Equity markets recovered from an early August sell-off to close mostly higher. In the US, large company stocks recovered and then posted gains. Smaller company stocks also recovered, but not enough to end higher on the month. In foreign markets the experience was similar, with both developed and emerging markets bouncing back and climbing higher.
Bonds rose as interest rates continued to creep lower while the credit environment remained benign. The slope and shape of the treasury yield curve has been changing as markets react to inflation and employment reports. The economy appears to be slowing, and the pace seems to have picked up a bit recently, particularly for the labor market and lower-end consumers. However, credit spreads for riskier borrowers have remained tight. Outside the area of the yield curve where the Federal Reserve is most influential, the market for bonds with less than a year of maturity, rates have fallen considerably and sit below the current Fed Funds rate.
The Fed appears ready to embark on an easing cycle, as officials have signaled that their focus has shifted to a weakening labor market. Most forecasters believe the September meeting will be the first in a series of rate cuts. We think the timing, size, and pace of rate cuts are open questions, as is the eventual endpoint. Should a slowdown accelerate further, so too could rate cuts. We note that the economy as a whole has grown while various sub-sectors of the economy have been through various boom-bust cycles of their own over the past several years.
Right now, the cycle appears to be hitting lower-end consumers. Inflation is leading to paring back on discretionary items, even if the total amount they spent is not changing much. Should the labor economy weaken further, that could lead to lower spending on less discretionary items and/or a pullback in discretionary spending from higher-end consumers. The US consumer is over two-thirds of GDP, so that dynamic bears monitoring. We note that overall, consumers are in pretty good shape, and betting against the US consumer consuming has tended to be a losing bet over the long run.
September, like August, is off to a volatile start. To some extent, that is to be expected. We have an election in November, and uncertainty is higher for both policy and the economy. While we do not express preferences on the election outcome, we monitor the political climate because it affects the economic and market climate. In an election cycle, there is a lot of noise surrounding various policy proposals, many of which have little chance of becoming law or wind up materially changed and watered down by the time they become enacted.
On the policy side, the issue that we think could be relevant to markets is the US tax code. The Tax Cut and Jobs Act (TCJA) is set to sunset at the end of 2025, at which point many provisions will revert to 2016 levels if they are not extended or replaced. Forecasting how, or if, that gets resolved requires a view on the election result and what compromise, if any, can get through the next Congress.
We will not hazard a guess on the election outcome but are cognizant of how government policy may influence various winners and losers in the market. We caution and guard against overconfidence in the analysis because there tend to be unintended consequences that could lead to counterintuitive outcomes.
