels but about 27% lower than the September volumes seen during 2019-2021.
As of this week, IG bonds are trading with a spread of 94 basis points (bps) over Treasuries, while high-yield (HY) bonds are priced at 308 bps. Despite overall resilience in economic data and the credit market, the lower-rated CCC and distressed segments continue to lag.
While credit investors find the current spread levels very tight, they agree that the total yield looks attractive. This results in high aggregate demand as investors seek attractive yields across the rates and credit markets. Much of the unmet demand from Treasury auctions has shifted toward top-quality IG credit.
This strong demand for credit pushes credit buyers further up the risk spectrum. Many cross-over investors, who missed out on the 6% yields available from high-grade bonds last year, are now beginning to move into high-yield (HY) BB-rated bonds. This shift has increased demand in the high-yield market, particularly for higher-quality speculative-grade debt. As a result, spreads have remained anchored at historically low levels, reflecting the market’s ability to absorb risk while offering attractive returns to investors. This demand dynamic keeps spreads compressed, even as credit risk rises slightly further up the spectrum.
This persistent demand quickly absorbs any market volatility that causes spreads to widen. Corporate fundamentals remain strong, with ongoing upgrades from HY to IG, although slower than the post-COVID recovery in the past 12-24 months.
The outlook for HY BB-rated bonds remains stable when looking for opportunities, with minimal risk of balance sheet deterioration or widespread downgrades. As a longer-duration segment in the HY market, it could also benefit from anticipated rate cuts by the Federal Reserve.
Equities
This week, financial conditions became more supportive as inflation continued to ease and market expectations for Federal Reserve rate cuts grew. The prevailing market view is a “soft landing” scenario, where the Fed could cut rates without triggering significant economic deterioration. Despite this optimism, market sentiment remains cautious, with persistent fears of an impending recession.
The S&P 500 ended the week nearly flat, closing at 5,648.40 points, slightly up from last Friday’s close of 5,634.61, sustaining a 17.5% year-to-date gain. It also closed August with a 2.3% gain despite a volatile start to the month, triggering a 6% pullback. In contrast, the NASDAQ fell 92 basis points this week, closing at 17,713.63 points, primarily due to weaker performance in the tech sector, dragged down by market reactions to Nvidia’s earnings.
In terms of earnings, the “Mag-7” group posted a robust 19% growth in the second half, compared to just 5% for the remaining 493 S&P 500 constituents. Analysts anticipate the rest of the index will gradually close this gap, reducing the market’s dependence on tech earnings. However, overall earnings growth for the S&P 500 was 14% year-over-year in Q2, with forecasts predicting a slowdown to 5% growth in Q3.
Small-cap stocks continue to present a valuation opportunity, with the potential for significant upside if a catalyst—such as substantial rate cuts—emerges. However, caution is warranted, as small-caps, being more pro-cyclical, could be vulnerable in a “hard landing” scenario.
Rate-sensitive sectors like real estate and utilities benefited this week from the anticipation of rate cuts, while growth sectors, particularly technology and consumer discretionary, faced headwinds. The housing market remains under pressure as new construction contracts and permits decline, indicating that higher interest rates are still affecting residential activity.
Historically, August and September are known for their market volatility, with September being particularly negative, especially in election years. The VIX is currently at 15, suggesting that options are relatively inexpensive, so investors might consider hedging by purchasing puts.
Investors concerned about a potential recession may consider positioning in more defensive sectors, such as utilities, consumer staples, and healthcare. Real estate also presents a relatively safe option, with reasonable valuations and the potential to benefit further from rate cuts.
Despite these concerns, investors remain cautiously optimistic. However, the medium-term outlook is clouded by rising unemployment risks and slowing wage growth, which could affect corporate earnings and overall economic activity in the coming months. The probability of a recession by early 2025 remains high, making defensive positioning advisable.
While markets have priced in a soft landing, underlying economic risks persist, and the likelihood of a recession increases while we are in the cyclically-negative part of the year. Therefore, a more cautious investment stance is recommended.