August 2024 Market Commentary

August 19, 2024

• The US economy grew at a 2.8% annualized rate in the second quarter.
• Fed Chair Jay Powell intimated that a September rate cut could happen assuming inflation continues to show signs of returning to the Fed’s longer-term 2% target.
• Returns: S&P 500 1.1%. Bloomberg US Aggregate Bond index 2.3%.

After a quiet start to the summer, markets witnessed an uptick in volatility in July as investors weighed whether slowing economic data was signaling a soft landing or recession. For much of the year, investors have embraced the idea that the Fed will manage to buck historical precedent and achieve a soft landing by raising rates high enough to bring inflation back under control, but not to such a degree that it completely stifles economic activity. The tricky part to a soft landing is avoiding economic “stall speed,” which could result in a hard landing or recession.

When a plane descends into an airport, it follows a general downward trajectory, even as there are little gyrations from turbulence along the way. Similarly, the Fed will no doubt encounter occasional turbulence, in the form of disappointing economic data, along its descent towards an anticipated soft landing. The challenge for the Fed, and investors, is determining whether disappointing data encountered along the way represents acceptable turbulence or a more significant slowdown that could result in a hard landing. In other words, how slow is too slow when it comes to economic data? With no uniform answer to the question, bouts of market volatility are likely as each investor attempts to answer the question for themselves.

For much of the year, markets took a relatively sanguine view of slowing economic data. In some cases, slower data was even embraced, as it reinforced the narrative that it would allow the Fed to begin cutting rates later in the year. However, of late, investors have become more anxious about economic slowing, concerned that the economy might be approaching stall speed and at risk of a hard landing. That was evident in the first three trading days of August as the S&P 500 fell 6.1%, triggered by a spate of disappointing economic reports showing unexpected weakness in the manufacturing sector and labor markets. Specifically, data released by the Institute for Supply Management (ISM) showed manufacturing activity in July contracted at its fastest pace in eight months, weighed down in part by employment, which fell to its lowest level since June 2020. Separately, weekly jobless claims jumped to their highest level in a year, while July nonfarm payrolls added just 114K, well below expectations. In addition, unemployment rose in July for a fourth consecutive month, ending at 4.3%, its highest level since October 2021.

Further exacerbating the selloff at the start of August was an unwinding of the yen carry trade following the Bank of Japan’s (BOJ) decision to raise its interest rates to support the yen and stem its slide against the US dollar. A carry trade is when an investor borrows in one currency with low interest rates, in this case the yen, and invests the money in other currencies or assets, e.g. US dollars, or other assets, with higher returns. The strategy works if interest rates, and exchange rates remain relatively stable. Unfortunately, for investors in the yen carry trade, trouble arose at the end of July when the Bank of Japan raised rates and simultaneously the US Fed indicated it was likely to begin cutting rates in September. That led to carry trade investors attempting to “unwind” their trades at the same time, thereby briefly putting pressure on global assets at the start of August.

Notwithstanding the scare experienced during the first three trading days of August, economic data released in July generally confirmed the economy remains in relatively good shape and that a recession does not appear imminent. At the highest level, US GDP expanded at a 2.8% annualized rate in 2Q24, twice the pace recorded in 1Q24 and well ahead of the expected 2.0% growth. Consumer and business spending were both strong, increasing 2.3% and 8.4%, respectively. The rebound in consumer spending, up from 1.5% in 1Q24, was particularly important given that the consumer accounts for approximately 70% of all US economic activity. It also suggested the economy entered the third quarter with good momentum.

Inflation data, arguably the most closely watched economic data currently, showed further improvement. On a headline basis, June consumer prices (CPI) reported in July slowed for the second consecutive month after unexpectedly increasing during the first quarter. At 3.0%, headline CPI fell to its lowest level in a year. Core CPI, excluding food and energy prices, eased to 3.3% in June, marking its slowest pace of growth in over three years. Similarly, the core personal consumption expenditures (PCE) index, the Fed’s preferred inflation measure, rose just 2.6% in June, tying May for the slowest pace of growth since March 2021. At his press conference following the Federal Reserve’s Federal Open Markets Committee (FOMC) meeting, Fed Chair Jay Powell stated that “second quarter’s inflation readings have added to our confidence, and more good data would further strengthen that confidence.” Based on the progression of inflation and signs of cooling in the labor market, market expectations for at least a 0.25% rate cut by the Fed in September increased from 64% to 100%.

Despite the increased market volatility in July, markets enjoyed positive returns with large caps (S&P 500) gaining 1.1%, while small caps (Russell 2000), which tend to be more interest rate sensitive, gained 10.1%. That marked the best month for small caps since December. International markets were mixed, with developed markets (MSCI EAFE) gaining 2.9%, while emerging markets (MSCI EM) were effectively unchanged, down 0.1%. Like equity markets, bond markets also experienced positive returns in July, with the Bloomberg US Aggregate Bond Index, the broadest measure of the US bond market, gaining 2.3%, its best month since December. The gains were driven by a significant rally in bonds, which sent yields on the 10-Year Treasury down from 4.40% to 4.04% over the course of the month. As a reminder, bond prices and yields exhibit an inverse relationship; thus, as investors shifted into bonds, driving prices higher, yields fell.

In the Treasury market, the rally sent yields to their lowest level since early February. The rally was initially spurred by signs of weakness in the June employment report. Though nonfarm payroll additions exceeded estimates, downward revisions to prior months removed some of the luster from job gains seen earlier in the year. In addition, the unemployment rate ticked up to 4.1% and hourly earnings growth slowed to 3.9%, the slowest pace of annual growth since 2021. The combination of higher unemployment and downward revisions to prior months’ reports raised questions about the underlying strength of the labor markets. As a result, the market began to assume Fed rate cuts would occur sooner rather than later, thereby pulling yields lower.

The employment report was followed later in the month by a second positive CPI inflation reading showing inflation, by nearly every measure, making meaningful progress in returning to the Fed’s longer-term 2% target. The combination of weaker employment data and slowing inflation fostered hopes that the first rate cut of this cycle might occur as soon as the Fed’s July FOMC meeting. Though the Fed held rates steady at their July meeting, Fed Chair Jay Powell suggested afterward that a rate cut could occur as soon as September, while stressing there were no guarantees. Markets, however, embraced his comments, sending yields to their lowest level since February. At month-end, markets were pricing in a total of three 0.25% rate cuts by the end of the year.

Municipal bond yields essentially tracked Treasury yields during the month, with yields at the longer end of the yield curve falling less than at the shorter end of the curve. Yields at the short end of the yield curve are largely controlled by the Fed and expectations for monetary policy, while the longer end of the curve is controlled more by macroeconomic factors. In July, the short end of the curve fell meaningfully, driven by increasing expectations that the Fed will begin cutting rates in September. The long end of the curve saw smaller declines as investors continued to be wary of deficits, the potential impact of current geopolitical tensions, and longer-term inflation expectations.

With so many questions and uncertainties surrounding a host of different topics, including inflation, labor markets, the consumer, monetary policy, geopolitical tensions, and upcoming US elections, investors should be prepared for periodic bouts of volatility as summer moves into fall. When encountered, investors should remember that turbulence is normal, whether flying in a plane or, in the Fed’s case, trying to bring the economy in for a soft landing. That doesn’t mean investors should treat a soft landing as a foregone conclusion—in fact, they shouldn’t—but it’s important to recognize that, like planes, the economy is unlikely to follow a perfectly smooth path, even if the landing turns out fine.

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