If you only look at global markets’ performance in July, you would see a typical summer pattern of relatively quiet markets, and you would think not much has happened in the past month. But then at the end of the month, a string of weaker economic data triggered a sudden recession fear, which caused bond yields to fall sharply and created a sell-off among growth stocks.
Obviously, there has been a lot of news, including President Biden withdrawing from the election, an assassination attempt on former President Trump, strong GDP growth in the U.S., several central bank meetings and solid corporate earnings.
This seemed to have created a lot of volatility, especially among highly valued tech stocks. U.S. Treasury yields came down, which gave a boost to bond prices. The Japanese Yen experienced a sharp recovery rally on the back of a more hawkish Bank of Japan.
- The U.S. Economy is Still Growing
- Did the Fed Make a Mistake Not Cutting Rates?
- The Magnificent Seven Took a Hit in July
- The Trump Versus Harris Election
- China’s Third Plenum Did Not Deliver for Investors
- The BoJ’s Surprise Hike
- Portfolio Positioning
The U.S. Economy is Still Growing
The most significant macro developments over the past month came from the July employment report, retail sales, and CPI. On the employment front, payroll growth remains strong, but the unemployment rate continues to rise.
Second quarter nominal GDP rose at a 5.2% annual rate, faster than the 4.5% in Q1 and the 5.1% in Q4 of 2023. Real GDP grew a robust 2.8% in the second quarter, higher than the Atlanta Fed’s 2.6% GDPNow forecast, and well above the 2.0% consensus.
The big question is if the U.S. economy will hold up and keeps growing at the current pace.
July nonfarm payrolls expanded by 114 thousand workers, a sharp slowdown from June’s downwardly revised 179 thousand, and significantly disappointing expectations of 175 thousand.
The unemployment rate unexpectedly edged 0.2% higher to 4.3% in July, rising for the fourth consecutive month. Wage growth decelerated at a faster-than-anticipated pace, with average hourly earnings decreasing from a downwardly revised 3.8% to 3.6% y/y.
Part of the rise in the unemployment rate can be attributed to an increase in labor supply, as the participation rate ticked 0.1% higher to 62.7% over the month. Notably, the prime age labor force participation rate increased by an even larger margin from 83.7% to 84%, suggesting that the rise in labor supply was broad-based.
Not all of the increase in the unemployment rate can be attributed to higher supply, however. The June JOLTS report suggested that demand for workers continued to slow and that the hiring rate decreased.
July’s weak employment report cements the case for a September rate cut and the question has shifted away from “when” to “how much”.
Did the Fed Make a Mistake Not Cutting Rates?
FOMC members unanimously voted in favor of keeping rates on hold in July but signaled that a September cut is on the table. After the unexpected rise in unemployment the question is whether the Fed is already too late, and made a mistake not to already cut rates in the July meeting.
Inflationary pressures have also eased. Notably, the Employment Cost Index (ECI), one of the Fed’s favored measures, decelerated at a faster-than-expected pace in Q2, from 1.2% q/q to 0.9%.
The press conference continued to emphasize the need for “greater confidence” in the sustainability of disinflation, though Chair Jay Powell acknowledged that recent data “have added to that confidence”.
However, the committee’s attention “to the risks to both sides of its dual mandate” constitute a change in language. Powell acknowledged that inflation has been the Fed’s main concern over the past year but that its maximum employment mandate is coming back to the forefront.
Although he characterized the softening in the labor market as a normalization from overheated conditions, he nevertheless stressed that policymakers would “stand ready to respond” should it be “more than that”.
The U.S. economy is definitely softening and the Fed will need to get ready to aggressively ease monetary policy if they would like to achieve a soft landing. The problem with one or two rate cuts in the next six months is that we doubt that will be sufficient to ensure a soft-landing. Unless the Fed lowers rates dramatically, which will not happen unless we see a recession, the economy will continue to slow because of the impact of higher interest costs on businesses and households.
