September Investment Comments
For much of 2023 and into 2024, markets experienced a low level of volatility in the face of the fastest interest rate tightening cycle in U.S. history. However, since reaching a peak on July 16 the S&P 500 recorded both its best and worst days since 2022 during the week of August 5-9. The reasons for higher volatility are a softer economy, Artificial Intelligence (AI) skepticism, global uncertainty, and a contentious election cycle.
Since 2022, the Federal Reserve has been able to focus on inflation as the employment market has enjoyed a strong recovery from the pandemic. The news here recently has been good. After inflation slightly increased during the first quarter, the CPI has now slowed for four straight months. July’s reading of 2.9% year over year marks the first time since March 2021 that the index has been below 3%. Progress on the core CPI, a measure that excludes the often-volatile food and energy components, is also encouraging, coming in at 3.2%. Other indicators confirm inflation’s downward path. The Fed’s preferred inflation index—the Personal Consumption Expenditures, or PCE—has fallen from a high of 7.1% two years ago to 2.5% in June. The Producer Price Increase, or PPI, rose 2.2% year over year in July and has cycled around 2% since early 2023.
The employment market has remained solid, but there are signs of weakness. In July the economy added 114,000 jobs, the second smallest monthly gain since the start of 2023, and job counts for May and June were revised downward by 29,000. The unemployment rate rose to 4.3%, up from 4.1% in June and the highest level in nearly three years. However, the jump in the unemployment rate resulted from more people looking for jobs as the labor-force participation rate, the share of working-age people who were employed or seeking work, rose to 62.7% from 62.6% in June. Absent this increase in the labor force the unemployment rate would have stayed at 4.1%.
Other economic indicators such as retail sales, goods production, and construction are weakening. Further, rising unemployment tends to coincide with recessions. Economist Claudia Sahm has enjoyed notoriety for a recession indicator called The Sahm rule that has predicted every recession since 1970. The rule states that if the average of the unemployment rate over three months rises 0.5% or more above the lowest three-month average recorded over the previous year the economy is in recession. Over the past three months, the unemployment rate has averaged 4.13%, 0.53% higher than the three-month average low of 3.6% over the past year. In a Wall Street Journal interview, Ms. Sahm stated she doesn’t believe the economy is in recession as changes in the supply of labor since the pandemic and the jump in immigration have led the Sahm rule to overstate how weak the job market is. However, she worries that unless the unemployment rate stabilizes her indicator will correctly confirm recession, a fear the market shares.
Excitement over the potential of AI has been the main driver of stellar S&P 500 returns, embodied by the growing share of the market capitalization-weighted index driven by large technology stocks popularly known as the Magnificent 7: Apple, Amazon, Microsoft, Nvidia, Alphabet (Google), Meta (Facebook) and Tesla. Before the second quarter earnings season, these seven stocks made up 33% of the S&P 500 and carried a weighted average forward P/E of 36.4, significantly above the overall index forward P/E of 21.4 at the time. The second quarter results for the Magnificent 7 were generally strong. However, aggressive capital expenditures to build and outfit AI data centers, coupled with slightly missed growth expectations for current AI deployments, caused investors to dump shares. All but Meta saw mostly double-digit share price declines. Because the Magnificent 7 makes up such a large percentage of the index, investor expectations, sometimes changing daily, have induced market volatility. Volatility is expected to continue as the Magnificent 7 still make up 31% of the S&P 500, and the weighted average forward P/E ratio of the Magnificent 7 is 31.5, which is higher than the overall index's forward P/E ratio of 20.2.
Global uncertainty and a contentious election cycle have also contributed to volatility. The weakening economies of China and Europe have led to a strong U.S. dollar, which has reduced inflation by making imports cheaper. However, this has also had a negative impact on U.S. companies that export abroad. The Bank of Japan’s interest rate increase has led to the unwinding of a popular trade that expected the Yen to continue to depreciate. Wars in Ukraine and Israel continue with increasing tensions. The change to Kamala Harris as the Democratic candidate for President has tightened the race and led some investors to unwind previous trades that were betting on a Donald Trump presidency.
The equity markets aren’t the only place that has seen volatility. The yield on the 10-year Treasury was just shy of 4.5% in early July, steadily fell through the month to about 4.1%, and fell sharply in the first part of August to around 3.8%. The drop in yields corresponds with the increasingly dovish tone set by the Federal Reserve that interest rate cuts could begin in September. Because of economic uncertainty and market volatility, investors now believe that the Fed will cut interest rates by a full percentage point by the end of 2024 and the Federal Funds rate will settle at a level of 3.00%-3.25% by the middle of 2025. This doesn’t seem unreasonable but could prove to be optimistic if inflation doesn’t continue to make the progress seen recently. Furthermore, the Treasury Department has updated its fiscal year 2024 guidance for the Federal budget deficit to $1.87 trillion. Funding decisions regarding the maturity range of bonds to issue to cover the shortfall could lead to upward pressure on rates.
The recent increase in market volatility is unwanted. However, investors should prepare themselves for more of the same until these factors come into clearer focus. As always, we recommend using price weakness to add attractive growth stocks at reasonable valuations to well-balanced portfolios.
Dan Boyle, CFA