Late Summer heatwave

Global stocks continued their climb higher until the latter part of this week. The rise up until Wednesday had shown remarkably steady gains in daily terms. When you put that together with gains over the last few weeks, equity returns have been very impressive. From Monday 5 August – the start of that day marked the nadir of the summer sell-off – the MSCI World Index gained more than 8% (in USD terms) to Wednesday 21 August. That is quite the turnaround from the panic that came before. Implied volatility has fallen sharply after the early August spike, and investors seem to have chased their fears away.

The week’s main political event has been the Democratic National Convention in Chicago. Despite the clear feel good factor for the Democrats, it hasn’t made much impact on the way the markets see the likely outcome. The political betting market has both candidates absolutely neck-and-neck.

The main financial event is taking place as we write, with Jerome Powell speaking at the Jackson Hole conference in Wyoming. He is confirming that his focus, and the focus of the Federal Open Market Committee, is now on employment. He describes the labour market as being less tight than in the months leading up to the Pandemic. A rate cut in September of at least 0.25% is already fully discounted by the market, and his comments are leading many to expect 0.5%. Stock markets are seeing it as good news and the S&P 500 is likely to end the week strongly.

As we wrote last week, though, this market optimism is a little unnerving. Background economic conditions are perceived to be better than feared at the start of the month, but may not have improved to the level that the rally would suggest. The medium-term outlook is solid, but markets have arguably been running a little hot again.

Meanwhile, US stock index returns are flattered because they’re quoted in US dollars. So far this month, the dollar has been slipping against major currencies, and Jerome Powell’s comments have dented the US dollar again.

An unusually good fortnight.

The market recovery from early August has been remarkable. US stocks in the S&P 500 are up around 8% over the last two weeks, putting this period in the top percentile of two-week periods in the past 50 years. Even Japan’s stock market – which suffered the worst sell-off of any major region at the start of this month – is nearly back to its end of July level in local currency terms. It has recovered fully in sterling terms, thanks to the strength of the yen.

The path up has been smooth, too. The chart shows the S&P’s daily performances since the start of July – with white bars representing up days and red bars down days. Thursday was the first daily loss of any note since 8 August, whereas the period before was marked by a series of losses and gains. This trading pattern does not happen very much after a sell-off, as we have noted. Volatility usually acts like a pendulum swinging to a gradual stop. This time, it stopped dead almost immediately.

Markets seem optimistic, but it would be wrong to think that everything is okay. Softening growth and inflation implies somewhat less positive company earnings. Meanwhile, equity valuations – most notably in the US – are still pretty high. These are not barriers to medium-term returns, but it is strange that investor worries have quickly dissipated; bears are few and far between. As we know from this week’s weather, at this time of year, two weeks of heat are often followed by another squall.

Does dollar weakness mean US weakness?

The rally has gone hand in hand with a weakening of the dollar over the past month against a range of other currencies. Investors tend to associate periods of dollar weakness with strengthening global growth (and so it can be a broad “risk-on” signal), since US demand creates stronger trade flows, benefitting the global economy. But, in this case, dollar weakness may be more a function of the slowing US growth narrative, with impaired trade flows still affecting the rest of the world.

Over the summer, there have been several signs that US growth outperformance was waning – most notably in the increase in unemployment. This is a key reason why markets are expecting sharper rate cuts from the Federal Reserve.

The “flash” purchasing managers’ indices (PMIs), based on a subset of survey responses, give a useful global comparison. According to these, global growth is likely to improve. All areas are above the neutral 50 level and all (except the US) strengthened from July.

The US PMIs have been much more positive than the downbeat ISM reports on business sentiment (which are similar in approach and have a longer history, but have fewer responders). Despite disappointment in manufacturing, the composite US PMI for August was above economists’ expectations. It fell slightly but the level remains buoyant. The only negative signal came from the employment indicator, which showed a weakening in services for the first time in three months.

Company earnings forecasts continue to go up too, which we would not be seeing if growth was about to turn negative. There was some suggestion this week that investors are a little nervous about Vice President Kamala Harris’ economic proposals, which include some price controls. Market intervention policies from US presidents are historically unusual, but her announcement could be a sign of how much US political debate has changed in a post-Trump world. In any case, though, US corporate earnings still look strong and are unlikely to be hurt too much be either candidate winning.

Goldilocks doesn’t mean strong growth.

The recovery over the last few weeks suggests a ‘goldilocks’ mentality in markets. Investors are happy with slightly slower growth if it means rates can be cut – but that also means slowing earnings growth. Stocks did well in that environment in the 2010s, but we need to be aware that it comes with fairly lethargic growth. That challenges the recent positivity around small and mid-cap stocks, for example.

There is also a possibility that the goldilocks narrative could become self-defeating. Markets do not mind slower growth because there are assuming a sharp rate cut path, so valuations are supported. But those expectations are themselves supporting corporates through lower borrowing rates. With that dynamic in mind – and growth still holding up okay – the debate now is whether the economy really needs drastically lower rates.

This weekend’s Jackson Hole conference has had the main speeches but much of the interesting stuff is in the detailed papers. Still, the headlines will revolve around the main messages: Powell is adding to the recent dovish messaging, arguing that recent employment trends are definitely soft and should not be allowed to worsen. Inflation is declining and is not threatened by tight labour markets, which allows short-term rates to fall, which in turn should ensure that growth remains at a comfortable level. Do not expect any talk about politics or any of the policies proposed by the US Presidential candidates.

Still, given everything we argued above, this weekend could be a potential banana skin for markets. The Fed’s messaging is increasingly about the economic downside, which might raise fears in a sensitized market. Another bout of short-term volatility is not a problem for long-term investors, but we should not be lulled into a false sense of security.