Equity markets continue to trade near the all-time highs even as volatility has picked up in recent weeks in response to shifting economic data. A weaker than expected July payroll report was the catalyst for a market reversal in which the stock market gave up half of its year-to-date gains amid a large market rotation and flight to quality. Nevertheless, in classic fashion, this fear-based correction was short-lived as subsequent data confirmed fears of recession were overblown. As a result, the S&P 500 rapidly rebounded and is now back to being up +18% year to date, just shy of its mid-July peak despite the interim turbulence.
The core reason markets have been on edge is that after two years of rising interest rates, the economy is finally slowing down, as evidenced by lower GDP growth and a jobs market that is still expanding but decelerating. This is welcome news to the Federal Reserve, which has been applying the brakes on the economy in an effort to bring inflation down. This effort has been largely successful with inflation back below 3%, just a tad above the Fed’s long-term target. Nevertheless, there is a fine line between bringing an economy back into balance and pushing it over the edge into recession, and markets right now are assuming the Fed successfully threads this needle to achieve a “soft landing” for the economy. This is why there was such a negative reaction to the July jobs report – the degree of the miss and unexpected rise in the unemployment rate made the market question whether there was a sudden negative shift occurring in the economy.
Fortunately, the following week brought about much positive news to soothe these recessionary fears. Weekly jobless claims came in better than expected with a surprisingly strong retail sales print to boot. We also had a positive Walmart earnings report which painted a healthy picture of the consumer, and a healthy inflation print of 2.9%, its lowest level since March 2021. Collectively, these data reassured investors that the soft landing was still intact and reinforced the belief that the Fed would start cutting interest rates at its September meeting. Whereas rate cuts ahead of a recession would have triggered selling, the renewed expectation of a soft landing has caused investors to buy stocks in anticipation of lower rates.
Stock fundamentals also continue to remain generally positive, with three-quarters of stocks in the S&P 500 beating earnings estimates last quarter. The AI trade has also continued to drive the market higher despite elevated valuations. A good reason for this is that some blue-chip companies such as Walmart are starting to mention on earnings calls the productivity enhancements they are seeing from generative AI technology. At a time when the market was starting to question Silicon Valley’s return on AI investment, it’s been comforting to see real-world use cases flowing the bottom line. This was part of what caused the sharp dip in Semiconductor stocks to be bought. Nevertheless, industry bellwether Nvidia has yet to report for the quarter, so all eyes will be on them when they release numbers next week. While the market overreaction helped to clear out overbought technical conditions, the reality of elevated valuations means companies will continue needing to beat expectations to drive further gains.
While this backdrop has been generally supportive, the recent volatility shows how quickly markets can pivot if the narrative suddenly changes. As a result, there are a few factors we are watching very closely as we head into Q4. Most notably, earnings strength will need to continue for the market to “grow into” its elevated multiple. Secondly, the degree to which the Fed cuts rates and signals its future intentions will be a key variable. Markets are likely to rally in the ‘goldilocks’ scenario where the Fed cuts into a soft landing, but any notable under or overshoot by the Fed will surely be rapidly repriced by markets. Lastly, the presidential election is starting to have some influence with industry sectors most exposed to the makeup of US government picking up in volatility. This is creating the conditions for sharp relative movements between market sectors even as the effect on the stock market overall is more benign.
Overall, we remain cautiously optimistic on markets right now given the underlying strength of the economy. At the same time, we believe markets will remain prone to volatility as we approach the election and gain clarity on key factors such as jobs and inflation. Geopolitics remain in the background as well despite having limited impact so far this year. Collectively, these factors reinforce the importance of maintaining a steady and structured approach to capital deployment. We will continue to monitor these developments closely and remain on the lookout to add value in portfolios as opportunities present themselves.