Macro
Powell’s comments at Jackson Hole on Friday and BLS payrolls benchmark revision on Wednesday were the week’s highlights. Jackson Hall symposium is vital as the central bankers from around the world will discuss progress on the inflation front, which was a global phenomenon this time. Since inflation is no longer a primary concern while the restrictive effects of higher rates continue to dampen economic activity, the global tightening cycle is ending. The difference between geographies is in growth dynamics, with most economies lagging the U.S. Europe is particularly problematic with its weak growth, high unemployment, and sticky service inflation.
As the FED recognizes that prices are on the path sustainably downward, everyone is preparing for the FED pivot. Powell said, “The time has come for the policy to adjust”. They mentioned expecting inflation to reach 2% while maintaining a solid labour market is reasonable. Inflation has now fully taken a backseat, and jobs are currently the most important economic variable for the market. Fed will indicate it is nearing a phase of easing while refraining from making any explicit policy commitments and emphasizing the ongoing reliance on data.
The consumer and the job market are currently propping up the economy, but there are signs of vulnerability. The latest job report was weak, though still cheerful. However, if unemployment rises significantly, consumer spending could decline, leading to a scenario where “bad news is bad news” for the market. Notably, over half of the recent increase in unemployment is due to job losses, while more than a third is attributed to new entrants and re-entrants returning to the labour force. The increase in unemployment is inflation due to the U.S. population surge of 7 to 15 million people over the last four years, which complicates assessments of labour supply and makes interpreting the unemployment rate more challenging. This influx has contributed to a rate of unemployment increase that is twice the historical average when Sahm’s rule was triggered in the past.
Before the revision, BLS data showed that employers added 2.9 million jobs annually, averaging 242,000 monthly. Therefore, average monthly job growth was likely closer to 174,000 (68k less per month than initially estimated)—a solid but significantly lower rate. Investors are now reassessing their views on the strength of the labour market, contributing to some recent volatility. Their worry is that the economy’s slowdown has passed the level where the Fed feels comfortable.
Rates
Rates have been volatile this week, with a 2Y moving in the 12 bps range. At the start of the week, we had a growth scare on the back of payroll revision, which pushed the rate from below 3.90 to above 4%. 2Y stayed stable for about 1.5 days, reaffirmed by jobless claims, which matched expectations. Then, at the end of the week, Jerome Powell’s remarks on the Jackson Hole symposium boosted expectations of the first rate cut and sent 2Y, 10 bps down from 4.02% to 3.92%.
The FED is expected to cut 25 bps at the next meeting, as it has conditioned the market to expect a more steady pace of cuts, especially since this is the last meeting before the presidential elections. Also, the only way we would get a 50 bps jumbo cut is on the back of a very negative jobs report, which would force the FED to take more drastic measures.
While the FED kept rates restrictive, it has already achieved some cooling through its dovish tone. The curve has moved significantly lower over the last few months, but the FED would need to start cutting to get this down much further. From the opportunity perspective, anything between 4 and 4.25% is a great opportunity to extend the duration.
The curve step-under was a very popular trade, and the 2-year/10-year spread is still 12 bps; however, there is much less steam left there.
Credit
After the volatility shock and spike in spreads at the beginning of August, credit markets are back to where they were a month ago. Valuations remain compressed and spread tight, with little room for error. There is little difference between sectors and categories from the credit rating perspective.
There is little premium to take on corporate credit risk, which reflects that we’re in a period of stability and have awaited positive development from the rate cuts. The potential for spread widening from the current levels is significant, and asymmetry of risk (limited upside, significant downside) is a key concern.
Equities
Despite growing concerns among economists about a potential recession, the S&P 500 is approaching its all-time high (ATH), reflecting strong market momentum. Optimism in the U.S. equity market contrasts sharply with international markets, which have struggled to keep pace over the past 15 years. During this period, the S&P 500 averaged over 15% annual returns, while international markets delivered roughly half that, at around 7-8%.
While the economy is slowing, equities remain very richly priced, especially relative to yields. The S&P 500 is now trading over 45% above its Net Present Value, which translates into pricing in very strong earnings growth and significant rate cuts. This is the highest premium since the dot-com bubble and one that occurred less than 5% of the time.
As the U.S. presidential elections approach, the equity market’s volatility tends to increase and remain stable. Historically, volatility tends to subside immediately after the election, regardless of the winning candidate. On average, markets have seen about 5% gains in the first 1 to 3 months post-election. Over a longer period of 6 to 12 months, returns are typically higher if the incumbent party wins, as this protects the status quo and supports existing trends.
This phenomenon coincides with seasonality. On average, August and September tend to be more negative and volatile. This is exacerbated in election years since the U.S. presidential elections are always held in November.
Only two election years have seen the market turn negative: 2000 and 2008. Both were caused by non-political events: the first one explained by the dot.com bubble burst and the second one by the GFC. Those examples show that staying invested and extending time in the market was the best strategy.
From the sector perspective, Real Estate has emerged as the top-performing sector this month and over the past 2, 3, 4, and 5 months. This performance is notable, considering that Real Estate had a relatively weak start to the year. The sector’s resurgence began at the end of April, coinciding with a significant decline in yields. As the most interest-rate-sensitive sector, Real Estate tends to react strongly to changes in interest rates. The rapid decline in yields since April has provided a substantial tailwind for the industry, driving its outperformance in recent months.
Asian markets experienced renewed volatility on Monday, with Japan’s Nikkei and Topix initially rising before plunging sharply as the yen strengthened and JGB yields increased. Hedge funds are turning bullish on the yen.
Next week, investors will focus on U.S. jobless claims, which became the main focus, signalling labour market health and influencing monetary policy.