The Shot Heard Round The World

Putting it all together

• The path for lower rates in the U.S. has finally arrived. Last week the Fed tipped the balance of risks on their scale from evenly balanced between inflation concerns and labor market concerns, to weighted to concerns about the labor markets.
• Powell was careful to note that the “timing and pace” of cuts are still in flux, but “the direction of travel is clear”.
• Historically a pivot in policy to lower rates is not a great thing for equities because the change in direction is either associated with a negative financial event / dislocation or a dramatic deterioration of economic activity. There is precedence dating back 1995 when neither negative outcomes occurred, and the markets continued to plug along higher, but rates didn’t move sharply lower either.
• The Fed’s balancing act is tricky. Inflation seems contained for the moment, but the trajectory of the labor markets, GDP and manufacturing are lower. On the flip side, the service side of the economy is holding up and the consumer continues to spend, so the economy is not devoid of momentum. Meanwhile, the world’s other two largest economies, the Eurozone and China, seem inextricably linked and struggling to find footing for growth, leaving it up to the U.S. to carve its own path.
• We think it’s possible for the economy to skirt a recession and continue to grow. We remain advising clients to be positioned for such an outcome, but a continuation of the pattern of strength in the economy and markets are by no means foregone conclusions. The economy is a complex system, where self-enforcing feedback loops can create both surprising strength and fragility.

Powell dovish – confirms lower rates

• In 2022, Powell gave the public eight minutes of gut-wrenching
  hawkish rhetoric. In 2024, he reversed course and provided a
  dramatic dovish transition to a new era. However, there’s a lot
  of wood to chop to get back to accommodative.
• History shows the equity markets perform much better during
  accommodative periods.
  • The average differential between year-over-year PCE and Fed Funds was -1.09 from 12/31/1999 to 12/31/2009. During that time, the S&P500 returned an average annual return of -0.95% per year.
  • Conversely, the average differential between year-over-year PCE and Fed Funds was 0.85 from 12/31/2009 to 12/31/2019. During that time, the S&P500 returned an average annual return of 13.54% per year.
  • Today, the differential between year-over-year PCE and Fed Funds is -2.90. The Fed needs to rapidly move rates lower by over 2.5% to prevent significant impairment of the economy.

BLS revises payrolls sharply lower

• The Bureau of Economic Statistics April 2023 to March 2024 annual benchmark revisions indicated that the economy added 818k few jobs than initially reported over that time frame.
• Significant weakness in the numbers was shown in the white-collar sectors of business and professional services of -528k jobs.
• The likely cause of the size of the error in calculation, which is about 5x larger than average, has to do with adjustments in the birth/death model, which estimates payroll growth of new and closing businesses.
• Revisions for the first half of 2024 all but wipe out payroll gains this year, signaling a potential upwards revision in the unemployment rate. The downward revision won’t be fully reflected in the employment data until February 2025 when the BLS incorporates revision into the previous 12-months.
• Significant downward revisions in the QCEW have historically been associated with weak economic periods.

Fed meeting minutes confirm bias

• The minutes from the July Federal Open Market Committee had a handful themes:
  • Broadness of disinflation across categories and among retailers
  • Diminished factors for inflation and risks of disinflation in the future
  • Citing “greater confidence” in reference to inflation retuning to the targeted range
  • The “vast majority” indicating that inflation coming in as expected.
  • Balance between inflation and employment mandates
  • Better balance in labor markets, associated with levels of equilibrium
  • Risk of accelerated deterioration in labor markets
  • Agreement that it would be appropriate to begin cutting rates at the next meeting
• It’s not much of a stretch to conclude that if the economy is at balance between employment and inflation and there is downward momentum in the labor markets, policy should be erring on the side of dovish.

Oil demand forecasts point lower

• Demand forecasts for the major agencies that project energy markets indicating that oil demand will soften.
  • US Energy Information Administration (EIA) – Projects global consumption of liquid fuels will increase by 1.6 mbd in 2024, down from 1.8 mbd in their previous forecast.
  • International Energy Agency (IEA) – Noted that oil demand continues to decelerate to 710 kbd, the slowest quarterly rate of increase since Q4 2022, while at the same time strong production gains from non-OPEC+ members is driving an increase in production forecasts.
  • OPEC+ - Cut their 2024 demand forecast from growth of 2.25 mbd to 2.11 mbd, based on weak demand growth from China. They also cut their 2025 estimates for demand growth from 1.85 mbd to 1.75 mbd.
• Energy prices are a major input into CPI and PCE. To the degree demand is falling, while non-OPEC+ continue to boost production, it likely places a ceiling on oil prices, barring geopolitical events that inject volatility.

PMIs support disinflation confidence

Manufacturing Purchasing Manager Indices have traditionally been a good leading indicator of economic activity. However, since the pandemic they have been a less reliable leading indicator of activity, and instead been a much better leading indicator of inflation.

The S&P Global Manufacturing PMI captures survey data from 30 countries. Focus Point has constructed our own diffusion index, which shows the number of countries in “expansion”, defined as having a PMI above 50.

Since the pandemic, when the number of countries in expansion is above 20 or rising and approaching 20, inflationary forces are high, and have been associated with upside surprises in CPI and PCE. Beginning in Q2, Manufacturing PMIs began falling, which coincided with a reduction of inflationary forces throughout the summer.

• Japan -- Still a good bet with a strengthening yen?
• The central banks of the US and Japan indicated contrary paths last week, with the Fed providing an outlook for lower rates and BoJ indicating that rates would continue higher. There are a host of factors the influence currency crosses, such as:
  • Relative interest rates policy
  • Current account surplus vs deficit
  • Relative growth trajectories
  • Fiscal policies
  • Geopolitical influences
  • Sentiment
• Over the course of 2024, the Nikkei has broken out on a combination of a weak currency, expectations that the
  corporate environment is becoming more investor-centric, the belief the years of disinflation are behind Japan and a manufacturing renaissance related to trading partners moving away from China.
• We think the currency has had an outsized impact on the strength in the Nikkei and the path higher for equities will be challenging as the JPY strengthens.

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