Finding Opportunities in Volatility

8/5/2024 Morning Update: We are bracing for today’s sell-off. It feels a bit extreme, but many asset classes and countries are selling off. We can point to many reasons: weakening trends in the labor market, the Fed being behind the curve, tech/communication services sectors rolling over hard (accounts for 35% of the SPX weight), and seasonality as Aug/Sept are typically the weakest months of the year. Japan is a mess with the yen carry trade unwinding as well, their markets fell 12% overnight. And throw in Warren Buffett selling Apple (AAPL) and Bank of America (BAC).

As a result, rates have fallen dramatically with the 10yr Treasury yield now at 3.69%. We have gone from a soft landing to something possibly more sinister. There is a 95% chance for a September 50 bps cut now. We think it is not likely the Fed cuts before September, but we will have to watch the data. Jackson Hole will be important and could be a chance for Powell to talk more firmly on cuts if not using the event to cut, which is August 23. We think it is too early to say hard landing. It will be bumpy, but the Atlanta Fed GDP tracker is still running 2.5% for 3Q and EPS is good up 11% y/y.

GDP is running above trends driven by the consumer, which is 75% of the U.S. economy. The consumer remains in solid shape driven by strong balance sheets, with an increase in prime age participation, and generally low dependence on credit. Wages are still above trend at 3.6%, inflation has come down as have commodity prices. The 30-year fixed mortgage is now at 6.4% versus the October peak at 7.8%. We will watch the data going forward, as will everyone else including the Fed. 

Amidst the volatility, there is always opportunity. Company fundamentals and EPS are always the most important things to focus on during uncertainty. Eventually, the market will reward those companies with strong earnings, revenues, market share, balance sheets, and growing dividends at attractive valuations. We will look for these companies to add to our portfolio on the market pullback.   

1. What Happened Last Week? Market sentiment shifted last week resulting from weakening economic data. ISM manufacturing data for July fell further into contraction territory at 46.8 (any reading below 50 is considered contractionary, above 50 expansionary). In the data, employment was especially weak, contributing -1.32 to the decline. Initial claims continue ticking higher with the 4-week moving average at 240K, still below recessionary levels of 350-375K but well above recent trends near 200K. 10-year treasury yields broke below 4% on the news for the first time since February 2024.

The July jobs report brought further selling pressure, with the data coming in at 114K new jobs versus expectations for 175K, along with revisions lower for prior months. The unemployment rate ticked higher to 4.3% and average hourly earnings were slightly lower at 3.6% y/y. 10-year treasury yields fell 15 bp on the news.

Growth remains strong with a cooling labor market. The most recent Atlanta Fed GDPNow reading (August 1) showed a projected 2.5% annualized growth for the third quarter. Inflation readings are nearing the Fed’s 2% goal with the personal consumption expenditure (PCE) index at 2.5% y/y. As Fed Chair Jerome Powell stated last week, the Fed’s dual mandate is now in greater focus with their attention on both the labor market and inflation. We wrote in last week’s Weekly Wisdom that the Fed should have cut its policy rate to get ahead of the curve, and the labor market data on Friday supported our claims. The next FOMC meeting is 44 days away, and markets are pricing a 82% chance for a 50 bp cut.^[1]

Chart 1: The Unemployment Rate and Jobless Claims Tick Higher, with Lower Job Creation^[2]

3. Managing Market Volatility. Market selloffs have not been numerous over the last several months. On July 24, the S&P 500 lost its third-longest streak without a 2% decline in 20 years, which lasted 356 trading days. On Friday the S&P 500 barely missed another -2% day, closing at -1.8%. Zooming out, the S&P 500 remains up 10% year-to-date, down about 7% from its peak. Over the last 20 years, 50% of the time markets have experienced a pullback of at least 10%. Relative to history, markets have been performing extraordinarily well as the S&P 500 average total return is 7.7%.

Recent market performance might be out of the ordinary, but historically what we have been seeing is not uncommon. The Fed induced the fastest rate hiking cycle in history, and as inflation is now falling to the Fed’s 2% goal, parts of the economy are showing signs of a slowdown. While market pundits focus on economic data and the Fed, company fundamentals and earnings are a big tell regarding the health of the economy. 75% of S&P 500 constituents have reported 2Q ’24 results and the blended earnings growth rate is 11.5% y/y – the highest since Q4 ’21. 78% of companies are beating EPS estimates, which is above historical levels, with eight of the eleven sectors reporting y/y earnings growth. With interest rate cuts on the horizon, easing monetary policy should further support company performance. As we always say, do not fight the Fed.  

Chart 2: S&P 500 Snaps Its Streak of Consecutive Trading Days Without a 2% Decline^[3]

3. Fixed Income. Treasury yields declined materially across the curve following cooling labor market data. Between Wednesday’s FOMC meeting and Friday’s economic data, the market priced in nearly two additional rate cuts for 2024, now totaling 4.6 cuts by year-end. The unexpected softening in the labor market resulted in the largest one-day move this year in the 2yr (-27 bp) and 10yr (-19 bp).

On the week the 2yr fell 50 bp to 3.88% and the 10yr fell 40 bp to 3.79%, levels not seen since July 2023. The curve inversion eased to just -9 bp, the least inverted since July 2022.

U.S. credit ratings improved last week as the main rating agencies issued 39 upgrades and 25 downgrades. Energy had the most upgrades, while Consumer Discretionary had the most downgrades. Spreads had their largest two-day widening since the regional bank crisis in March 2023, with IG and HY finishing +11 and +49 bps wider, respectively. Muni yields followed Treasuries, falling 17-18 bp across the curve.

4. The Week Ahead.

Earnings – Monday: CSX, SPG, TSN; Tuesday: ABNB, AMGN, BLDR, CAT, CEG, DUK, FANG, FIS, FTNT, MPC, O, SMCI, UBER, WYNN, YUM, ZTS; Wednesday: CVS, DIS, EMR, HLT, MCK, MNST, RL, ROK, ZBH; Thursday: EXPE, GILD, LLY, NRG, OXY, PARA, PH, SOLV, VST, VTRS; Friday: EVRG.

Economics – Monday: Markit PMI Services, ISM Services; Tuesday: Trade Balances; Wednesday: Consumer Credit; Thursday: Continuing Jobless Claims, Initial Claims, Wholesale Inventories.

Stephanie Link’s TV Schedule:

Return for Selected Indices^[4]

Disclosure

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^[1] Source: CME Group. As of August 5, 2024.

^[2] Source: FactSet. As of August 4, 2024.

^[3] Source: Bloomberg. As of July 24, 2024.

^[4] Source: Bloomberg. As of August 5, 2024.