Macro
In July, headline and core CPI eased for the fourth consecutive month, with year-over-year rates dipping to 2.9% and 3.2%, respectively. The 3-month moving average fell to an annualized 1.58%, its lowest point over three years. However, the overall CPI drop was largely driven by a sharp 2.3% decline in used vehicle prices—a trend unlikely to persist. Meanwhile, “super core” inflation, excluding shelter costs, increased by 0.1% after being flat in June, while shelter inflation accelerated to 0.4% from 0.2%.
On the other hand, July retail sales provided an unexpected boost, growing by 1.0% month-over-month, significantly outpacing June’s 0.2% contraction and beating forecasts of a 0.4% increase. Vehicle and parts sales surged by 3.6%, driving broader retail growth. However, the retail sales control group, a key GDP input, slowed to 0.3% from 0.9%.
Despite resilient retail sales, the labour market is showing signs of strain. Unemployment is now 80 basis points above its cycle low in April 2023, raising concerns about the potential for a consumption-induced recession by late 2024 or early 2025. While the recent increase in unemployment has been partly attributed to immigration, layoffs have also played a significant role.
Over the past three weeks, markets have experienced high volatility, swinging with each new macroeconomic data point. We saw a sharp de-risking following the Bank of Japan’s rate hike, a growth scare after the U.S. labour market report, and a normalization following strong retail sales. With inflation concerns easing, markets are now adjusting their expectations, with a 25 basis point rate cut in September seeming likely, though this could increase to 50 basis points depending on upcoming labour market data.
Consumer confidence has risen despite increases in real rates, and while the Financial Conditions Index from Goldman Sachs shows easing conditions, the U.S. Economic Surprise Index remains negative. The Fed is at a critical juncture, needing to balance its response to rising unemployment and slowing economic growth. As the Producer Price Index (PPI) declined, housing remains a key factor preventing a rapid drop in inflation. However, this week’s data indicated that housing activity is starting to decline, with mortgage rates down 80 basis points since October 2023, yet housing starts and permits disappointed in July, falling 6.8% and 4% month-over-month, respectively.
In summary, while inflation worries have diminished and growth expectations have cooled, the labour market’s rapid deterioration remains a focal point. As the risks associated with rising unemployment and potential recession continue to grow, the Fed may need to be less data-dependent and more forward-looking. Investors should prepare for further volatility, with the August jobs report being the next critical data point to watch.
Rates
After the volatility shock, interest rates have started to edge back up from their recent lows, though the middle of the yield curve remains below 4%. The 2-year Treasury yield ended the week at 4.05%, just 10 basis points shy of where it stood before the weak July jobs report, which triggered a shock in the rates market. Since bottoming out at 3.65% on August 5, the 2-year yield has rebounded by 40 basis points, or 10.9%. Meanwhile, the 5-year yield, now the lowest point on the curve, sits at 3.75%, a notable drop from three months ago when yields on maturities from 5 to 10 years were around 4.45%.
Yields have trimmed last week’s declines, pushing Treasuries lower, which is in line with recent rate expectations. The 2-year/10-year spread, which briefly reinverted to +1.5 basis points on August 5, has returned to inverted territory, declining by 6 basis points this week to -17 basis points. As the FED has yet to start cutting rates, the 3-month/10-year spread remains deeply inverted, finishing the week at -133 basis points after a 5 basis point decline. In context, during recent yen carry trade turmoil, the 3-month/10-year spread reached -153 bps. Year low was on February 2 at -155bps, and the cycle low was -199.6 basis points on May 4, 2023.
Market expectations for Fed rate cuts have also shifted. Following this week’s robust retail sales and consumer confidence reports, the Fed has gained more flexibility to adjust its pace of monetary policy. Two weeks ago, after the jobs report, the market rapidly adjusted, pricing in aggressive and swift rate cuts, with some even predicting a 50 bps jumbo cut or an inter-meeting emergency cut before September. Now, the market has significantly pulled back on those expectations and is now pricing less than 100 bps cuts.
The appetite for locking in attractive duration remains strong, suggesting a continued downward bias in yields. Last month, the 4.50%-4.75% range was seen as attractive for extending duration. However, with the job market weakening, economic growth slowing, and the first-rate cut approaching, the new attractive range is expected to be 4.00%-4.25%.
The challenge remains the negative carry resulting from the inverted yield curve, leading to a negative roll-up. Over the past two years, the U.S. dollar and bond yields have been tightly correlated. However, the traditional correlation between bonds and equities has recently broken down.
