In recent months, financial markets have been marked by wide fluctuations, influenced by changing economic data and the decisions of the US Federal Reserve (Fed). With inflation falling and signs of an economic slowdown, many investors are wondering how the Fed might adjust its monetary policy, and what impact this might have on the markets. In this week’s dossier, we explore the implications of these recent developments and what they could mean for the future of financial markets.
1. The market recovery is underpinned by two factors: softer inflation and better economic data.
Inflation, which gave cause for concern at the start of the year with higher-than-expected figures, is starting to fall, surprising even the experts.
Last week, US inflation figures for July were released, and they were lower than expected. The Producer Price Index (PPI) rose by 2.2% year-on-year, against expectations of 2.3%. Similarly, the consumer price index (CPI) rose by 2.9%, against forecasts of 3.0%. This is the CPI’s lowest level of the year.
A closer look at the CPI reveals that prices have fallen in several sectors, such as food (cereals, bakery), clothing, new and used vehicles, and even airline tickets. However, some areas remain expensive, such as housing and rents, as well as car insurance. Although housing prices are slow to come down, they are likely to do so in the months ahead. Similarly, insurance prices rose sharply last year, but this trend is set to slow.
In summary, this week’s inflation data is good news for consumers and for the U.S. Federal Reserve (the Fed), which is targeting 2.0% Personal Consumption Expenditure (PCE) inflation. According to the Fed’s current forecasts, PCE inflation is set to fall below 2.6% in July, in line with or even below forecasts made in June, which called for 2.6% for overall PCE and 2.8% for core PCE (excluding food and energy) by the end of the year.
Economic data better than expected
In early August, markets fell sharply on growing fears that the US economy was slipping into recession. This sentiment was triggered primarily by the July US employment report, which showed a slowdown in job creation and a higher-than-expected unemployment rate of 4.3%. Since then, however, a number of economic indicators have turned out to be more positive, suggesting that the economy is slowing down without plunging immediately into recession.
One of the most striking indicators was last week’s retail sales figures, which showed that US consumers are continuing to spend. Monthly growth in retail sales reached 1%, well above forecasts of 0.4% and the previous month’s -0.2%. This increase in spending was observed in 11 of the 13 major categories, with a strong rebound in car sales. At the end of the week, the University of Michigan’s consumer confidence index was also strong, reaching 72.1 against forecasts of 68.5. These data show that US consumers remain confident and continue to spend.
Another important indicator, published weekly, is the number of new jobless claims in the US, which gives a real-time picture of the health of the labor market. This indicator became particularly important after last month’s weak employment report. The good news is that, after peaking at 250,000 two weeks ago, claims have fallen steadily, recently reaching 227,000. This has reassured investors, who feared a continued increase in claims and a rapid deterioration in the labor market. Instead, the data seems to be stabilizing as we enter the second half of the third quarter. The next US non-farm payrolls report will be released on September 6, providing a further assessment of the health of the labor market ahead of the Fed’s September 18 meeting.
2. What is the impact on the Federal Reserve and the markets?
The history of the Federal Reserve
A crucial question for the markets at the moment is whether recent inflation and economic data will influence the Federal Reserve’s interest rate decisions. In our view, falling inflation, combined with growing uncertainty around the labor market, sets the stage for the Fed to begin cutting rates at the FOMC meeting on September 18, from current levels of 5.25% to 5.5%. Although some have speculated on a larger cut of 0.50% rather than the traditional 0.25%, we believe that the recent better economic data do not justify the urgency for a more radical adjustment.
It’s also worth remembering that the Federal Reserve will be meeting at its annual symposium in Jackson Hole from August 22 to 24, with a speech by Fed Chairman Jerome Powell scheduled for Friday August 23. Historically, the Fed uses this meeting to signal policy changes, and we could hear Fed officials hint at a possible change at the September 18 meeting. The Fed could also outline trends in inflation and the labor market, and whether these bring it closer to the start of a rate-cutting cycle. Although markets are anticipating two to three rate cuts this year, any confirmation or signal from the Fed would be welcomed.
Market outlook
Markets have clearly welcomed lower inflation and better-than-expected economic data in recent days. Financial markets rallied after the massive sell-off on August 5, with the S&P 500 rebounding by more than 6.5%, and the yield on 10-year Treasury bonds, which had fallen to 3.66% during the market volatility, climbed back to around 3.9%, signaling a return of confidence in the wider economy.
In addition, the VIX volatility index, often referred to as Wall Street’s “fear barometer”, which had climbed to 65 on August 5, its highest level since 2020, fell back below 15, in line with last year’s average.
The recent stock market rally was again led by the technology and growth sectors, which had also been hardest hit during the recent downturn. As we move closer to a period of rate cuts by the Fed, and as inflation continues to moderate and earnings growth extends to other sectors beyond technology and growth, we believe that a diversification of market leadership could emerge once again. While the theme of the past 18 months has been narrow leadership (with large-cap technology stocks leading the way), we see the next 18 months as one of diversification, with portfolios including both growth and value/cyclical segments performing well. We continue to favor large- and mid-cap stocks, and believe that sectors such as industrials and utilities will continue to catch up with technology and artificial intelligence-powered fields.
In short, history shows that if the Fed cuts interest rates and the economy holds up (i.e., a “soft landing”), markets can continue to perform well in this environment. While we know that market fluctuations are normal, especially as we approach the seasonally weaker months of September and October and the US elections, we see these periods of volatility and pullbacks as opportunities, especially if inflationary trends continue to improve and economic growth, though slowing, remains positive.
