After a volatile start of the month, markets found their footing and August was another positive month for global equity markets.
Despite the volatility, the real news in August was Jay Powell’s confirmation that the Fed is ready to ‘pivot its policy’. Powell’s speech at the Jackson Hole conference confirmed what the market was expecting: the Fed will begin cutting interest rates this month, joining other central banks to kick off a monetary easing cycle.
His speech also confirmed that the Fed’s dual mandate is now tilting towards “maximum employment” as the U.S. economy cools. Nevertheless, with few signs of economic and financial stress, it is unlikely that the Fed will cut by 50 basis points. We think a 25 basis point cut is more likely. We also think that the pace of cutting rates will be gradual.
As the monetary easing cycle will get underway this month, the speed of rate cuts will be determined mainly by upcoming payroll reports. One of Chair Powell’s key points at Jackson Hole was that the upside risks to inflation have declined, while the downside risks to the labor market have increased. The implication is that policymakers’ focus has shifted toward the “maximum employment” part of the dual mandate. Pressure to quickly ease policy will build as unemployment rises.
Rapid immigration is adding to the labor supply, which pushes up the unemployment rate, even though job creation remains positive. Rising unemployment opens the door to Fed rate cuts even as the economy continues to grow.
Nonetheless, a lot of rate cuts are already discounted in the curve. The key question is whether the Fed will attain a soft economic landing, or whether it is too late to head off a downturn, even if the Fed eases aggressively in the coming months. The Fed’s track record on achieving a soft landing is admittedly not a good one. The post-pandemic recovery has been highly supply-driven, allowing inflation to decline with little economic pain. The improved trade-off between inflation and growth provides policymakers with room to maneuver on policy rates.
- The Risk of a U.S. Recession
- A Different Fed Easing Cycle
- Will Productivity Gains Save Profit Margins?
- Monetary Conditions Have Already Eased
- U.S. Election – Harris and Trump Tied
- China’s Crisis of Confidence
- Portfolio Positioning
The Risk of a U.S. Recession
The rate of nominal GDP growth will be a key factor in FOMC policy. Most data points still suggest that nominal growth is running at roughly a 5.0% annual rate. We expect economic growth to persist in the coming quarters but at a declining rate.
What is the risk that the economy will slow enough to fall into a recession?
The structure of the US economy is less vulnerable to an economic recession than it was back in the 1980s and 90s. The volatile and interest-sensitive manufacturing and housing sectors are a smaller proportion of the economy, while the demographically driven, largely non-profit, and government paid, healthcare sector now dominates US growth.
Economic activity usually slows in the quarter or two before recessions. However, the slowdown often occurs from strong levels, making it difficult to distinguish between soft and hard landings in real-time. A weakening in consumer and business surveys is often evident before the hard data take a turn for the worse.
A deterioration in the housing sector usually offers the best early warning signal of a looming recession. Initial unemployment claims have also been helpful, although not so much in the lead-up to the 2008 recession.
Ongoing weakness in business surveys and housing activity, along with signs that the labor market is cooling, raises the risk that the U.S. could fall into a recession in 2025.
One thing we keep in mind is that like bull and bear markets, recessions begin at level peaks, economic growth may be decelerating when a recession begins, but it still seems strong enough that no one is expecting a recession.
A Different Fed Easing Cycle
This inflation cycle is different from previous cycles where inflation only began to fall either during or after a recession. Today, core PCE inflation has already fallen to levels very close to 2%, while monetary tightening has not inflicted much damage on aggregate demand, at least not yet.
The key reason for much faster disinflation is that supply-side disruptions have distinctively driven this inflation cycle, and therefore inflation started to fall as the supply side recovered. In other words, disinflation was bound to happen as the Covid-19 pandemic impact passed, with or without monetary tightening. In all previous cycles, however, rising inflation was always led by excess aggregate demand, which needed to be squeezed by tight money before inflation could fall. Often, the Fed inflicted too much damage on demand to bring down inflation, tipping the economy into a recession. So, it is possible that we see a different interest rate cycle this time.
