The S&P 500 fell last week by over 4%. The tech-ladened NASDAQ fell by even more. This all happened after the Dow Industrials set a new all-time high the Friday before last. What caused such a sudden reversal? Fundamentally, nothing! The key economic data point last week was Friday’s employment report. More on that in a moment. But it was largely consistent with recent data.
To delve further, we are clearly at a convergence of transitions. The Fed is almost certain to cut the Fed Funds rate for the first time in several years next week. It will be the first in a series of rate cuts. Tomorrow evening is the first and most likely the only debate among the two Presidential candidates. It will almost certainly be a battle of form over substance. Virtually every poll going into the debate predicts a tight race. In some years, the debates made a critical difference. I doubt either will have anything of substance new to offer during the debates. Fact checkers will find flaws in what both say. From a market perspective, there is probably more concern over the possibility that one side sweeps both the White House and Congress than who wins the White House. The vast majority of campaign promises are unlikely to be converted into law. There are still concerns, notably about tax policy and regulation that will have to be ironed out over time. But there aren’t
any answers today and there likely won’t be any answers come Wednesday morning.
Labor Day marks its own transition. Summer vacation season is largely over, the kids are back in school, Wall Street conferences proliferate once again, and consumer spending morphs from leisure to necessity based. Transitions are a tough time for investors. Going up the mountain one can see the top but not what’s on the other side. Lower interest rates should help stimulate an economy that increasingly appears to need a dose of stimulation.
Look at last Friday’s employment report. On the surface an increase of 142,000 jobs was a bit better than in July. But factor in negative adjustments to both June and July plus the propensity of these reports to need even further downward adjustments later on, a three-month moving average of just over 100,000 new jobs may be closer to 75,000, barely enough to equate to population growth. With immigration slowing appreciably and likely to continue to do so, economic growth over the next several quarters is likely to slow. I would also note that what jobs are being created are happening in health care, education, leisure & hospitality, and government. The rest of the economy is net zero. Despite all the political talk over reshoring jobs into the U.S., the CHIPS Act, Infrastructure spending, etc., the reality is that the manufacturing sector has added virtually no new jobs over the past few years. Any astute investor can understand why.
With all this said, it’s still a close call whether a recession is close at hand or a soft landing can be achieved. Futures markets still say there is a 70% chance that the first cut in the Fed Funds rate next week will be 25 basis points and a 30% chance of 50 basis points.
It should be 50.
The Fed has dual mandates, keeping inflation close to 2% and fostering economic growth without reheating inflation. I think we can all agree that inflation is nearing 2% and still going down. One of the big bugaboos keeping inflation high to date has been shelter costs. But listings of existing homes for sale are up by more than a third year-over-year. The time from listing to sale is increasing. With interest rates falling, affordability will improve. Rents have been stubbornly high but the supply of new rental units coming to market is robust. Housing-related inflation is coming down and will come down further.
Therefore, if inflation isn’t the problem any more, the primary focus should shift to maintaining economic growth. Although consumer spending has remained strong, there are multiple indicators suggesting that may not last. Savings rates are now below 3%. Checking account balances are falling. Credit card debt is rising. Stores that cater to the low end, like Dollar Tree and Dollar General are suffering. Even high-end luxury goods sales are slowing despite a record stock market. Apprehension is increasing.
The Fed sees this. It knows it has to start cutting rates. If it starts slowing, say 25 basis points per meeting, it runs the risk that the factors leading to a slowdown accelerate and cause a recession before the impact of lower rates kick in. The converse might suggest too steep a cut would reignite inflation. But that’s a hard argument to swallow today. For one, commodity prices are in decline across the board from lumber to copper to oil. Companies are losing pricing power. A year ago, McDonald’s was raising prices amid strong demand. Today, it is heavily promoting value meals to bring customers back. The same applies all over the consumer universe from Starbucks to Wal-Mart.
It is not unusual for a first rate cut to be 50 basis points. It makes a statement. It says firmly that the Fed understands that fostering steady growth today is the primary mandate, at least until there is at a minimum a hint that inflation might reaccelerate.
Most likely, a 50-basis point cut, followed by two cuts of 25 before year end will raise confidence going into year end and Christmas. Don’t expect much from Washington at least until the middle of 2025. Significant legislation takes time, if it’s going to happen at all.
How does all this relate to financial markets? September and early October traditionally are the times of greatest worry. Recession or soft landing? Harris or Trump? Split Congress or not? Then on top of all that comes the question whether the Generative AI boom is slowing and, if so, how quickly? After all, virtually all the economic growth in the U.S. this year relates to the booming capital spending to support a coming AI boom. Make no mistake about it. AI isn’t hype. It’s as real as PCs, smartphones and the Internet. First the infrastructure has to be built, computers and users have to be trained, and software has to be optimized to make this all happen. It will happen very fast. There will be different winners in different phases of AI development. Not all the big legacy names will be winners in the end. But technology has been the driver of growth in this country for decades and will be even more so in the decades ahead.
Thus, while markets have rotated over the past couple of months from the Magnificent 7 to banks, utilities, healthcare, and consumer staples, prices have now adjusted to the point that based on 2025 estimated earnings, names like McDonalds#, Wal-Mart, Procter & Gamble and Coca-Cola# sell at higher P/Es than Meta Platforms# and Alphabet# and similar to many of the others. I have little doubt which will grow faster over the next 5 years.
I can’t answer the question whether six months from now we face a recession or not. Two months ago, markets said “no way”. Today, they say “maybe”. Even “probably”. The Fed’s response next week will matter. A tepid response won’t be well received.
With all that said, the next 4-6 weeks are likely to be bumpy as Fed policy unfolds, as the election gets closer, as companies shut down stock buybacks in advance of third quarter earnings reports, and then the earnings reports themselves. But fast forward to mid-November. By then, we should know who is the next President, the Fed will have acted twice to lower rates, third quarter earnings will be in the rear view mirror, and companies will be setting sights, hopefully optimistically, on 2025. This, a bumpy ride between now and then should set the stage for a reasonable rally into year end. The only negative would be significantly weaker economic data than expected increasing the odds of a meaningful recession.
If you need to do some tax selling, now might be a good time to get started. A little extra cash to buy the dip wouldn’t be such a bad idea.
Today, Adam Sandler is 58. Hugh Grant turns 64. Joe Theismann is 75.
James M. Meyer, CFA 610-260-2220