Summary

Sectors are Rotating: Our Monthly Survey of the Economy, Interest Rates, and Stocks The stock market experienced a mid- to late-July selloff and a very rocky start to August. Yet the S&P 500 ended up rising for both months, extending its latest winning streak to four months. The stock-selling spasms that erupted in both months were triggered by concerns that the Fed had waited too long to cut rates and, due to the lags in rate changes impacting the economy, the U.S. was headed for recession. The markets then calmed, following reassuring commentary from Fed officials and solid earnings and GDP data. The market is now in September, which since 1980 has been the worst market month with an average 1.1% decline. Election-year Septembers can be particularly volatile, though on balance they are better than all Septembers since 1980. The Economy, Interest Rates, and Earnings The broadest measure of the U.S. economy, Gross Domestic Product, appeared to show a healthy and even accelerating economy as of mid-year. The preliminary (second of three) report of second-quarter GDP exceeded the advance report and was meaningfully above first-quarter levels, and in particular indicated a recovery in consumer spending. A review of the second quarter does appear to indicate a normally growing economy as of mid-year. The preliminary report of second-quarter GDP showed growth of 3.0%, more than double the 1.4% growth rate reported for 1Q24. Ahead of the advance report release, the consensus call was for low 2% growth in the first quarter. The increase in second-quarter 2024 GDP primarily reflected increases in personal consumption expenditures, private inventory investment, non-residential fixed investment, and total government spending. These gains were partly offset by a decline in residential fixed investment. Imports, which are a subtraction in the calculation of GDP, increased and exceeded exports. Personal consumption expenditures for 2Q24 increased 2.9%, up from 1.5% for 1Q24 and 2.2% for all of 2023. Spending on goods increased 4.9% in 2Q24, after falling 2.3% in 1Q24. Durable goods spending rebounded by a sharp 4.7% in 2Q24, after declining 4.5% in the prior quarter. Durable goods spending was up 4.2 % for all of 2023. Non-durable goods spending also bounced back, rising 2.0% for 2Q24 after declining 1.1% for 1Q24. The decline in annual inflation growth has mainly been concentrated in goods, while services inflation remains stubbornly elevated. Consumers may now be willing to buy goods at stable or even lower prices. Consumer spending on services grew 2.9% in 2Q24 and was the one component of PCE that declined from the first quarter. Consumer spending on services grew 3.3% in 1Q24. Some of the growth in consumer services spending is being driven by rent equivalent and insurance, two costs consumers cannot control and many cannot avoid. The very weak trend in 1Q24 consumer spending appeared to provide further evidence of the consumer under siege from multiple years of inflation. The bounce-back in second-quarter consumer spending could suggest that consumers have adapted to higher prices, or it could turn out to be a head-fake. We expect PCE within the GDP accounts to continue to send conflicting signals, with overall goods spending more volatile than services. Non-residential fixed investment, the proxy for corporate capital spending, rose at a 4.6% annual rate in 2Q24, after rising 4.4% in 1Q24. This category was also healthy in 2023, rising 4.5%. Spending on equipment increased in low-double-digit percentages, while spending on intellectual property was up in low-single digits. Some of the growth in capital spending in 2023 and in the 2024 first half has been the result of corporations facing higher costs for everything. PCE and non-residential fixed investment represent about four-fifths of gross domestic product in any quarter. In 2Q24, consumer spending added 1.95 percentage point to GDP, while non-residential fixed investment added 0.6 percentage point. Residential fixed investment, which surprised with 16% growth in 1Q24, dropped back into negative territory, declining 2.0% in 2Q24. The export-import balance heavily favored imports in 2Q24, as it did in 1Q24. Exports grew 1.6% in 2Q24, while imports were up 7.0%. Given the higher dollar value of imports, the net exports-imports balance subtracted about three-quarters of a percentage point (77 basis points) from overall 2Q24 GDP growth. We expect this category to remain volatile quarter over quarter. Another volatile character has been the change in private inventories. This category added 78 basis points (bps) to GDP in 2Q24, after subtracting 42 bps from 1Q24 GDP