August 2024 Market Update
While July started off the same way that many months have recently, which is more gains for large-caps and tech, the markets experienced a massive shift within U.S. equities that it hasn’t seen in a while. A cooler than expected inflation number in June raised the market’s expectation for more rate cuts later this year and that resulted in a revival in small-caps, value and dividend stocks. The magnificent 7 suddenly found themselves vulnerable in a way that we haven’t seen since 2022. A rotation into cyclicals and value stocks is typical of what we see when the markets anticipate looser monetary conditions and those poised to benefit most from lower rates tend to rally. The sharpness of the rotation, particularly in small-caps, was a bit unexpected, but not altogether surprising given the huge valuation gap between the two. While it’s too early to declare the value trade back for good, our view is that there is a fair amount of longer-term potential here and this segment of equities could provide some degree of risk protection should sentiment continue to deteriorate.
Our larger concern is that the global economic environment is weakening, perhaps more than the markets anticipated. GDP growth in the U.S. is still solid, but the jobs market is clearly weakening, credit risks are starting to grow and the consumer is getting fatigued. The labor market is likely the most concerning catalyst of the bunch since that’s what tends to drive the economy. If workers are losing their jobs or feeling less comfortable in their jobs, they usually slow their spending habits and that trickles down into everything else. Once the unemployment rate begins accelerating higher, it tends to keep moving in that direction. Therefore, we’re maintaining a cautious stance here and would encourage investors to consider risk protection.
The Fed’s decision to hold off on rate cuts in late July is looking like it could be a policy miscue given the weak jobs report just two days later. In 2022, the Fed was slow to raise interest rates in response to spiraling inflation and they could be late to respond again to a slowing economy. Instead of a gently easing glidepath, Chair Powell could be forced to enact more aggressive 50 basis point cuts starting in September and again later on this year. These larger policy shifts tend to add to market volatility and that’s usually bad for equity prices. We’ve seen a more extreme version of that recently. Our view is that rate cuts usually correlate with economic slowdowns and the latest data suggests we’re heading in that direction here.
We also remain concerned about the current situation in Japan, both with respect to interest rates and the yen. The days of investors and institutions borrowing in cheap yen to leverage up on U.S. tech stock exposure appear to be over. Now, we’re feeling the pain of the unfortunate unwinding of that situation. This is another of the catalysts increasing market risk at the moment and one that may not resolve itself for some time. Not to belabor the point, but this is another example of why we feel risk management is critical at this point. The overweighting of the magnificent 7 stocks in many portfolios is leaving investors ill-positioned as conditions turn more bearish. If the global economy continues to slow, finding ways to add downside protection should be a strong consideration.
