Reasons to be bullish
Equity market internals are looking more constructive as leadership is broadening out from the narrow megacap technology leadership. The performance of large-cap growth sectors has begun to go sideways, but the S&P 500 remains in an uptrend.
As growth leadership stalled, the relative performance of the cyclically sensitive value sectors have begun to turn up.
A similar pattern can be seen in the relative returns of small-cap value sectors, which are not burdened by the performance of megacap growth stocks in comparing performance. The relative uptrend in small-cap industrial stocks is particularly impressive.
These charts are supportive of the bullish soft landing and cyclical rebound scenario.
Reasons to be skeptical
One maxim of good investing is to look for reasons to be skeptical of your investment posture as a way of avoiding confirmation bias. Here’s what’s keeping me awake at night. The possibility of a credit event that derails the bull (see Could A Credit Event Derail the Equity Bull?) and weakness in employment that plunges the economy into recession.
Regarding loans to businesses, survey respondents reported, on balance, tighter standards and weaker demand for commercial and industrial (C&I) loans to firms of all sizes over the second quarter. Meanwhile, banks reported tighter standards and weaker demand for all commercial real estate (CRE) loan categories.
For loans to households, banks reported that lending standards tightened across all categories of residential real estate (RRE) loans, especially for RRE loans other than government-sponsored enterprise (GSE)-eligible and government loans. Meanwhile, demand weakened for all RRE loan categories. In addition, banks reported tighter standards and weaker demand for home equity lines of credit (HELOCs). Furthermore, standards tightened for all consumer loan categories; demand weakened for auto and other consumer loans, while it remained basically unchanged for credit card loans.
The employment puzzle
The Fed announced after its July FOMC meeting that it was raising rates by a quarter-point and the Committee would be watching incoming data in order to make further decisions about the direction of monetary policy. Fed Chair Powell was repeatedly asked about the Fed’s reaction function to data, but he deflected all questions and declined to give further forward guidance, other than to say that upside and downside risks were relatively balanced.
I’d say it this way, it’s really a question of how do you balance the two risks, the risk of doing too much or doing too little? And, you know, I would say that we’re coming to a place where there really are risks on both sides. It’s hard to say exactly whether they’re in balance or not. But as our stances become more restrictive and inflation moderates, we do increasingly face that risk. But, you know, we need to see that inflation is durably down that far.”
The labour market is cooling, but it’s not cool enough. The latest JOLTS report shows that both the job openings/hires and quits/layoffs ratios are falling, which is a sign of a cooling jobs market. However, levels are still above pre-pandemic levels. There are still 1.6 job openings for each person hired, indicating wage pressure. But more drops in vacancies will mean higher unemployment and a slowing economy.
The July Jobs Report serves as window of this problem. Headline employment growth and average weekly hours were softer than expected, indicating decelerating economic growth. But average hourly earnings was higher than expectations, indicating wage pressure.
While Fed Chair Powell deflected questions about the Fed’s reaction function, the former Obama CEA Chair outlined his estimate in a recent tweet (UR=unemployment rate), which he claims to be roughly consistent with the reaction embedded in the last SEP.
In summary, investors are faced with another situation where the technical and macro indicators disagree. The price charts are screaming “cyclical recovery and new bull”, while macro indicators are calling for caution. Investors are advised to trust the bull, but verify there’s no potential credit event or recession ahead.