Weekly Stock Market Recap – August 2, 2024

The typical summer lull was nowhere to be found in the markets last week. The final week of July was a whirlwind, filled with a flurry of earnings reports, three central-bank meetings, and key labor-market data. At first glance the abundance of datapoints suggested several crosscurrents. The Fed continued to hold rates steady even as Chair Powell recognized growing risks to the labor market. Corporate earnings are exceeding estimates, yet stocks have declined since the start of the second-quarter earnings season. Concerns about the growth outlook drove a U-turn in the recent rotation into cyclicals and small-cap stocks, while the artificial intelligence (AI) darlings experienced their biggest pullback this year¹.

Looking through the noise, we see several turning points in

1. Fed policy;
2. The labor market;
3. The yield curve;
4. Market leadership; and
5. Volatility.

These factors will likely define performance in the months and quarters ahead. Here is our take:

1) Fed policy: The start of an easing cycle is now in sight as focus shifts to jobs

After the most aggressive tightening cycle in 40 years and the second-longest pause in history with rates in restrictive territory (371 days since the last hike vs. 445 days in 2006-2007), last week the Fed sent the clearest sign yet that a new easing cycle might be around the corner¹. Over the past two-and-a-half years, inflation has been solely front and center guiding policy. But as the Fed gets closer to achieving the first part of its mandate — stable prices — it is becoming more attuned to the second — maximum employment.

The Fed left its policy rate unchanged last week at 5.25% – 5.50%, as was expected, but it tweaked its statement to reflect the growing chance of a September rate cut. Chair Powell, in his press conference later, confirmed this possibility, saying, “The job is not done on inflation. Nonetheless, we can afford to begin to dial back the restriction in the policy rate.” With additional confidence that inflation is moving in the right direction, Fed officials have become more sensitive to downside risks to the labor market, which is why we think they will cut interest rates two or possibly three times this year instead of just the one that they projected back in June. Since June, inflation has fallen below the Fed’s 2.8% year-end projection, and the unemployment rate has now jumped above its 4.0% forecast¹.

The key takeaway, in our view, is that the labor data may play as big a role in shaping what comes next from the Fed as the inflation data, or bigger.

Source: Bloomberg, Edward Jones, and June FOMC SEP.Chart description

2) The labor market: Still adding jobs, but the weak July report raises questions

For several months now the U.S. labor market has been cooling, but up until this point this deceleration has simply been a normalization from overheated conditions, and, as a result, it has been welcomed by the markets. As often mentioned by market participants, bad economic news has been good news for the markets, signaling that inflation would come down. But after a string of disappointing datapoints this week and inflation being closer to target, this mantra might be changing, as investors question whether the Fed is too late in cutting rates.

The July payrolls report showed that the U.S. economy added 114,000 jobs, less than the 175,000 expected, with some modest downward revisions to prior months. The unemployment rate jumped to 4.3% vs. consensus of 4.1%, and wage growth increased 3.6%, the smallest gain in more than three years¹. Our take is that the labor market is clearly adjusting to slower economic growth, and last months’ data suggest that it might be doing so more rapidly than investors and policymakers are comfortable with, cementing expectations for a September cut. However, we would caution against reading too much into one month’s data, and we would still characterize employment conditions as healthy for several reasons:

• Over the past three months payroll gains have averaged 170,000, which is a big step down from an average of 380,000 in 2022 and 600,000 in 2021, but about in line with the 180,000 average monthly gain during the last economic expansion from 2010 -2019¹.
• At 4.3%, the unemployment rate is still historically low. In fact, it’s lower than 90% of the time, with data going back to 1949¹.
• The rise in unemployment has been largely a function of an increased labor force rather than a drop in employment. While job openings have come down from 12 million in 2022 to 8.2 million, they still comfortably exceed the number of unemployed, which currently stands at 7.2 million¹.

Source: Bloomberg and Edward Jones.Chart description

3) Yield curve: Bonds are back, and the longest inversion in history may be about to end

For more than two years now, the yield curve has been inverted, meaning that unlike most of the time during the course of a typical business cycle, yields on short-term bonds have been higher than long-term bonds. An inverted yield curve has historically been a negative signal for financial markets because higher short-term yields lift borrowing costs for consumers and businesses, while lower long-term yields discourage banks to lend. It is also a signal that Fed policy is overly restrictive.

