September and October are typically volatile months for asset markets, and this year has not been an exception. September started again with another equity market sell-off as weaker U.S. job data combined with weak data from Europe and China triggered another bout of recession fear.
And then the Fed started its monetary easing cycle with a bang and China delivered its largest stimulus since 2015, reigniting the risk-on soft-landing narrative in September.
Chinese and emerging markets equities led the pack. Beijing’s aggressive stimulus package gave a shot of adrenaline to financial markets, allowing Chinese risk-assets to rally from depressed price and valuation levels.
Unlike equities, bond markets were relatively calm last month as the market is making up its mind whether the Fed rate cuts will eventually lead to lower or higher bond yields.
The prospect of further Fed easing sent the U.S. dollar lower and it has given back more than half of its year-to-date gains.
- The Fed Delivered
- What is Next for the Fed?
- What to Expect for Q3 Reporting Season?
- What Would U.S. Political Gridlock Mean for Equities?
- A Widening Conflict in the Middle East
- China’s ‘Whatever it Takes’ Moment
- What’s Different This Time?
- Will It Be Sufficient?
- Portfolio Positioning
The Fed Delivered
The Federal Reserve delivered an outsized interest-rate cut designed to preserve the strength of the U.S. economy as risks to the labor market mount, marking an end to their focus on inflation.
Powell launched the rate cutting cycle with a big move while the U.S. economy is still strong to help limit the chances of a downturn. But he was careful not to commit the Fed to a similar pace going forward, saying future moves would be based on how the economy performs in the months ahead.
“The labor market is actually in solid condition, and our intention with our policy move is to keep it there,” Powell told reporters after the FOMC meeting.
One positive data point is that slower job growth has not been reflected in lower wage growth. In August, wages rose a faster than expected 0.4% which is faster than inflation. This was a rebound from a softer 0.2% reading in July.
Over the past three months, wage gains averaged 0.31% a month, exactly the same as in each of the past four quarters. This kind of stability in wage growth, especially when inflation has been cooling seems inconsistent with a softening labor market. Rather, it looks like demand is still strong for qualified workers.
Another reason for not expecting significant layoffs is that firms have experienced productivity growth in recent quarters and, as a result, very low growth in unit labor costs. Recently revised second quarter data showed a 2.5% increase in output per worker, and up 2.7% for the past year.
What is Next for the Fed?
September nonfarm payrolls grew by 254 thousand, from 155 thousand in August, much stronger than expected. Manufacturing jobs declined by a lower-than-anticipated seven thousand, while leisure and hospitality, as well as healthcare, led an otherwise broad-based increase in payrolls. The prior two months’ numbers were also revised 72 thousand higher. The unemployment rate ticked lower to 4.1% and average hourly earnings unexpectedly accelerated from an upwardly revised 3.9% y/y to 4.0%.
The data is still solid, but it is disconcerting that quick and extended declines in the past were associated with recessions. Chair Powell warned not to expect a string of 50 basis point rate cuts and suggested that the pace of easing will be data dependent. Nonetheless, the FOMC feels an urgency to neutralize policy. Chicago Fed President Goolsbee emphasized that the Fed funds rate needs to fall quickly to a neutral level to avoid an overshoot in the unemployment rate.
As long as the jobs market holds up, we think it is unlikely that we will see a recession any time soon. However, as we discussed last month, recessions can start quickly and unexpectedly when the labor market deteriorates. So, we will be following closely the developments in the labor market.
The recently announced Chinese monetary and fiscal stimulus package will also help the global economy. A meaningful commitment to stimulating domestic demand within China would go a long way to jumpstarting the global manufacturing recovery and should boost sectors and industries with global goods exposure. Chinese stimulus will be especially helpful for Japan and Europe.
What to Expect for Q3 Reporting Season?
The third quarter earnings season is about to kick off. Reaction to third-quarter reporting season should be more positive after the tone during the second quarter was that of slight dissatisfaction – given a smaller magnitude of earnings beats and concern regarding the monetization of artificial intelligence (AI).
Expectations for Q3 results have trended lower in recent weeks, with S&P 500 consensus earnings down by -3% since July. Each sector has seen negative revisions, on average, with some of the largest cap-weighted declines in Health Care and commodity-related industries. The silver lining is that this creates a solid opportunity for actual results to come in well above expectations.
What Would U.S. Political Gridlock Mean for Equities?
In our view, it’s unclear who will win the U.S. Presidency in November. However, we think there is a good chance that no matter who wins the White House, Congress is likely to be divided.
This political gridlock scenario could be positive for markets as both sides will have to negotiate with each other, and large policy changes are then much less likely.
Trump is known as a dealmaker with less ideological dogma. He’s more likely to cut deals if he senses they benefit his cause, even if they benefit those of Democrats and deviate from traditional Republican platforms. His policy objectives would incorporate security and an extension of his signature tax legislation.
Harris and Walz are less tested as dealmakers, making the composition of their cabinet more critical. As a Senator, Harris exhibited more ideological tendencies although she’s walked back some positions as Presidential candidate. A mainstay of her rhetoric, however, has been advocacy for higher taxes on corporations and the “wealthy” in exchange for lower income and family funding.
