Last month was quite a rollercoaster! Between the August surprise unemployment increase to the Yen carry trade unwind, we saw US equity markets drop 8% to 20% depending on the associated index. Within days people went into frantic mode and started to call for the FED to cut interest rates immediately, and to make big rate cuts. Of course as the panic subsided analysts, pundits, and other commentators began to regain their composure leading the same people who called for drastic cuts to pare back their commentary. So what exactly happened that caused these “experts” to essentially freak out?
In the July Market Update I published commentary that hinted at US immigration policy masking the deterioration in the US economy. I noted that with the recent acceleration in the unemployment rate could continue to increase quickly. This was corroborated with the August 2nd release of the unemployment rate of 4.3% (or 4.25% unrounded). With the unemployment rate jumping that high the Sahm Rule, which I have mentioned in past Market Updates, was triggered. Based on history (the last 50 years) when the Sahm Rule was triggered a recession was seen nearly 100% of the time. This trigger led investors to worry if the FED’s “higher for longer” interest rate policy bypassed a soft economic landing and instead is pushing the economy into a recession.
If that wasn’t bad enough the following Monday (August 5th) the world woke up to the Japanese stock market down 12.4% in one day, which led to the US equity markets slated to open up down 4% to 6% that same morning. While the drop in US unemployment impacted Japanese equities, the real impact to Japanese equities was related the Bank of Japan increasing interest rates 0.25% which triggered margin calls on investors that borrowed money in Japanese Yen. In other words, with the loose Japanese monetary policy keeping interest rates quite low investors borrowed against the Japanese Yen to invest in other areas of the world. When the cost of borrowing increased significantly (due to the BOJ’s rate change) investors needed to rapidly sell investments to cover their margin calls.
One would think that these two data points would lead to more volatility, and August didn’t let us down. Within almost 10 days the US equities bounced back, almost completely, based on two beliefs: 1) the FED would cut interest rates 0.50% in the September meeting and 2) Nvidia would beat analyst estimates leading to further growth amongst the Magnificent 7. Unfortunately, as the end of August approached the 0.50% rate cut expectations dropped from +75% to +35% and Nvidia beat expectations, but by the smallest margin in the past 24 months.
So how were our investments strategies impacted?
August’s volatility created many opportunities for additional nibbling in specific strategies within the portfolio. We added to some AI equities, some Core cyclical equities that pulled back significantly, and we added to some defensive investments. For those accounts with short positions, they started to rally.
Looking ahead, it is our belief that the Yen carry trade (the situation mentioned above) will continue to impact global markets as either the Bank of Japan or the US Federal Reserve adjust their respective interest rate policies. For example, if BOJ increases rates 0.25% or the FED cuts interest rates 0.25% the Japanese Yen will continue to strengthen causing further pressure/strain on the Yen carry trade. Furthermore, September tends to be the most volatile month in a calendar year. This would mean that US equity markets could move lower into the end of the month. Although I should note, US equity markets could continue to move lower into the election for two big reasons:
- The US market is uncertain about who will win the election which means the market is unclear which set of economic policies to plan for.
- Q3 earnings are starting to come down based on companies lowering guidance in Q2 earnings calls. As Q3 earnings are announced, starting in October, many companies may continue to lower Q4 guidance which will dramatically affect earnings estimates, especially since analysts forecasted almost 20% earnings growth in Q4. If earnings forecasts were to come down then US equity markets would need to reprice corporate valuations which in turn should lead to lower stock prices.
I know I have been saying the US economy is weakening for the past year, and it is only now that we are seeing the results, but I continue to pound my fist on the table that the mismatched risks between US equity markets and the US economy continues to build. Considering the following items:
1. US broad markets trading at peak valuations and peak P/E ratios
2. +75% of US consumers living paycheck to paycheck
3. Delinquency rates on all consumer credit cards/loans at highs last seen in 2012
4. Bank charge-offs at highs last seen in 2011
5. Commercial Real Estate unrealized losses continuing to mount
6. Unemployment rate continuing to climb (i.e. 3.7 to 4.3)
7. Recession Indicators flashing (e.g. Sahm Rule, Inverted Yield Curve, Unemployment to Vacancy Rate)
7. Consumer cyclical companies (e.g. HOG, SBUX, MCD, NKE, AAL) lowering forward guidance due to the weakening consumer…
I remain very concerned about the future of the US economy and correspondingly equity markets. In prior Market Update emails I have offered an analogy that when the market goes up it takes an escalator; whereas when the market drops it takes the elevator. This can be seen over the last 23 months as the US equity markets powered higher due to the aforementioned equity concentration.