growth. Disruptions in the distribution channel began with the trade and tariff wars of 2017-2020 and worsened with the supply-chain crisis in 2021-2022 and the supply-chain glut in 2023. We look for private inventories to maintain the excessive volatility in this series that has prevailed since the pandemic. Overall government spending was up 3.1% and added just under one-half percentage point to GDP growth. Federal spending increased 3.3% in 2Q24 after declining in 1Q24, while state and local government spending grew 2.3%. The price index for gross domestic purchases increased 2.4% in 2Q24, compared with an increase of 3.1% in 1Q24. The PCE price index advanced 2.5%, down from 3.4% in 1Q24. The core PCE index also came down from 1Q24. Higher GDP with lower price increases in 2Q24 marked a real improvement from 1Q24. Much of investors’ concerns can be found outside the GDP accounts. U.S. economic indicators generally suggest deceleration, although growth continues at a subdued level. The consumer economy continues to send mixed signals, with jobs and wages still growing – but at a meaningfully slower pace. The U.S. economy shocked with 114,000 new jobs in July, well below the consensus of 175,000. July was also well below the 12-month average of 215,000. The unemployment rate rose to 4.3% for July 2024 from 4.1% for June, and was up sharply from 3.5% a year earlier in July 2023. Average hourly earnings increased eight cents month-to-month for July and were 3.6% higher year-over-year. July annual wage growth represented a return to sub-4% growth; annual wage has mainly exceeded 4% since June 2021. Annual wage growth continues to run above inflation, but the premium has narrowed. In August, the Bureau of Labor Statistics within the Department of Labor reported revised data showing 818,000 fewer nonfarm payroll jobs than initially reported were created for the trailing one-year period. From April 2023 through March 2024, the economy added about 2.1 million new jobs – 30% fewer than the initially reported 2.9 million. Most industries reported downward revisions, with notably lower levels in information services, professional & business services, and mining & logging. Transportation & warehousing was the only category to be revised higher, indicative of our increasing reliance on e-commerce. The consumer seems slightly more optimistic or perhaps reconciled to higher prices. After three straight tepid months in April through June, retail sales for July surged by 1.0% from June levels. On a year-over-year basis, retail sales were up 2.7% in July, compared with 2.3% annual growth reported for June 2024. Annual growth was particularly strong for electronics & appliances, motor vehicle parts & gasoline, and health and personal care items. Purchasing managers across the industrial economy remain cautious. ISM’s manufacturing PMI came in at 46.8% for July 2024, down from 48.5% in June. The manufacturing PMI remained in contraction territory – below 50 – for the fourth straight month and for the twentieth time in the past 21 months. ISM’s services PMI slipped into contraction territory in June, falling to 48.8%. ISM’s service PMI rebounded to 51.4% in July, however, and has been in positive territory in six of the seven months reported for 2024 to date. The services economy is significantly larger than the manufacturing economy, and continued strength in this category is vital to ongoing economic growth. Industrial production showed surprising weakness in July, declining 0.6% month over month after rising a revised 0.3% in June. July capacity utilization dipped to 77.8%, putting it nearly two percentage points below the long-run average. Straddling the commercial and consumer economies is housing. Consistent with the negative residential fixed investment data from 2Q24 GDP, the housing economy continues to struggle. Based on SAAR (seasonally adjusted annual rate), both new and existing home sales are running at about 60% of peak pandemic levels. At the same time, pent-up Millennial demand for housing continues to intensify. Aging Baby Boomers have been locked into too-large homes by low mortgage rate. The plunge in interest rates accompanying the summer stock selloff could have a silver lining if it unlocks the housing market. Following surprising second-quarter strength, Director of Economic Research Chris Graja, CFA, raised the Argus forecast for 2024 GDP growth to 1.9%, from a prior 1.7%. Chris expects quarterly GDP to growth in the sub-2% range in the third and fourth quarters. We expect GDP growth in the 2% range in 2025, with the economy strengthening into the second half as lower rates stimulate consumer and business activity. Given