If the Fed changes its tone quickly and indicates that in September we will see the start of an aggressive easing cycle, we will likely see equity markets bouncing back, on renewed hopes for a soft landing.
So far, the pattern still fits a typical U.S. election year. A good start, a weak summer and a good finish to the year. Only the last part we don’t know yet.
The Magnificent Seven Took a Hit in July
The biggest sell-off in recent weeks was in highly valued tech companies. Especially among the magnificent seven stocks, as the hype over artificial intelligence (AI) suddenly cooled.
There is a great deal of uncertainty to which extent AI will boost productivity growth. There is also considerable uncertainty over when such productivity gains will occur and whether companies will be able to monetize them sufficiently compared to the sizable capital investments that have been made into AI.
Recall that the productivity benefits of the IT revolution appeared in the mid-1990s, but it was not until the mid-2000s that internet companies finally figured out how to profit from online commerce. And when companies such as Facebook did begin to make serious money off the internet, it was mainly by exploiting network effects.
It is not at all clear that similar network effects apply to AI. If anything, the output of various LLMs seems to be converging, which is not all that surprising given that they have similar architectures and broadly use the same training data. In the end, AI models could end up being more like airlines; very valuable to consumers but so indistinguishable that they cannot make monopoly profits.
On average U.S. stocks are now priced for a similar productivity boom as occurred starting in the mid-1990s. With expectations so high, the risk of disappointment is real.
The Trump Versus Harris Election
The U.S. election campaign has been a wild ride over the past month. Joe Biden’s poor performance during the first presidential debate caused a cascading failure for his campaign, which had already been mired by poor popularity and concerns about his age. The assassination attempt on Donald Trump’s life further boosted the odds in favor of his candidacy.
Biden’s withdrawal from the race and the Democratic party unity around Kamala Harris have thrown investors another curve ball, with the policy outlook for 2025 and beyond now quite uncertain.
But with a slowing economy, the odds still favor that Donald Trump will win in November. However, three months is still long time in an election cycle.
A key question for investors concerning a second Trump presidency is whether tariffs are prioritized by the administration. A legislative focus on immigration over tax cuts, alongside the imposition of new tariffs, would be the worst alignment for equity markets. 60% tariffs on all imports from China would be much more significant than what occurred in 2018-19 and would substantially increase the odds of a global recession.
We also do not think a Trump administration would impose tariffs only for China but more likely on all its major trading partners unless it receives major concessions in return.
President Trump’s nomination speech at the Republican convention in Milwaukee gave some direction on his policy priorities. Two passages were instructive. First, on tensions with China over trade he said:
Large factories, just started, are being built across the border in Mexico…. They’re being built by China… We don’t mind that happening. But those plants are going to be built in the United States and our people are going to man those plants…
Trump believes that he can employ 1980s solutions to the 2020s China-US trade war. This is relevant because he does not see China as a national security threat, first and foremost. He sees it as a commercial competitor.
Second, on tensions with Iran Trump said: “Iran was broke. Iran had no money… Iran was going to make a deal with us and then we had that horrible, horrible result that we’ll never let happen again.”
President Trump effectively admitted that he was on the brink of concluding a deal with Iran. This is important as it suggests that he is not ideologically opposed to making a deal with Tehran. These remarks suggest a level of pragmatism from Donald Trump.
Another question is whether Trump would use stimulative fiscal policy keep the economy out of recession?
The problem is that fiscal policy is already extremely stimulative, which is one reason why it has taken the economy so long to cool down. The Congressional Budget Office expects the federal government budget deficit to average 7% of GDP in 2024, an exceptionally large number for an economy that is still close to full employment.
If Donald Trump wins in November and the Republicans take control of the Senate and retain control of the House of Representatives, they will likely permanently extend the personal income tax cuts that were passed under the 2017 Tax Cuts and Jobs Act, which are set to expire at the end of 2025.
Some incremental cuts to income taxes for middle class earners are possible, but this will likely be offset by higher tariffs. Nearly 90% of federal income taxes are paid by the top 25% of income earners. In contrast, tariffs disproportionately hurt lower-income households with relatively high marginal propensities to consume. Thus, even if higher tariff revenue is entirely recycled into income tax cuts, the net effect on aggregate demand will be negative.
