Rate cuts are supposed to ease financial conditions and encourage credit growth. But we already have both in spades. Financial conditions today are easier than when the Fed began hiking, and demand for yield is so strong that junk bonds trade nearly in line with investment-grade credit. In this environment, easier money risks fueling “fiscal dominance” and inflation expectations. Below is the picture of this spread. I think this is super important to look at as it provides us the opportunity to recognize when credit is becoming challenging and the cost for higher risk debt rises while US Government debt remains pretty much a constant:
I begin this week’s note with this as this is an extremely important concept. I mean think about it. If the economy is having issues, then credit should reflect this. But in this case, the ONLY issue that is being bantered about within the domestic economy is labor. Last Friday’s employment numbers were said to be “all that is needed” for the Fed to lower rates on the 17th of this month. But do they? GDP is strong, wages are solid. The industrial numbers of PMI are solid. So is it strange that employment is being challenged? I think not. There seems to be a tug-o-war going on presently between jobs available due to the immigration crack down, and at the same time numerous layoffs due to AI taking the place of many jobs.
This is a very uncommon situation indeed as it has been a very long time since immigration was an issue, and never before a time when AI even existed! We do not expect any dramatic cuts from the
Fed but rather measured trims that exemplify its sensitivity to practicing its dual mandate to nurture economic growth toward full employment without untoward levels of inflation. On the release of the numbers last week, the broad market rallied at first and then weakened as traders and investors considered what two successive disappointments (both the July and August non-farm payrolls reports) might portend in terms of economic growth and the markets.
So, what’s the market telling us?
In our view, the equity market digested the previous non-farm payroll number for the month of July (with expectations for a number of 105,000 jobs added faced with an actual number of 73,000 and with revisions to two prior months) with relative ease: the S&P 500 shed just 1.6% on the day (Aug. 1) that the number was released. After exhibiting some wonkiness, it then managed to rally some 4.2% to its latest record high of 6502 reached last Thursday (September 4).
In looking at what is driving the markets, or pulling the prices up as it may be, I still believe that the strongest horses are the Magnificent 7 companies that have been at work in this action since the end of 2023. They continue to not only rise to new highs but also continue to lead verses a comparison to the overall S&P 500 Index. Although this doesn’t happen in a straight line, as soon as a couple of the seven take a breather, it almost appears that the baton is passed to the others, and this allows this group collectively to continue moving higher.
As can be seen below, the Mag 7 hit an absolute high in December, pulled back with the markets in April, and have since now broken to new highs much like the overall market. But relative to the broad index itself, this select group has now again regained its overall leadership:
The most important chart in this week’s note to keep on your desk and in your mind is that of the seasonal expectations for the overall S&P 500. As I often like to combine the one-year seasonal cycle, to the four-year presidential cycle, and the ten-year decennial cycle, and then compare it to the current year, this gives us an indication of exactly where we stand based on history. September is a weak month seasonally, and then the markets tend to get back on their horses and ride into year end. If you happen to wonder why September tends to be such a bad month, it is because this tends to be the beginning of the new year for the schools. In the olden days it was said that the traders were closing up their homes in the Hamptons for the summer and getting their kids set up for the new school year and hence took their money to the sidelines until the beginning of October.
In closing, I thought I would show you where unemployment currently is going back to the early 2000’s. You can see the unemployment spikes during the Great Financial Crisis and COVID, but of late initial unemployment claims seem to remain quite muted. I bring this up as this is what the media has been tending to focus on with the supposed need for the Fed to ease interest rates. I believe that they could, as it has been some time since the last ease, but other than the last couple of months’ employment data, the economy remains quite robust.
Please take a moment and refresh your expectations for the economy and the real reason why interest rates should be adjusted. As you will find, it might make it better for business, but exclusive of major policy decisions, longer-term interest rates might rise as a result and this could make things a bit difficult next year.
- Ken South, Tower 68 Financial Advisors, Newport Beach
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