The Fed-Growth-Inflation theme is key now

The four themes

There are four themes that shape the performance of the S&P 500 (SP500) in the near term:

1. First, the GenAI bubble burst. Tech megacaps have invested heavily in Gen AI, but it seems that the return on investment in Gen AI Capex might be too low, at least in the short term. Additionally, based on Nvidia’s latest earnings report, growth is slowing, which doesn’t justify lofty valuations.
2. The second theme is the Fed-growth-inflation story. Specifically, based on the weakening labor market, it looks like we could be facing an imminent recession. Thus, the Fed is expected to aggressively cut interest rates over the next 12 months. Given that we are not yet in a recession, some hope that Fed tapering will actually avert recession. This is the soft landing scenario, where the key assumption is that inflation continues to fall towards the 2% level for allow the Fed to cut.
3. The ongoing geopolitical situation. We are currently facing an ever-escalating geopolitical situation in the Middle East and Russia, and both of these situations could escalate into regional wars, involving NATO.
4. The trade boom of the yen. The Fed is expected to cut interest rates, while the Bank of Japan will raise interest rates further, which could boost the value of the Japanese yen and thus force hedge funds that have borrowed against the yen to liquidate their yen-backed positions. .

The interplay between these themes will determine the S&P500 price action in the short term or over the next 6 months.

The key assumptions are:

1. The geopolitical situation will remain under control until the point where the price of crude oil (USO) does not rise. Rising crude oil prices could increase inflation and prevent the Fed from cutting interest rates despite a weakening labor market – this would be stagflationary and therefore very negative for the stock market. However, this is also a situation that can be controlled, at least until the November US elections.
2. The BOJ and Fed can keep the yen’s rise in check, and thus another episode in the event of a yen trade blowout is unlikely.
3. The AI ​​bubble bust can be postponed as long as the general sentiment remains positive and at least until the next earnings season. AI tech megacaps will begin reporting in mid-October, until then the Nasdaq 100 (QQQ) may only gradually decline and even remain flat.

It’s all about the Fed now

Thus, the key theme driving the markets in the near term will likely be the Fed and the related growth-inflation environment.

The Fed is expected to begin cutting interest rates in September and cut at each meeting in 2024 and continue to cut in 2025 to about 3% of the federal funds rate.

These expectations are consistent with a recession—that’s the only time the Fed actually cuts interest rates by more than 2%. Thus, if these expectations are correct, we should get more data confirming an impending recession, especially in the labor market.

The latest data has yet to confirm an impending recession.

Initial jobless claims rose to 250,000, but over the past 3 weeks, claims have fallen to 230,000. The trend is still up, so more weakness is expected. However, in the last 3 years, we have had two previous episodes where claims spiked to the 250K level and then dropped back to the 200K level. In these cases, recession was avoided. What will happen in the current situation?

In order to have a clear signal of an impending recession, claims must break above the 250K level and continue to rise.

Similarly, continuous jobless claims are at a 3-year high, but have stagnated over the past 3 weeks. We need to see the top above the 2M level to get confirmation of an impending recession.

The labor market is weakening and the Sahm Rule has been triggered – the unemployment rate has risen to 4.3%, well above the low point of 3.4%. However, at the moment, the increase in the unemployment rate is largely due to an increase in the supply of labor – due to immigration and increased participation, and not due to job losses. We need to see actual job losses to confirm a recession and that is not the case at the moment.

The next problem is inflation. The Fed needs to be confident that inflation is falling to the 2% level in order to start cutting interest rates in September. Core PCE has been “stuck” at 2.6% over the past 3 months, and monthly core PCE inflation rose 0.2%.

Based on base effects, core PCE is likely to remain at 2.6% until the end of 2024 and indeed begin to decline in 2025 towards the 2% level, which could be reached by next summer. That’s assuming core PCE continues to rise 0.2% per month.

The problem for the Fed will be if the unemployment rate holds at 4-4.3%, meaning that everyone entering the labor market is employed while no jobs are lost, and thus shelter inflation fails to is moderating as housing demand continues to fall. grow. Thus, this could increase the rate of core inflation and prevent the Fed from tapering. The Fed’s Inflation Nowcast predicts core CPI could reach 0.3% in August. That would make it more difficult for the Fed to cut in September.

Implications

The medium-term baseline scenario remains that we are facing an imminent recession, and thus the S&P500 is facing a bear market that is accelerating the bursting of the Gen AI bubble. However, we need data to confirm this theme.

If labor market data remains solid and the Fed still begins to cut interest rates in September, positive sentiment may keep the market from falling, at least until the next earnings season.

So the next few weeks will be all about the growth/inflation data and the Fed. That assumes there are no geopolitical shocks, which is a weak assumption.