Detailed Analysis:
We continue this Market Update with an attempt to address the upcoming Employment Fiasco. In particular, what happens if unemployment continues to climb from here? I wish there was a simple answer, but the reality is the impact to the US economy could go one of a few ways.
First, considering we accepted in nearly six million new immigrants into the US between 2021 and 2023 (as compared to the nearly six million that were accepted between 2008 and 2020) the US economy needs to go through a period of digestion. In other words, the recent immigrants displaced a large portion of those that couldn’t find a job, were forced into retirement, or who voluntarily retired after COVID. However, as prices for everything jumped nearly 30% after COVID those displaced workers living on savings, or a fixed income, find themselves needing to go back to work. This complicates the labor market as many of the new immigrants and displaced works are “fighting” for the same job. With job growth slowing the unemployment rate may end up rising at a slower pace; however this will not stop consumer spending from further deteriorating leading to further pressure on earnings.
Second, historically speaking, when the unemployment rate increases beyond the “critical point”, which some may say is the point at which the Sahm Rule is triggered, the speed of further increases can be quite quick. As the Richmond FED stated, “The rapid increase of the unemployment rate has frequently been mentioned as a good indicator for the start of recessions.” Noted in last month’s Market Update I posited that if history holds true this time then the unemployment rate could accelerate to 4.8% – 5% by January 3, 2025. From a historical low of 3.4% that is a big increase. And yet, while the FED has mentioned they are watching the acceleration in unemployment they have decided to classify the increase in the unemployment rate as “normalization”, which is true if we use 5.5% as 30 year average between 1990 and 2020. Although if the FED is expected to allow the unemployment rate to drift to 5% – 5.5% then that would mean another +4 million people (4.3% to 5.5%) will lose their jobs over the ensuring weeks and months.
Finally, while it would be nice if the FED had the ability to flip a switch to stop the increase in unemployment that isn’t something they have direct control over. Fundamentally, the FED’s toolbox focuses on monetary policy (think of how much money is injected or removed from the US financial system) whereas Congress focuses on fiscal policy (think of increasing debt in order to cut more checks). So if the FED’s normal toolbox strategy is to cut rates to stimulate spending when we are in the middle of a slow down, or recession, then the assumption that FED rate cuts will be stimulative to consumers who are living paycheck to paycheck is where the current fallacy exists. Just like the FED couldn’t impact supply shocks from the COVID crisis (which led to inflation spikes) they cannot stimulate a stretched consumer burdened with mounting debt. Thus if a debt laden consumer isn’t able to spend (like they did post-COVID), without an injection of cash like Congress did post-COVID, then businesses will not be able to grow sales – unless they drop prices. In either case, lower consumer spending or price cuts, business growth will slow which in turn means hiring will slow.
With the immigration labor supply falling to a trickle, after the June 5th Presidential Executive Order, and hiring growth declining it is only a matter of time before layoffs accelerate as a means to maintain margins (corporate earnings). According to Factset, “companies are reporting earnings that are 3.6% above estimates, which is below the 5-year average of 8.6% and below the 10-year average of 6.8%.” They went on to say “In terms of revenues, 60% of S&P 500 companies have reported actual revenues above estimates, which is below the 5-year average of 69% and below the 10-year average of 64%. In aggregate, companies are reporting revenues that are 0.7% above the estimates, which is below the 5-year average of 2.0% and below the 10-year average of 1.4%.”
Bottom line, the next eight weeks headed into the election will be quite volatile AND could foreshadow the turbulence ahead.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. You cannot invest directly in an index. Asset allocation is no guarantee of risk reduction. Past performance is no guarantee of future results.
