Financial markets closed on Friday, June 27th, in a risk-on mood after senior officials from the US and China confirmed a trade framework on Thursday night that solidifies recent negotiations in London and Geneva. The selling pressure in the Treasury market had been only modest so far, pushing yields up a few basis points from Thursday’s lows. However, the short-term trend of the 10-year Treasury Note yield was downward. The yields of all Treasury maturities along the yield curve, except for the overnight yield governed by the Fed, were moving lower. Bond investors were giving the Fed a green light to lower rates, perhaps as soon as July.
On Thursday, July 3rd, US financial markets closed early at 1:00 pm in New York, in anticipation of Independence Day, a national holiday. On the same day, the Labor Department reported that 147,000 jobs were added in June, resulting in a decrease in the unemployment rate to 4.1% from 4.2% the previous month. Most economists had expected an increase of 110,000 jobs. Treasury yields rose as investors anticipated that the strong labor market would prevent the Fed from lowering rates in July. This was the opposite of what happened the week before. However, this was a short week, and Thursday’s session was brief, with few participants. I’m curious to see how bond investors will react next week.
The stock market is reaching all-time highs. Over the last couple of months, the US has shown its economic dominance by getting its trading partners to align with it. Recently, the country has also demonstrated its technological and military superiority, shifting the global order not just in trade but also as a superpower. Additionally, it has acted as a peacemaker, maintaining the dignity of the Iranian people by offering support through global commerce. These are all positive signs for the international financial markets. The message is clear: there won’t be long-term wars, but misbehavior will be strongly punished to maintain peace.
The US effort as a peacemaker reminds me of a real-life story. I attended an all-boys high school where the Headmaster, a gentleman in his mid-sixties with a dry sense of humor and no children of his own, was extremely just and fair. He kept two pairs of boxing gloves in his office. When a fight between two students was unavoidable, instead of ignoring it and letting it happen somewhere unseen and unsupervised, he brought both students into their classroom, moved the desks to make space for the fight, and had classmates serve as spectators. Though it felt longer at the time, most fights lasted no more than a few minutes, and sometimes several hard punches were exchanged with boxing gloves. Nevertheless, no one was ever hurt because the Headmaster acted as the referee, keeping both fighters in line, fair, and balanced. The most interesting part was that after a gentleman’s fight, the two students involved typically never fought again. In my memory, most of them became friends, perhaps like the US and England, or the US and Japan, more recently.
I don’t know if Israel and Iran will face the same fate, but I’m pretty sure that if another encounter happens, the price of oil won’t be affected. All Arab countries in the region have committed to increasing oil production, making substantial capital investments in the US economy, and they won’t provide military support for the Iranian regime. I also doubt it will ever be allowed to close the Strait of Hormuz.
Bottom line: PCE inflation increased by only 0.136% in May. Friday’s June 27th report showed slightly higher core inflation than expected, based on CPI and PPI data, but not enough to raise concerns. The Fed’s policy aims to prevent its imagined worst-case inflation scenario, not the baseline. Meanwhile, as shown in the chart of real consumption, the Fed’s restraint is having a harsh economic impact. Real consumer spending has decreased in three of the first five months of this year. As Chair Powell explained, FOMC members are confused by an unusually unclear forecast environment and are hesitant to rely heavily on “backward-looking” data. Nevertheless, Fed policy might be more restrictive than necessary, regardless of a strong labor force. Friday’s report strengthened the case for easing. Coincidentally, the Consumer Discretionary sector (XLY), which comprises two-thirds of the US economy, shows poor signs of momentum, despite its recent performance. Additionally, Year-to-Date, XLY is the worst-performing sector of the S&P 500, with a return of -0.92%. Consumers are feeling the squeeze.
As previously noted in past articles, Q2 was a bullish quarter for the stock market, with GDP growth and inflation accelerating simultaneously. Our forecast for Q3 remains bullish, but it is likely to be more volatile if our projection proves correct. We anticipate GDP growth to slow down (as mentioned in the XLY comment above and Real Personal Consumption, unless the Fed acts quickly) and inflation to pick up slightly, as commodity prices are beginning to rise.
The following bar graph shows the year-to-date performance of the S&P 500, Nasdaq 100, the Communication Services Sector (XLC), and the Technology Sector (XLK). The companies in these indices and ETFs have broad exposure to international markets, making them less vulnerable to fluctuations in the US economy. Compare these breakouts with the lagging performance of the Mid-Cap S&P 400 ($MID), the Dow Transports Index ($TRAN), the Small-Cap Russell 2000 (IWM), and the Consumer Discretionary Sector (XLY). Most constituents in these indices are more closely tied to the US economy. A good data table needs no explanation.
The behavior of the Treasury Yield Curve, which was compressing (we will see how it reacts next week), and the underperformance of the indices below suggest that investors are more concerned about the US economy than the global one. Remember, most central banks have already lowered their rates, some multiple times, which has supported global growth, while the Fed remains restrictive.
Conclusion: The S&P 500 and the Nasdaq are in bullish trends. The Mid-Cap and Small-Cap have delivered excellent performances during this short week. A rotation of capital is occurring into commodities, financials (including regional banks), silver, and energy. The consumer discretionary sector is lagging, but volatility ($VIX) is decreasing and breaking down.
We expect the US economy to remain in Phase II, where GDP and inflation accelerate together. Even if the Fed does not lower rates, we believe this bull market will be difficult to stop in the short term. Volatility is likely to increase if either the U.S. or the global economy, or both, enter Phase III of the economic cycle. Phase III occurs when inflation accelerates and GDP growth decelerates. However, the stock market does not collapse during Phase III. We anticipate pullbacks, but we doubt the S&P 500 will test the April lows anytime soon. Nevertheless, if we are right, adjusting positions based on their weight, beta, and inflation sensitivity will be essential to manage risk effectively while repositioning based on incremental quantitative market signals.
