Markets Need an Emergency Rate Cut

Volatility spiked last week following a string of disappointing second-quarter results, the assassination of a Hamas leader in Tehran, dismal manufacturing data and a jobs report that showed growth in the U.S. labor market slowing rapidly. The CBOE Volatility Index, known also as “the fear index,” leapt to 29.70 during Friday’s session before backing off to close at 23.39. Such a parabolic move typically marks a selling climax, but it is by no means a guarantee.

Despite some not-so-magnificent Q2 results from the Magnificent Seven leaders that weighed heavily on the major averages, according to FactSet, for Q2 2024 (with 75% of S&P 500 companies reporting actual results), 78% of S&P 500 companies have reported a positive earnings-per-share (EPS) surprise and 59% of S&P 500 companies have reported a positive revenue surprise.

For Q2 2024, the blended (year-over-year) earnings growth rate for the S&P 500 is 11.5%. If 11.5% is the actual growth rate for the quarter, it will mark the highest year-over-year earnings growth rate reported by the index since Q4 2021 (31.4%). At the end of Q1 on June 30, the estimated (year-over-year) earnings growth rate for the S&P 500 for Q2 2024 was 8.9%. Nine sectors are reporting higher earnings during Q2 (compared to Q1 June 30) due to upward revisions to EPS estimates and positive EPS earnings guidance.

Going forward, for Q3 2024, 39 S&P 500 companies have issued negative EPS guidance, and 35 S&P 500 companies have issued positive EPS guidance. The key takeaway from this set of quarterly stats is that the negative reaction to big-cap tech, with the bar set so high, and the big miss on the jobs report are really overshadowing what is otherwise a pretty impressive performance by the broader S&P 500. The chart of the S&P Equal Weight ETF (RSP) shows a much more constrictive pattern than the SPDR S&P 500 ETF (SPY), where the top ten holdings, eight of which are mega-tech, account for roughly 36% of total assets.

What has become clear is that commodity prices, which were such a big part of the rise in inflation, have made a material move lower in the past two months. The CRB Index, which tracks the overall price movement of commodities, is in a steep decline. It consists of 19 different commodities, including energy (39%), base/industrial metals (13%), agricultural products (41%) and precious metals (7%). It would be lower if gold were not trading at an all-time high.

Credit to stockcharts.com.

Rates on 10-year government bonds have declined sharply during the past month, sending a clear signal to global fixed income markets that when the U.S. economy, which accounts for 26% of the global economy, is experiencing a cooling of its labor markets, it is incumbent upon the Federal Reserve, aka the world’s central bank, to respond with swift action. Markets are roiled because of the growing concern the Fed is once again behind the curve.

The Fed failed to manage inflation in a timely manner, and the U.S. economy and consumers suffered painfully from their delayed reaction. The decision to hold the Fed Funds Rate at 5.25-5.50% last week by unanimous decision was clearly wrong in the eyes of the fixed income and equity markets. The latest read from the bond futures market is for a 50-basis point cut in September, a 50-basis point cut in November and a 25-basis point cut in December. This past weekend, JPMorgan Chase & Co. also predicted half-point rate cuts in September and November.

The markets are reacting not just to one soft jobs report as manufacturing in the United States has been on a steady decline for almost two years. The July ISM Manufacturing Index checked in at 46.8% (consensus 48.5%) versus 48.5% in June. The dividing line between expansion and contraction is 50.0%, so the July reading suggests there was a faster pace of contraction in the manufacturing sector last month. This was the fourth straight month (and 20th out of 21) that economic activity in the manufacturing sector contracted, which conveys clear weakness in the manufacturing sector that is a byproduct of subdued demand.

Fed Chair Jerome Powell noted in his post Federal Open Market Committee (FOMC) presser that incoming data would set the stage for upcoming rate cuts. Between now and the next Fed gathering on Sept. 18, markets will digest a litany of data that may or may not corroborate the weaker employment data. Based on the falling prices of energy and commodities noted, the risk of sticking a soft landing is being called into question if the Fed waits too long.

A JPMorgan economist said there’s even an argument to be made for an unscheduled cut. “With the benefit of hindsight, it’s easy to say the Fed should have cut this week,” wrote Michael Feroli, chief U.S. economist at JPMorgan, in a note on Friday. “It’s also easy to say they will cut soon. How soon and how much are harder questions.”

Even if the weakness in the job market levels off later, the Fed would still appear to be “offsides” by 100 basis points or more, he added. “From a risk management perspective, we think there’s a strong case to act before Sept. 18,” Feroli wrote. “But perhaps Powell doesn’t want to add more noise to what has already been an event-filled summer.”

There is clearly disinflation at work and the Fed should respond sooner than later. It would not be the first time the Fed has cut rates between meetings, and the market would find it prudent if they did call for an immediate response to the newfound data that points to some potential contraction in the labor market. The Fed’s dual mandate is to control inflation and maintain stable and healthy labor markets.

The fight on inflation is being won, and the pace of hiring is slowing. So why wait? The bond market is calling loudly for action, not in September, but now. I’m sure Fed Chair Jerome Powell and his 11 other voting members that make up the committee are taking serious notice to the bond market’s reaction, and hopefully, they are on a Zoom call with the intention of getting in front of a potential economic slowdown so that the path to a soft landing remains intact.

There is no loss of pride for doing the right thing when nothing was done at last week’s Fed gathering. Markets would cheer loudly, and the Fed would earn a gold medal.