Written by Steve Andrews
From July Optimism to August Correction
What a difference a month makes. Back in mid-July, the markets were humming along, enjoying the best of all worlds, with both stocks and bonds rallying. But things changed in early August as the stock market suffered its first correction of 2024. After reaching new highs on July 16, the rally in stocks took a breather as investors rearranged the deck chairs following more good news on CPI and PCE inflation which boosted market optimism for a September rate cut. Investors began to shift their focus away from tech, which has been driving the stock market rally for over a year now, to smaller-cap companies which would benefit from lower rates, especially since many of them borrow on a floating rate basis (Prime, SOFR, etc.). As a result, the Dow began to outperform the NASDAQ and the S&P 500.
Investor Sentiment and Market Volatility
Investors tend to get antsy when stock markets are sitting near record highs. The reallocation rattled some investor’s nerves, worrying that the tech boom had run its course, and this metaphorically raised the market’s blood pressure. Or in the market’s case the VIX Index (or the volatility index) which measures market volatility. Until the first weeks of August, it had been relatively stable for most of the year.
Impact of Employment Reports and Global Trades
Investors were slightly rattled when the July employment report failed to meet expectations. At the same time, a “carry trade” was unwound which sent tech stocks plummeting. The “carry trade” refers to global stock traders who had been exploiting the weak Japanese Yen. They borrowed money at comparatively low Japanese interest rates and used the funds to invest in stocks (mainly US tech stocks) and other assets. When the Bank of Japan started raising interest rates, it boosted the Yen and forced these traders to cover their short positions. This resulted in a scramble to sell the assets - many of which were in the US tech sector. And this snowballed into the stock selloff. Fortunately, investors soon realized that the selloff was not brought on by risks in the financial system, or by economic fundamentals, and the so-called “Great August Swoon of 2024” reversed itself.
Economic Fundamentals and Corporate Earnings
As we know, markets are made up of people and people can get emotional. This means that at times those emotions will move markets up and down. However, once those emotions settle down, markets are once again driven by economic fundamentals and expectations. We may have been overdue for some sort of stock market correction, given the length of the rally and the uncharacteristically low market volatility. With over 90% of the S&P 500 having reported to date, Q2 earnings are up 10.6% from a year ago - better than the 8% to 9% growth expected – and most firms reported that their earnings growth came from real demand - not cost-cutting measures. The companies that suffered most in the selloff were those with higher price-to-equity ratios and riskier stocks sold off more than safer stocks.
Future Outlook and Federal Reserve Policy
The selloff in stocks brought out the recession hawks who have been relatively quiet this year but, despite their protests that the Fed has fallen far behind the curve in terms of cutting rates, the economy doesn't look as if a recession is imminent despite the softness in the manufacturing sector and the slow housing market. Following Q2’s 2.8% GDP performance, current estimates for Q3 GDP are looking for a repeat, with growth expected somewhere between 2.5% and 2.9%.
There remain threats to economic growth, not the least of which are rising geopolitical tensions, where the odds for a war between Iran and Israel are rising daily, and the burgeoning federal deficits which rob real investment capital from the private sector. In the meantime, the US economy continues to “normalize,” as Fed Chair Jerome Powell put it at the July 30 FOMC meeting, as most of the stimulus from the shutdowns has been expended and the economy is easing back into the 2.1% (plus or minus) pace that ensued in the years following the Great Recession.
As investors reallocate assets among the various stock sectors (small-, mid-cap, etc.), and as we head toward election day, don’t be surprised to see US stock indexes muddle around current levels until a clearer political landscape emerges, but the forward earnings guidance that accompanied Q3 (record) corporate earnings results point to continued growth well into 2025. Despite all the trepidation, it looks like the economy has been able to handle the disinflation cycle without falling into a recession. This is boosting morale among US small business owners whose outlook for business conditions jumped 18 points in July to its highest reading since February 2022.
Federal Reserve’s Response and Market Expectations
The Fed, to its credit, did not overreact to the critics who called for an immediate ¾ point (0.75%) cut in the Fed Funds rate following the stock selloff. That doesn’t mean that pressure is off the Fed but, barring a calamity, we expect that the Fed will cut rates by a quarter-point (0.25%) in September with another quarter-point cut before year end. That’s about right for an economy that’s still expanding.