The Fed had previously communicated that it was likely to move at a pace of approximately one 25 bps rate cut per quarter once it begins easing monetary policy. During Powell’s speech, he noted that “the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
The market is currently pricing in a 30% chance that the Fed will cut interest rates by 50 basis points in September and expects 2.2% of cuts over the coming year.
Are these expectations reasonable? A larger September cut to kick off the Fed’s easing cycle is possible but unlikely in our view. It may signal panic and have a negative effect that the Fed is unlikely to be willing to risk. We also do not expect the Fed to cut the policy rate by 220 bps over the coming year unless the U.S. experiences a recession next year. If there is a recession, however, then interest rates could be cut to the 3% level very quickly.
Significant Fed rate cuts could increase the odds of a soft-landing outcome assuming they occur quickly enough to stave off recessionary dynamics. An easier monetary policy in the U.S. would also have positive implications for global growth dynamics, which are not to be underrated. However, there is definitely the risk, and historical high likelihood, of Fed misjudgments in navigating from here.
Will Productivity Gains Save Profit Margins?
Whether we will experience a recession next year or not, the trajectory of corporate profit margins will be the driver of equity market performance.
Over the past several decades, U.S. labor productivity (output per hour worked) has generally trended upward, shaped by technological advancements, economic cycles, and sector-specific dynamics. From 2000 to 2010, productivity grew at an annual rate of 1.7%, driven largely by the 1990s tech boom and innovations in information technology. However, the following decade experienced a slowdown, with growth decelerating to 1.3% annually due to the lingering effects of the Great Recession and slower technological progress. Looking ahead, as we are at the cusp of another major AI-led tech cycle, further U.S. productivity gains could help shield profit margins and thus cushion the profit cycle, even if the economy witnesses a soft landing or a recession in 2025.
Recently we have seen renewed momentum, with labor productivity rising above 2% annually, reflecting the influence of AI and the benefits of investments in digital technology and automation made during the pandemic. Hybrid or working from home trends have also structurally reduced real estate costs for corporations. The second quarter of 2024 highlighted this productivity rebound, with a 2.3% quarter-over-quarter increase, which brought year-over-year productivity growth to 2.7%, a solid pace compared to the 1.6% annualized growth seen from 2015 to 2019.
This rebound in productivity has also moderated unit labor costs, which grew by just 0.9% in the second quarter after a sharper increase in unit labor costs earlier in the year. The year-over-year growth in unit labor costs is now at 0.5%, the lowest level since late 2019, helping to soften inflationary pressures despite elevated nominal wage growth. This matters for business profit margins as labor costs account for approximately 65% of total business costs on average.
The recent acceleration in U.S. productivity offers a promising long-term profit margin outlook which could help cushion profit cycle downturns. More resilient profit margins could contribute to shallower recessionary periods as businesses may simply not need to lay off as many workers. From an investment perspective, shallower recessions would suggest tamer increases in risk aversion as the economic and earnings recoveries will be quicker.
The current expectations are for U.S. corporate earnings to grow on average by 15% in 2025. This seems optimistic in a slowing economy. It sets financial markets up for likely disappointment at some point over the coming months. If that happens, we would want to position portfolios more defensively.
Monetary Conditions Have Already Eased
On the positive side, the U.S. dollar has weakened since the end of July, while 10-year Treasury yields have dropped more than 50 basis points. Both of these dynamics are stimulative for growth and, therefore, stocks. As a rule of thumb, every 10-point drop in the dollar index is equivalent to a 100-basis point rate cut, so the recent weakness in the dollar has already eased monetary conditions for the U.S. economy. This is different from 2022, when falling stocks coincided with a rising dollar and bond yields. The key point here is that so long as the dollar weakens, bond yields drift lower and the Fed brings down the short end of the curve, in the short-term the environment for stocks could remain benign.
U.S. Election – Harris and Trump Tied
The U.S. presidential race has tightened over the past month. Harris’ VP pick, the attention surrounding her nomination at the Democratic National Convention, and a few missteps from the Trump campaign have all contributed to a rebound in the odds of a Democratic win, even though Harris’ national poll numbers are not as rosy as they appear. Polls are statistically tied in critical Midwestern states.
