US Strategy Weekly: Discounted the Fed Rate Cut

Stocks bounced back quickly from a steep early August sell-off that was triggered by recession fears and the first rate hike by the Bank of Japan in 17 years. However, it was actually driven by a massive unwinding of the yen carry trade. This was followed by eight days of consecutive gains which were the longest winning streaks for the S&P 500 and the Nasdaq since November and December, respectively. And if the S&P 500 index had closed higher for one more day, the 9-day winning streak would have been the longest in 20 years. The streak was broken, nevertheless, it was the best week of the year for stocks. We would not be surprised if these gains prove difficult to sustain, particularly as representatives from central banks around the globe are expected to converge in Jackson Hole, Wyoming, this week for their annual Economic Symposium. Traders will be laser-focused on Federal Reserve Chair Jerome Powell who is expected to deliver remarks on Friday. Markets are currently pricing in a 69.5% likelihood of a 25 basis-point reduction of the Fed funds target rate at the conclusion of the Federal Open Market Committee meeting on September 17 and 18, with a 30.5% chance of a super-sized cut of 50 basis points, according to CME’s FedWatch tool. In our view, the markets have been discounting a Fed rate cut all year and the actual event may prove to be less than satisfying for investors.

Economic News

There were a number of economic releases in recent days and in summary, the results display a mixed economy with the exception of housing, which is clearly in a slump.

The University of Michigan consumer sentiment index was at 67.8 in August, up from July’s 66.4, and up for the first time in five months. Present conditions dropped to 60.9 from 62.7, its lowest reading in twenty months. But expectations were the driver of the overall index rising to 72.1, up from 68.8. The gain in expectations had an interesting twist and was led by a 6% uptick from Democrats in an apparent response to the Harris nomination. The expectations index for Republicans fell 5% and rose 3% for Independents. The survey showed that expectations for inflation remained the same and the job market, the housing environment, and political uncertainty continued to weigh on sentiment. See page 3. Conference Board confidence data for August will be released at the end of the month.

Investors were relieved that headline CPI rose the expected 0.1% in July versus a month earlier. On a year-over-year basis CPI fell 0.08% and, on a decimal-rounding basis, fell from 3.0% YOY in June to 2.9% YOY. Core CPI fell from 3.3% YOY to 3.2% YOY. Service sector inflation fell from 5.0% YOY to 4.9%. Services less rent of shelter fell from 4.8% YOY to 4.6%. Transportation services fell from 9.4% YOY to 8.8%. Hospital & related services fell from 7.1% YOY to 6.2%. In short, service inflation is trending lower but almost all segments remain substantially above 3% YOY. See page 4.

Retail sales were surprisingly buoyant in July, rising 1.0% for the month and up 2.7% YOY. This news helped to spark the equity market’s rebound, particularly since June’s report showed a 0.2% decline for the month and a lower 2.0% YOY gain. Excluding autos, year-over-year retail sales were up in July, but lower than a month earlier. Excluding autos, sales rose 3.1% (3.3% YOY in June) and excluding autos and gas sales increased 3.4% (3.6% in June). The strongest gain was seen in electronics and appliances where sales rose 5.2% YOY after being up only 1.0% YOY in June. Still, after inflation, retail sales fell 0.3% YOY in July following a 0.9% YOY loss in June. Retail sales have been negative on a YOY basis for 19 of the last 29 months, a pattern typically seen only during recessions. See page 5.

Consumer credit is an area we are monitoring. Total consumer credit rose 1.6% YOY in June and nonrevolving credit rose a mere 0.3% YOY. These decelerating growth rates in credit are critical because negative growth is a characteristic of a recession. And note that after adjusting for inflation, total consumer credit growth has been negative for the last 13 months. See page 6.

The National Association of Home Builders confidence indices deteriorated in August from negatively revised numbers in July. The headline NAHB index fell from 41 to 39, the lowest reading this year, and down to recessionary levels. Current sales of single-family homes fell from 46 to 44. Next six-month sales rose a notch from 48 to 49, but traffic of prospective buyers fell from 27 to 25, its lowest level in 8 months. Construction data was not any better. In July, housing starts fell 6.8 % MOM and 16.0% YOY. Permits fell 4.0% MOM and 7.0% YOY. Single-family permits were slightly better, falling 1.6% YOY. See page 7. By most measures, the housing sector is slowing significantly, and it will be interesting to see if August’s decline in long-term interest rates buoys this market. See page 7.

Valuation

With stock prices backing up near record highs, and consensus earnings forecasts for this year and next year ratcheting lower, valuation benchmarks are getting worse. The SPX trailing 4-quarter operating multiple is now 24.8 times, and well above all long- and short-term averages. The 12-month forward PE multiple is 21.2 times and when this is added to inflation of 2.9%, it sums to 24.1 which is above the top of the normal valuation range of 14.8 to 23.8. By all measures, the equity market remains richly valued. Current valuation levels have only been seen during the 1997-2000 bubble, the financial crisis of 2008, or the post-COVID-19 earnings slump. See pages 8 and 9.

Technical Update

The VIX index is a good measure of panic in the marketplace and is therefore helpful in defining lows. But as we pointed out last week, the extremes seen on August 5^th were not the third highest in history or that unusual. Since 1986, there have been 286 higher closes in the VIX and 47 higher intraday highs. We dug deeper to see if days with both higher intraday and closing highs were important in defining significant price lows. What we found was there were 9 days of more extreme readings than August 5^th between October 19, 1987 and October 29, 1987 and the market troughed on December 13, 1987. In 2008, there were 26 nonconsecutive days between October 10, 2008 and December 5, 2008, plus 132 consecutive trading days with higher closing VIX prices. The SPX had an interim trough of 752.44 on November 20, 2008 but eventually troughed at 676.53 on March 9, 2009. In 2020, 12 nonconsecutive extreme days between March 12, 2020 and March 30, 2020 did include a low made on March 23, 2020. Overall, the peak levels in the VIX index on August 5^th appear to be neither historic nor predictive. Moreover, extremes in the index usually last substantially longer and precede major lows by several days and/or months. See page 10. The equity indices have made a remarkable recovery from their early August lows and the Dow Jones Industrial Average and the S&P 500 index are now challenging their all-time highs. However, the easy part of the rebound is over, in our view, and we expect the old highs to be resistance due to the unlikelihood that the carry trade will be reinstated, the fact that earnings season is nearly over, and that the market has already factored in a rate cut in September. A new catalyst for further gains may be needed to drive prices higher.

Gail Dudack

Click to Download