Regardless of how many rate cuts occur, the outlook for bonds remains bullish. The immediate market reaction to recent reports saw the 2-year yield rise by 12 basis points and the 10-year by 9 basis points, reflecting the ongoing adjustment to the evolving economic landscape.
Credit
Credit markets in August are strong despite the typically slower sales volumes associated with the month. This week, U.S. investment-grade (I.G.) volume reached $29 billion, hitting the high end of the forecasted range, though slightly lower than the $30-40 billion seen in previous weeks. Similarly, U.S. high-yield (H.Y.) issuance was strong, with $17 billion in volume as junk bond yields dropped to a new yearly low of 7.53%.
After a volatility shock and rapid spread widening at the start of the month, the credit market regained confidence. I.G. spreads have narrowed back to 96 basis points, while H.Y. spreads finished the week at 322 basis points. These tight spreads indicate that the market is pricing in a soft landing and anticipates relief from the high costs of capital, driven by expected easing from the FED.
However, as the economy slows, idiosyncratic risks are beginning to emerge in the lower-quality segments of the market. With no particular area of credit appearing especially cheap, investors gravitate towards higher-quality assets. Collateralized loan obligations (CLOs) have become popular, offering more attractive yields relative to their risk profiles.
Another critical development in the credit market has been the narrowing spread between U.S. and European yields. Over the past month, the wide yield differential made European credit markets particularly attractive. However, this gap has been steadily converging and is now close to its relative fair value, reducing the arbitrage opportunity for investors.
Credit activity has started to pick up in retail markets, adding another layer of support. Following the tightening in August, investment-grade and high-yield spreads have returned to levels seen before the July Employment Situation report, suggesting a normalization of market conditions.
Credit activity is picking up in retail markets, and both I.G. and H.Y. spreads have returned to pre-July Employment Situation report levels, indicating a normalization of conditions. Meanwhile, the U.S. Dollar Index (DXY) has hit its lowest point of the year.
Equities
This week, they marked a normalization in global equity markets after the turbulence caused by the Bank of Japan’s rate hike and the growth scare related to rising unemployment. Investors sentiment was improved by July retail sales, improving consumer sentiment, and lower inflation expectations. Fear has subsided, and the VIX dropped significantly, significantly reducing volatility and potential systematic buying. Markets have rebounded strongly, particularly in the U.S., where the S&P 500 and Nasdaq are breaking a four-week losing streak and posted their best weekly performances since November 2023. Market Cap weighted index outperforming the S&P 500 Equal Weight index.
The comeback was largely driven by mega-cap tech winners, with standout performances from Nvidia (+18.9%) and Tesla (+8.1%). Other winners include Walmart (+8.1%), which reported solid earnings and raised its full-year guidance, and Starbucks (+26.3%), which announced that it was replacing its CEO. After announcing that Brian Niccol, the former CEO of Chipotle, would take over, Starbucks’ shares jumped 26%, the largest single-day gain in the company’s history. From a sector perspective, we saw strengths in semiconductors, large-cap banks, regional banks, and consumer staples.
Small-cap stocks also turned positive, though to a much lesser extent, as investors remain cautious after the July rally reversed. Despite this, small caps are in an extremely attractive position from a macro, technical, and fundamental perspective. Valuation-wise, small caps are trading at roughly 10x forward P.E. ratios, a significant discount to large caps, and continue to show earnings growth. Technically, they are in a rare multi-year consolidation, which typically ends abruptly. From a macro standpoint, small caps are highly sensitive to changes in interest rates and will be a major beneficiary of the expected rate cuts, which could catalyze the rally. However, the small-cap universe carries more idiosyncratic risks, including many highly leveraged “zombie” companies with little growth. Investors need to conduct thorough due diligence to avoid value traps.
In contrast, Chinese equities continue to experience an exodus of foreign investors, exacerbated by a production slowdown, broader economic concerns, and geopolitical tensions’ impact. Despite this, notable investors like Michael Burry, the legendary figure from the GFC known for “The Big Short,” have increased their exposure to Chinese e-commerce stocks. In Q2, Burry raised his stakes in Alibaba Group and Baidu, per F13 filings. Despite slowing growth from double digits to low single digits this year, Alibaba is expected to grow at high single digits over the next few years. The stock trades at historically low valuations, having just recovered from its lowest multiples ever, and remains one of the most heavily shorted Chinese stocks.
Overall, this week was positive for all indexes, but the market’s optimism was primarily concentrated in the tech sector. While the rally in small caps shows potential, the broader market remains cautious, especially with the ongoing uncertainties and the mixed economic signals from the U.S. However, the expectation of upcoming rate cuts provides a strong underpinning for future gains, particularly in interest rate-sensitive sectors.