With the Fed hinting on dialing back the restriction in interest rates and last week’s data highlighting downside economic risks, the bond market has started to price in a more aggressive easing cycle, driving a sharp rally in bond prices and a drop in yields. The policy-sensitive 2-year yield fell below 4.0% for the first time since May 2023, while the 10-year dipped below 3.90%, down from April’s high of the year of 4.70%¹. While the initial rebound in bonds from oversold conditions has already materialized, we continue to think that the path of least resistance for yields is lower, and we expect short-term yields to fall faster than long-term yields, helping the yield curve normalize.

We reiterate our beginning of the year call to slightly overweight duration (increase a portfolio’s interest-rate sensitivity) relative to an investment-grade bond benchmark, favoring intermediate and long-term bonds (prefer seven- to 10-year Treasuries over longer maturity). Even though CD and money-market rates will likely remain attractive from a historical perspective in the short term, yields will gradually come down as the Fed embarks on a rate-cutting cycle. Therefore, now is a good time for investors to take note of the reinvestment risk of having an overweight allocation to cash during a period of falling rates.

Source: Bloomberg and Edward Jones.Chart description

4) Market leadership: AI is here to stay, but tech is no longer the only game in town

Given the recent rotation out of growth stocks, all eyes were on the mega-cap tech stocks this week, as four of the Magnificent 7 stocks reported earnings (Microsoft, Meta, Amazon, Apple). The tech giants reported strong growth, but that wasn’t enough to push prices higher for the group, as the bar of expectations was high. The tech-heavy Nasdaq entered correction territory (down 10% from its peak), as investors are growing increasingly impatient to see the heavy spending on AI translate into a return in these investments¹. We think that AI is poised for rapid growth over the next five to 10 years and can continue to drive earnings for the companies that are spending heavily today to enable its development. However, there will likely be a timing gap between when the costs occur and when companies might reap the benefits of their investments.

Beyond tech, the outlook for earnings remains positive, as S&P 500 earnings growth is on track to accelerate from 6% in the first quarter to about 11% in the second². The biggest upside surprises are coming from a combination of cyclical and defensive sectors, such as financials and health care, and less so from the growth sectors. These shifts are consistent with our expectation that leadership will broaden as we get close to the start of the Fed rate-cutting cycle. While we navigate this risk-off phase, defensive sectors that tend to move inversely with bond yields could provide portfolio stability. More broadly, as the bull market continues with some bumps along the way, we think that leadership will be more balanced than it has been over the past year. We expect more back and forth between tech, cyclicals and defensives, suggesting that appropriate diversification will go a long way in the remainder of the year.

Source: Bloomberg and Edward Jones.Chart Description

5) Volatility: Bull market likely to continue even as market fluctuations pick up

Volatility was subdued in the first half of the year, with the VIX index, a proxy for stock-market fluctuations, hovering around 14, which is 30% below its long-term average¹. But the first weeks of the second half are sending a very different vibe. Last Thursday stocks experienced the biggest intraday swings since late 2022. The S&P 500 was up 0.8% in the morning but then fell as much as 2% at its low before recovering some of its losses late in the day, and the selling continued on Friday after the jobs report¹. Is this a sign of more challenging conditions ahead?

Concerns that the Fed may be behind the curve by cutting rates too late, along with election-related uncertainty, can be catalysts for volatility, especially as we enter a seasonally weaker part of the year. Historically, the three-month stretch between August and October has been the worst for stocks in terms of lower returns and higher volatility. However, this negative seasonality has been more pronounced when stocks were in a downtrend, rather when they were in a strong uptrend like they are this year. Going back to 1941, whenever the S&P 500 rose by 10% or more in the first six months of the year, it has risen by 7% on average in the second half. And the percentage of time that returns were positive in the second half of the year was almost 80% vs. 66% for any given period¹. The one caveat is that pullbacks in the second half tend to be deeper than the first half, averaging 9%¹.

Source: Bloomberg and Edward Jones.Chart description

From a fundamental standpoint, while we see a potential turning point in volatility, we do not expect any short-term pullbacks (which no doubt are uncomfortable) to change the relatively positive outlook. Inflation is moving closer to target, providing breathing room for the Fed to start letting off the brakes; the economy continues to expand but at a slowing pace; productivity is on the upswing; and corporate earnings are rising. As a result, we do not believe the bull market (which started back in Oct 2022) is over, and we would use any pullbacks, such as the one experienced last week, as opportunities to rebalance, diversify, and deploy fresh capital.

Source: Bloomberg. S&P 500 forward earnings per share.Chart description

Angelo Kourkafas, CFA
Investment Strategist

^{Sources: 1. Bloomberg, 2. Edward Jones}

Weekly market stats

^{Source: FactSet, 8/2/2024. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *4-day performance ending on Thursday.}

Edward Jones – Weekly Market Wrap (Angelo Kourkafas)