Whether stocks go up or down in the 6-12 months following a Trump victory would depend heavily on the state of the U.S. economy and whether it has already entered a recession. But it will also depend on the balance of trade shock and fiscal stimulus.
The sequencing of policies will also be very important to monitor. Trade policy under a second Trump presidency represents the greatest cyclical risk to investors.
A Republican sweep could also mean substantive restrictions on immigration, which could lead to higher wage growth.
The immigration crackdown will be the top policy priority of the new administration and investors should not underrate the potential for serious labor shortages to develop.
China’s Third Plenum Did Not Deliver for Investors
Coming out of the third Plenum, China does not seem to have a bold new plan but rather is doubling down on a strategy of focusing on key technological developments that they hope puts them at the forefront of global influence in a decade.
Consumer spending seems to be a secondary concern. As is a rapid resolution of the housing crisis. Western investors may not like the approach but with a definitive agenda now set for five more years, multinational businesses are likely to adjust their business models accordingly to maximize revenues.
China implemented a modest, but unexpected, cut in interest rates to help add stimulus to the economy. While only ten to twenty basis points depending on the rate, cuts in China are often more to send a signal to banks that lending is ok rather than to set rates at a level that encourages a market reaction. The problem is that demand for loans is low and falling in China and lower interest rates will only have a limited effect on credit demand.
The BoJ’s Surprise Hike
The Bank of Japan hiked its policy rate by 15 bps from 0.10% to 0.25% on Wednesday, and announced further quantitative tightening, reducing its pace of monthly bond buying from JPY 6 trillion to JPY 3 trillion. While the central bank had previously telegraphed its intention of tapering asset purchases further, the rate hike took market participants by surprise.
The BoJ upgraded its inflation forecast for 2025 to 2.1% from 1.9% back in April, as a wage-price spiral may be underway. Broad Japanese wage growth measures are catching up. Meanwhile, long-term inflation expectations continue to rise.
Political pressures against a weak yen may be intensifying. Notably, comments from Minister Kono Taro, a contender for Japan’s premiership, and fervent proponent of higher rates and stronger JPY have been capturing investors’ attention in recent weeks. He stressed the limited benefits of a cheaper yen on exports given Japanese firms’ production facilities abroad. Moreover, the monetary policy statement showcased several references to imported inflation due to a weaker currency.
Policy normalization supports the yen, which is deeply oversold and undervalued. The resurgence of trade tariffs would support Japan’s trade balance as U.S. imports are redirected from China to Japan. We remain positive on the yen as long as the BoJ proceeds with policy normalization.
Portfolio Positioning
Despite a whirlwind month of significant political volatility, we continue to hold the same view as we did last month about the global economy and appropriate portfolio positioning over the coming year. The U.S. labor market and inflation continue to cool, and that would normally be positive for the economic outlook. But for that to work out, the Fed will need cut interest rates enough to stabilize economic activity before a recession takes hold.
Last month we positioned the core portfolio slightly more defensive by taking profit on the overweight in Japanese stocks and the financial sector and adding exposure to the more defensive healthcare sector.
We also rebalanced portfolios to lower the equity weight slightly in favor of fixed income. We are comfortable with the current portfolio positioning for the coming months.
DISCLOSURES
The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.
This material represents an assessment of the market and economic environment at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results.
Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies.
The Gross Domestic Product Price Index (GDP) measures changes in the prices of goods and services produced in the United States, including those exported to other countries. Prices of imports are excluded.
The Employment Cost Index (ECI)measures the change in the hourly labor cost to employers over time. The ECI uses a fixed “basket” of labor to produce a pure cost change, free from the effects of workers moving between occupations and industries and includes both the cost of wages and salaries and the cost of benefits. The ECI is prepared by the Bureau of Labor Statistics (BLS), in the U.S. Department of Labor.