A Widening Conflict in the Middle East
In recent weeks, the conflict in the Middle East has expanded. Israel attacked Lebanon and Iran made another attack on Israel because they cannot abandon Hezbollah or let its proxy’s leaders be assassinated with impunity.
But Iran does not want to get bombed. Its leadership is vulnerable because of its domestic instability and social unrest. So, the way Israel will react to Iran’s missile attack will be important.
After Iran’s attack, oil prices jumped but have since come down again. The key reason is that so far there has been a very limited impact on oil production in the Middle East. However, that could change if the Israel attacks Ian’s oil facilities. Potentially dragging the U.S. into the conflict, which would complicate relations with other oil producing countries in the Middle East.
A higher oil price could then have an impact on inflation at a time that the Fed has shifted its focus to the jobs market.
China’s ‘Whatever it Takes’ Moment
The Chinese government has finally capitulated to growing deflationary pressures and the rising risk of an economic implosion, announcing a number of aggressive measures to stimulate the economy. It is too early to know whether this much needed and long-overdue monetary reflation will be a game changer, but the 30% rally in Chinese stocks is an encouraging sign.
The Chinese central bank, together with financial regulators, announced a slew of stimulus measures, triggering a sharp rebound in Chinese stocks. The big surprise was how aggressive the PBoC’s steps were to prop up the stock market.
What sets the latest reflation drive apart from the one earlier this year is a greater sense of urgency. After months of poor performance, any hope that the economy could recover on its own should have waned. Beijing is very concerned about growth and the risk of deflation and must take on more heavy lifting to boost the economy. Meanwhile, the government sees the onset of the Fed easing cycle as an opportunity to reflate more aggressively without worrying about the exchange rate. The tone of central bank governor Pan Gongsheng is more determined and aggressive than before, and the measures are much broader, raising the possibility that Beijing may stimulate in a more persistent manner.
It is encouraging that Beijing seems to be waking up to mounting economic pressures and social tensions. We expect these measures to trigger a sizable rebound in Chinese stocks, and it is not too late to join the rally. However, for this rebound to evolve into a sustained bull market, Beijing must do more to fundamentally revitalize the economy.
What is specifically interesting for equity investors is that some of the measures are specially targeting boosting the equity market. The PBoC now allows non-banking financial institutions to use “swap facilities” to obtain liquidity by using their equity holdings as collateral.
A special loan facility will be established to help and support stock buybacks. The pool of money is small, starting at $42 billion, but more funding will be provided if the program works well. A stabilization fund will be established to steady the stock market, whenever necessary.
What’s Different This Time?
China has announced many piecemeal actions to shore up its economy in recent years, but until now these actions and announcements have been poorly received by markets.
This monetary stimulus package is more aggressive and comprehensive than all previous reflation efforts. Central bank governor Pan Gongsheng sounded more determined than ever to steady the economy. Most importantly, the central bank’s announcement was immediately followed up by a Politburo meeting last Wednesday when President Xi was forthright about the economy’s key challenges and reaffirmed his commitment to use “active” fiscal and monetary policies to stabilize the housing market and the economy. Chinese stocks, both the onshore and offshore markets, have also embraced the announcement with a big rally, a significant departure from typical disappointing responses to Beijing’s policy announcements in recent years.
Although the Chinese government has announced RMB2 trillion (US$285 billion) in bond issuance, the planned fiscal stimulus seems small (1.5% of GDP) relative to the seriousness of the economic problem. That being said, China’s fiscal and monetary stimulus is often mixed together, and the line is frequently blurred. For example, the 2008 stimulus programs were entirely funded by bank deposits rather than bond issuance, and spending was also done via government-directed loans. There is also a fiscal component from the monetary action.
For example, the PBoC will cover 100% of loans to local governments buying unsold homes with cheap funding. Clearly, this is fiscal stimulus dressed up as monetary policy. The key difference here is that President Xi was very explicit in last week’s Politburo meeting, stressing that active fiscal and monetary policy, particularly public sector spending, are necessary to safeguard economic growth.
Will It Be Sufficient?
The measures announced are probably not enough to turn around the economy. The interest rate reductions are small, and the RRR cut is also within its historical range. Nevertheless, what is encouraging is that authorities have indicated that last week’s actions are only the first instalments of policy stimulus. More policy support is forthcoming.
The key concern is whether Chinese policy makers might decide they have done enough based on the strong equity market rally. Because the equity market is not the economy, and the Chinese economy needs significant fiscal support to ignite more domestic consumption.
The stock market rally does help to change the sentiment and that is also important as China was suffering from a crisis of confidence. This boost to the equity market could make people feel more secure about their future and inspire more spending. That could mean that the equity market has further to run.
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, but economic growth is still solid and the labor market is still holding up. The Chinese stimulus package can also give an impulse to global growth.
This summer we positioned the core ETF portfolios slightly more defensively. We are comfortable with the current portfolio positioning for the coming months. Our slight overweight position in China profited from the big rally in Chinese stocks in recent weeks.
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
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.
Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
Investments in emerging markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
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.