The odds of a Trump victory are still underrated, but investors need to look past the White House: the makeup of next year’s Congress is more important.
At this moment it is impossible to predict who will win and what that would mean for policy. So, we focus on economic fundamentals and will not try to second-guess the election outcome in our investment strategy.
Regardless of who wins the U.S. election, the Federal Reserve will be loosening monetary policy as it shifts its focus from its low inflation mandate to its low unemployment mandate.
The actions of the FOMC may be even more important to the rest of the world than to the U.S. While we can argue that a 5.3% overnight rate is not restrictive for the U.S. it is clearly too high for the rest of the world, which is still struggling to exit the global manufacturing downturn
Thus, the most important consequence of Fed easing is not likely to be in the U.S. but rather in a reacceleration of global trade, which likely helps emerging markets more than anywhere else. That may not be in the Fed’s mandates but it is the most likely outcome of the relaxation in the U.S.’s monetary stance
China’s Crisis of Confidence
On the other side of the world, China’s money and credit numbers have been extremely weak in recent months. Narrow money supply (M1) contracted by 6.6% in July, the worst reading in history. The net increase in credit creation has fallen to new all-time lows as well. If history is any guide, the contraction in the money supply typically leads to a deceleration in economic growth going forward.
What’s more troubling is that policymakers appear paralyzed. Instead of addressing these issues, they have been downplaying the warning signals. The Chinese central bank governor once again hinted that the PBOC is ready to ease further but gave no indication of how aggressive the measures might be.
The main problem is that there is now a widespread confidence crisis among consumers and investors, and policymakers seem to lack a strategy to address the mounting economic and social challenges.
As the second-largest economy in the world, China’s growth outlook and financial markets are important for investment markets and the rest of the world. Now the needle has shifted towards the risk side: it is now more likely that we see a significant deceleration in Chinese growth data.
Chinese stocks are already trading at low valuations, but a major breakout is unlikely until the government starts a large-scale stimulus program, which does not seem to be in the cards. As such, it is too early to bet on a sharp reversal in Chinese indices, particularly in relative performance.
In essence, Beijing is repeating the classic policy mistake that Japan made after the asset bubbles burst in the early 1990s. For years, the Japanese government dragged its feet with countercyclical measures. Instead, they focused heavily on addressing structural issues in the economy, hoping these initiatives would “rebalance” the economy and restore growth to trend. As a result, Japan suffered a prolonged economic recession, price deflation, and stock market decline. The chronic decline did not end until 2012 with Prime Minister Shinzo Abe’s aggressive “Three Arrows” policy.
Portfolio Positioning
Despite the recent market volatility, we continue to hold the same view as we did last month about the global economy. 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 fast enough to stabilize economic activity before a recession takes hold.
Earlier this summer we already positioned the core ETF portfolios slightly more defensively. We are comfortable with the current portfolio positioning for the coming months but we could position the portfolios even more defensively if we see a deceleration in corporate profit growth.
Our single-stock portfolios provided material downside protection during the early weeks of August. Our perennial focus on quality, safety and volatility when constructing stock baskets pays off in negative markets and continues to be a hallmark of our approach going forward.
In fixed income, we maintain a benchmark neutral duration position as U.S. Treasury yields might not come down much further even when the Fed cuts interest rates. Our allocation to emerging markets and higher-quality credits should benefit as the Fed starts to lower rates.
DISCLOSURES
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.
Core PCE Price Index y/y shows changes in prices for a fixed basket of consumer goods and services purchased by US residents in the given month compared to the same month of the previous year. This indicator is also called “PCE deflator”. It takes into account households’ actual and imputed spendings on durable and non-durable goods and on services. Prices for food and energy are excluded from the core index calculation due to their high volatility. The index is benchmarked to a basis of 2009.
Rebalancing/Reallocating can entail transaction costs and tax consequences that should be considered when determining a rebalancing/reallocation strategy.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
