Bad news is bad news

Earlier in the week, we had worse-than-expected manufacturing (ISM) data, which declined for the fourth month in a row and spooked the market. More critically, on Friday, last month’s jobs number came in worse than expected, and the unemployment rate rose to 4.3%, worse than expected. Given the low was at 3.4% in early 2023, the data triggered the “Sahm” rule, which suggests that a rise of 0.8% off the low unemployment rate often marks the start of a recession. This potential weakening in the labor market could put pressure on consumers, impacting overall economic stability.

• More notable than this one data point is the market reaction
• Since the beginning of the Fed’s rate hiking cycle, bad economic data has been received positively by markets
• The reasoning was a weakening economy brings closer the end to the rate hiking cycle
• As the market wants lower rates, stocks and other risk asset would rally on bad economic news
• The market reaction this time was definitively negative, with stocks selling off and bonds rallying
• More notable than the selloff in stocks, the 10yr has declined from 4.4% to begin July to 3.8% on this news, with the decline becoming more acute this week
• While it is too soon to tell if the economy is really weakening, the market reaction seems to have certainly changed

Did the Fed miss?

The Federal Reserve met this week and decided to hold interest rates steady (5.25-5.5%). However, they indicated that there will likely be a cut following the next meeting in September. Their justification, as has been all along, is that they need to see additional data to be sure inflation continues to come down to its target 2% level while employment remains strong. Many speculated immediately after that the Fed is waiting too long to cut, with the risk of a recession taking shape.

• The Fed waited too long to hike rates in the face of rising inflation
• Many are speculating that the Fed is making the same mistake as the economy cools down
• While the Fed does tend to be cautious, it is hard to jump to conclusions that we are definitely heading into a recession
• In addition, yields on the long end of the bond market have come down precipitously recently
• Given most consumer and corporate credit is based on the 10yr versus the Fed Funds rate (which the Fed controls), this will already serve to soften the blow of tighter monetary policy
• A lower 10-yr yield will mean lower mortgage rates and other consumer credit rates

Earnings season halfway done

This quarter’s earnings season is a little more than halfway finished, and the results have been mixed. Thus far, 78% of companies are beating expectations, but the stocks of those that are missing are suffering bigger losses than the gains of those that beat. The market seems to be punishing losers more than rewarding winners, signaling a market that is priced to perfection. In particular to the mega-cap, while most of the companies are still showing strong growth, we have seen some companies rewarded (META, AAPL) while others (MSFT, GOOGL, AMZN) have sold off post earnings. The market seems to be focused on the massive amounts of CAPEX that these companies have spent and whether or not they are seeing an actual return on their investment.

• AI-related CAPEX has been the story for the last several quarters
• As every company has taken a slightly different approach to AI, we are likely to see winners and losers based on how their strategy plays out
• Market reaction to the recent earnings season helps support our view that active management is likely going to be important in the foreseeable future
• While the passive approach of the prior decade helped feed the overall market, this may no longer be the case
• Picking and choosing winners and losers, whether they be sectors or companies, will likely determine the outcome going forward more so than just having passive index exposure

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