the overhang of high prices and interest rates, and with the consumer weary from years of inflation, our GDP growth forecasts for 2024 and 2025 are likely to remain volatile. We also continue to believe the U.S. economy can avoid recession in 2024 and 2025, as it did in 2023 and 2022. The U.S. central bank started its rate-hiking campaign in March 2022 well behind the inflation curve. Sixteen months and more than five percentage points later, the Fed halted in July 2023. At its mid-July 2024 FOMC meeting, the Fed voted to hold the fed funds rate steady at the 5.25%-5.50% tendency, as it had done for eight straight meetings since July 2023. The market mood has certainly changed, however. Weariness with inflation has given way to worries about recession. At the beginning of the central-banking rate-hiking campaign, investors feared that the Fed was ‘behind the curve’ in its fight against inflation. With inflation down to within a point of the Fed’s 2% target, that now seems like the last war. Investors once again fear that the Fed is ‘behind the curve,’ this time in its need to cut rates before the U.S. tips into recession. In July, the FOMC statement pushed back against recession fears, noting that economic activity ‘continues to expand at a solid pace.’ Although employment growth has moderated, the statement continued, unemployment has moved up but remains low. Language in the June FOMC report noted ‘modest further progress toward the Committee’s 2% inflation objective.’ In July, the Fed echoed its ‘further progress’ commentary. In August, Fed Chair Jay Powell used the forum of this year’s Jackson Hole Economic Symposium to allay recession fears. In his calm and reassuring speech, the Fed Chair stated that the ‘time has come’ to cut interest rates in response to cooler inflation and slowing economic growth. Inflation has ‘declined significantly,’ he added, and the labor market ‘is no longer overheated.’ Perhaps most notably, Fed Chair Powell acknowledged that ‘the balance of risks to our two mandates has changed.’ Inflation is receding, and the mandate to return inflation to 2% has nearly been met. At the same time, the economy has softened from recent peaks, and the mandate to maintain maximum sustainable employment is now at risk. Reversals in Fed policy, and particularly the move from raising rates to cutting rates, inevitably come at a fraught time for the economy. In those periods, the economy is seen as vulnerable to too little stimulus, while inflation is at risk of returning from too much stimulus. Mr. Powell’s calm tone in addressing the dual mandate, in our view, was a necessary lubricant in the shift from restrictive to accommodative monetary policy. The Fed’s preferred inflation gauge, the core PCE price index, rose 0.2% in July and was up 2.6% year over year. The monthly number matched the June and May levels. The annual change declined from the June reading, which had been the lowest annual rate of change in the core PCE price index since March 2021. The core PCE data confirmed inflation inputs from the July CPI report issued in August. The all-items CPI rose 0.2% month over month in July, after declining 0.1% in June. On an annual basis, the July all-items CPI was up 2.9%, down from June’s 3.0% annual rate of change. Core CPI was up 0.2%, and the annual change in core CPI was 3.22%, also down one tick from June. Goods inflation has come off markedly, while inflation in services is still stubbornly high. The index for shelter rose 0.4% month-over-month in July and accounted for nearly 90% of the increase in all-items CPI. The 10-year Treasury yield was 3.91% as of the end of August, level with 3.89% at the end of July and down from the 4.7% level as recently as the end of April. The two-year Treasury yield was 3.91% as of the end of August, down from 4.16% as of end of July and the peak level of 4.96% as of end of April. On 8/27/24, the two-year and 10-year Treasury yields were both 3.83%. This marked the first time the two-year yield was not above the 10-year yield since April 2022. These two yields also ended August at the same level. Argus expects long yields to move relatively higher from current levels and short-term yields to move relatively lower. But we are not ready to call for a decisive end to twos-10s inversion. Given recession fears and potential volatility in inflation data, two-year and 10-year yields may remain in close proximity as late as the first quarter of 2025. We also see the potential for twos-10s inversion to end during 2024. Argus Fixed Income Strategist Kevin Heal is now modeling three quarter-point rate cuts in 2024: one each at the September, November, and December FOMC