It was another wild week for equities punctuated by the largest single day drop in close to two years on Wednesday. The VIX index, which measures market volatility, rose by close to 30%. Bonds moved far less than stocks, ending the week about where they started.
This week’s highlights will be a continued flood of earnings reports, a two-day FOMC meeting ending Wednesday afternoon, and the July employment report which will be released Friday morning.
Two weeks ago, before the Republican convention and the announcement by President Biden that he would not seek reelection, I commented that I believed the market was within the range of fair value but risks to that conclusion were stacked to the downside. I specifically called out five risk factors:
1. A potential deceleration in GDP growth
2. Lower future immigration totals
3. Rising Federal debt and deficits
4. Change associated with a new Presidency
5. Susceptible downside should the dominating Magnificent Seven stocks undergo a market correction.
The first three factors remain risks but nothing in the past two weeks has increased concerns. In fact, economic data relative to retail sales and personal spending have tweaked second quarter GDP forecasts up a notch.
As for the other two, from a market perspective, it was rotation out of the Magnificent Seven into other market sectors that increased the volatility. There were multiple catalysts beyond simply valuation. Both Biden and Trump announced protectionist steps that would lessen semiconductor exports to China. Whether either actually occur is irrelevant for the moment. The threat was damage enough. Two of the seven reported earnings last week. The reaction to both was negative. Tesla had weak car sales and a weak outlook. While CEO Elon Musk tried to shift the post-earnings discussion to energy storage, autonomous vehicles, and robots, investors didn’t buy the hype. Alphabet# reported an OK quarter. Only YouTube revenues missed their mark. But when stock prices and optimism are elevated, an OK quarter isn’t enough. Investors then extrapolated the negative reactions to these two earnings reports and lightened up on the rest of the big tech names. Four more will report this week. Investors will remain skittish until after the last reports Thursday after the close.
As I noted two weeks ago, valuations for these names are high, but deservedly so. That doesn’t mean a short-term correction of some size isn’t appropriate given the rapid run ups over the past 18 months. But should core fundamentals remain intact, I would expect the corrections to be contained. What does contained mean? We are entering the seasonally weakest part of the year on a historic basis. Markets, on average, decline in August and September. This year investors face economic risks, political and policy risks, and a likely change at the Federal Reserve with the likelihood that the FOMC will start to lower rates in September.
Since World War II, the Fed is close to its longest interval from the time of the last rate increase (July 2023) to the first rate cut. The only longer period was in 2006-2007 when the first rate cut in October 2007 almost coincided with the onset of the Great Recession that lasted until early 2009. I am certainly not forecasting a repeat. But the Fed has a habit of being late to start raising rates and late to start cutting them as it relies on historic data to predict future outcomes. The Fed would like all of us to believe that it is forward looking and, of course, it is. Its policy decisions take months or even years to flow through the economy. Growth, today, is slowing. Does the slowdown end with a soft landing or a recession? It’s too early to tell. Hopefully, the rate cut most likely coming in September will be followed by a series of cuts that will be stimulative enough to avoid a recession. But as of today, we can only surmise. Earnings reports for the second quarter to date have been mixed. Management outlooks for the rest of this year have been largely muted. The selling of the big tech names has correlated with new money flowing into financials, energy, materials, utilities and consumer staples, a mixture of cyclical and non-cyclical companies. There were signs toward the end of last week that the pace of market rotation might be slowing but it is too soon to draw a conclusion with any conviction. Perhaps the next step is for seasonal factors to take over and push the whole market a bit lower.
That plays into the fourth risk mentioned at the top, namely uncertainties associated with a new President. Now that Biden has dropped out, the one conclusion I can predict with maximum confidence is that in January we will have a new President. The Democrats chose a coronation rather than a competition. Whatever. VP Kamala Harris now needs to present her own views to the electorate. Between now and the end of the Democratic convention in August, voters and investors should have a better idea of the specifics that relate to her economic agenda. There is no doubt she will be a spender. There isn’t much doubt that Trump will be a spender as well. But how each plans to spend and how the spending will be paid for are open questions.
Ms. Harris is undergoing a bit of a honeymoon and it shows in the polls. The race today is dead even but it is also a race between a known (Trump) and an unknown (Harris). When I say unknown, it’s the details and the differentiation from Biden that we don’t know yet.
While the focus last week was on the Democrats, it is unclear how age and VP choices play out. Mr. Trump’s selection of J.D. Vance doubled down on his populist leanings. It wasn’t intended to widen his base. Ms. Harris will be pressured to move toward the political center and a start would be a moderate from a battleground state. As for age, Mr. Trump is now the elder statesman. Any concerns that he will be almost 79 if he is inaugurated will put some focus on Mr. Vance and his policies, some quite different than Trump although he will certainly not want to differentiate himself during the campaign.
Right now, the political picture is so uncertain, including the political balance in both the House and Senate, that Wall Street has not focused on the race. But that could change in the months ahead. It is also important to remember that much of Trump’s tax changes sunset at the end of 2025. What happens in 2026 and beyond matters greatly but at this point in time, the uncertainties are so large that they are ignored until there is greater clarity.
As noted at the start of this note, the keys this week will be earnings, Chairman Powell’s post FOMC comments, and Friday’s employment report. As for earnings, the specific focus will be on the four big tech names, Microsoft#, Apple#, Amazon# and Meta Platforms#. Collectively, the comments of leaders of key cyclical companies also reporting may have significant impact on the market’s direction over the coming months.
As for Chairman Powell, markets place a 94% chance on no rate changes this week. The Fed almost never goes against 94% odds. But it almost certainly sets the table for a rate cut in September and possibly one or two more before year end. Despite all the fuss about the road map for short-term rates over the next 18 months, it’s what happens to the 10-year yield that matters most to investors. That is market driven and isn’t likely to be significantly different 12 months from now than it is today unless there is a meaningful recession or a resurgence in inflation.
Finally, Friday’s employment report is expected to be in line with recent trends showing a modest slowing in the pace of labor force growth. A number too low (below 100,000) may spook investors and raise fears that a recession is coming sooner than expected. A number too high accompanied by higher than expect wage gains will reignite inflation fears and raise the specter that the Fed will have to wait until November to start cutting rates.
There is one last risk worth noting. Russia, China, Iran and North Korea share a common dislike for U.S. democracy although each has its own agenda. All could see a somewhat destabilized U.S. given the new Presidential choices. Each will have a favorite of their own which could lead to some actions that further destabilize relations with the U.S. in a manner that will be perceived as pro-Harris or pro-Trump. The range of possibilities is large and beyond my capabilities to predict. But any action could have a negative impact on markets, if only for a short time. It’s just another risk to reinforce the negative seasonal trends.
With all this said, one shouldn’t lose sight of the fact that markets remain fairly valued although susceptible to a 5-10% correction. Assuming either a soft landing or very mild recession, both 2024 and 2025 should be solid years for equities with positive returns within normal historic ranges.
Today, country singer Martina McBride is 58. Charles Schwab turns 87.
James M. Meyer, CFA 610-260-2220