meetings. Note that the November FOMC meeting occurs post-election. Each cut is expected to be 25 basis points, bringing the Fed’s central tendency to the 4.50%-4.75% level by year-end. We regard the rate-cut outlook as dynamic, to say the least. As shown in the CME FedWatch tool, the probability of a 25 bps cut at the September FOMC meeting is about 66%; the probability of a 50 bps cut at the September meeting is now about 34%. As of the November meeting, the CME FedWatch tool indicated a 42% probability of cumulative 50 bps reduction in fed funds and 47% probability of cumulative 75 bps reduction. And by the December meeting, the CME FedWatch tool indicated a 44% probability of cumulative 75 bps reduction in fed funds and 27% probability of cumulative 100 bps reduction. Despite the increasing likelihood of multiple rate cuts in the final four months of 2024, the Fed is expected to proceed cautiously next year, according to Kevin Heal, with a measured pace of additional rate cuts in 2025. First-quarter 2024 earnings outpaced expectations, but were below the double-digit growth that prevailed in the pandemic and immediate post-pandemic era. Second-quarter 2024 earnings from continuing operations are up in high-single-digit to low-double-digit percentages, according to our vendor survey. Along with GDP growth, second-quarter earnings represent a bulwark against growing recession concerns. With over 75% of S&P 500 component companies having reported results, second-quarter 2024 earnings from continuing operations were up 11.5% compared with 2Q23 EPS, according to FactSet, and up 12.9% according to Refinitiv. According to Bloomberg, 2Q24 earnings w up 12.5% on a share-weighted basis and 16.5% on a market-cap-weighted basis. This premium of market-cap-weighted to share-weighted EPS growth is reflective of the earnings outperformance of large-capitalization companies compared with small- and mid-caps. An unusually high percentage of companies (25%-plus) have reported negative earnings for 2Q24. The average EPS decline for the negative-earnings group, which is heavily weighted in Energy, Materials, and Real Estate, is 16%. For the 75% of companies reporting positive EPS, average earnings growth is a robust 22%. A key reason investors are optimistic about second-half 2024 earnings growth is that the negative drag from Energy, Materials, and Real Estate is expected to diminish in 3Q24 and potentially reverse in 4Q24. About 78% of companies have reported positive EPS surprises in 2Q24, compared with 14% of companies reporting negative surprises. These percentages are above the 10-year average of 74%. For these companies, the median beat against consensus estimates is 5% (FactSet has it at 4.5%). For the first time in several quarters, the median beat against expectations is below the 10-year average of 6.8%. At the sector level, the strongest earnings growth is coming from Financial, Information Technology, and Utilities – all up in mid-teen percentages year over year. Other sectors reporting positive EPS growth include Communication Services, Healthcare, Consumer Discretionary, Consumer Staples, and Industrials, in descending order. As noted, Energy, Materials, and Real Estate are all down; Materials is off in high single digits, while Energy and Real Estate earnings are down 20%-21% from a year earlier. Second-quarter earnings were coming in about in line with Argus expectations. For 2Q24, Argus continues to model high-single-digit continuing-operations EPS growth for S&P 500 component companies. We see a higher likelihood that our forecast misses on the upside than on the downside. In other words, once all the component companies are tallied, we are more likely to see low-double-digit EPS growth for 2Q24 than we are to see mid-single-digit EPS growth. According to Argus President John Eade, our stock-bond barometer is near equilibrium. Given declining inflation growth and interest rates along with our forecast for high-single-digit EPS growth for 2024 and 2025, coupled with the July-August selloff, stocks appear favorable at current levels. A key risk to valuations would be earnings growth failing to meet the market’s targets and/or inflation or interest rates ticking higher. Either of those factors would result in elevated valuations, but represent just modest risks at present. Domestic and Global Markets Growth stocks sectors began to pull away from the broad market in May and extended that leadership in June. Both July and August had strong sell-offs but rallied to post wins for the month. Beneath the surface, both months extended the severe rotation away from growth leaders and toward stocks seen as safer havens. For the firs