Sometimes, bad news is good news. A macroeconomic data point comes out below what was forecast, but all Mr. Market can see is a juicy rate cut on the near horizon. Other times, though, bad news is bad news. And good news is bad news, and so-so news is bad news. We seem to be in one of those times now. Fortunately, perhaps, it is happening in August rather than in the historically trickier months of September and October. Let the market blow off some steam during the dog days of beach reading and low trading volumes, and then head into Labor Day weekend with a clearer perspective. We shall see. In the short term, of course, anything can happen. But so far, at least, we don’t see enough evidence to buy into some of the gloomier narratives out there about an impending hard landing for the economy. Let’s look at what the latest batch of data are telling us.

The Bad…

Yesterday’s bad vibes started with a piece of data called the Manufacturing ISM Report on Business, a survey of sentiment among purchasing and supply executives at over 400 industrial companies. That number came in lower than expected, a contractionary reading of 46.8. At the same time, the weekly report of new unemployment claims showed more filings than had been predicted, 249,000 versus the 235,000 forecast.

The previous day, Wednesday, had also supplied some data reflecting a general cooling of the labor market with a weaker than expected ADP Employment Survey. And for the cherry on top, this morning’s jobs report from the Bureau of Labor Statistics, which is the headline data point for labor market conditions, validated those prior reports with a relatively weak payroll gains number of 114,000 (175,000 expected) and a rise in the unemployment rate to 4.3 percent from 4.1 percent last month. A year ago, the unemployment rate was at a 55-year low of 3.5 percent.

…And The Good

But there was one very important piece of data yesterday that seemed to get lost in the midst of all the negativity, and in many ways it was the most important report. Productivity for the second quarter grew by 2.3 percent, more than the 1.8 percent forecast. For the past four quarters, productivity has grown by an average of 2.52 percent, a rate substantially above the 30-year average of 2.05 percent. Why is this important? Because long-term growth comes from only three sources: an increase in the overall population, or an increase in the percentage of the population participating in the labor force, or an increase in productivity

The population isn’t growing by much, and the demographics are ageing, so no help is coming any time soon from either of those. That leaves productivity as the only viable source of long-term growth. The good news is that productivity does seem to be trending up. Amid all the recent hype about artificial intelligence, those optimistic about AI’s impact on the economy point to the potential for a sustained boost to productivity. As we noted in our commentary a couple weeks ago, this is by no means a unified viewpoint among those paying close attention to developments in AI. But if we keep seeing better than expected growth in productivity, we may have solid evidence that something is working here.

A Global Sea of Red

Investors are finding plenty of reasons to not like things happening in other parts of the world, as well. Earlier this week the Bank of Japan raised interest rates by a quarter of a percentage point, to its highest level since the 2008 financial crisis. The BoJ’s move came even as recent data show a cooling economy, and the news sent the Japanese stock market into a tailspin. The Nikkei 225 stock index lost about eight percent over the course of Thursday and Friday, and the index is now 15 percent below its recent July 11 high point.

Not much good news has been coming out of China, either, with the country’s vast manufacturing sector in contraction for the third straight month, and new home sales falling by more than 19 percent in July. Beijing’s economic policy leaders don’t seem to have a viable solution for perking things up, at least in the near term, as they remain laser-focused on strategic manufacturing initiatives while paying little attention to the country’s moribund household consumer sector. Despite heroic attempts by the so-called “national team” of financial institutions called in periodically to prop up the Chinese stock market, shares remain mired in double-digit losses for the year to date.

And here at home? As things stand right now (and they will no doubt be different one way or the other by the end of the day) the S&P 500 is down around five percent from its recent high. Pullbacks of 5-10 percent are not unusual during a bull market, and it has been more than a year since we last had met the threshold of a technical correction, which is a peak-trough pullback of 10 percent or more. This is hitting most corners of the market, including the recently high-flying small cap sector. The Russell 2000 small cap index is off more than 3.5 percent today as we write this in mid-morning. We will not be unduly surprised to see more volatility in the coming days.

So far, though, this does not look to us like much more than letting off a bit of pressure after a sustained upward trend. And for investors who want to countenance the potential silver lining, there is always that “bad news is good news” refrain to fall back on, with a rate cut looking more and more likely when the Fed meets on September 18.

Some summers are quiet. This is not one of those summers. One month ago, a hitherto dull and dreary political contest supercharged into a must-see roller coaster of events. Two weeks ago, a benevolent inflation report sent securities markets into a tizzy, producing dramatic rotations in and out of asset classes in both equities and fixed income. So here we are, as July heads to a close, not expecting that August will offer much in the way of opportunity for a quiet repose at the beach. It’s at times like this that we like to remember what the dormouse said to Alice: Keep your head. It can be hard to resist the impulse to act when there is so much going on every day. But these are the times, more than any, that call for discipline, patience and care in the management of portfolios with long-term objectives.

A Benevolent Economy

Let’s start with the economy, because here is where things are actually relatively steady. We got two new pieces of data this week. Second quarter real GDP growth came in higher than expected, at 2.8 percent (quarter-to-quarter, annualized). Then, this morning, the Personal Consumption Expenditures (PCE) report showed core inflation growing by 0.2 percent in June, translating to a 2.6 percent increase year-on-year, a cooling trend roughly in line with economists’ expectations.

Economic growth was driven by consumer spending and nonresidential private investment, while the cooling inflation trend suggests that the continued brisk pace of economic activity is not pushing prices up unduly. Importantly, the trend of the past several months has validated the view that moderating growth will not turn into stagflation, which some had feared earlier this year following a series of hotter than expected inflation reports.

Meanwhile, roughly 40 percent of S&P 500 companies have reported second quarter sales and earnings results, and the current growth rate (combining actual figures for companies already reporting and estimates for those still on tap) for earnings per share is 9.8 percent, higher than the 9.0 percent consensus forecast when the second quarter began. Although we still hear the term “macro uncertainty” peppered throughout the analyst calls with management, the uncertainty seems to be somewhat less forbidding than it was several months ago.

The Performance Bar Is Ever Higher

All that good news might lead one to believe that markets would keep on with the pleasant, gently upward vibe we saw throughout the second quarter. No such luck. As we noted in our commentary two weeks ago, investors seemed to be waiting for a catalyst to reappraise their positions in the expensive trades that had been hitherto been working so well, namely Big Tech and the AI narrative. They got the signal from that week’s CPI report, combined it with a newfound conviction that Republicans were going to sweep the electoral contests in November, and off to the repositioning races they went. Interestingly, though, while the initial rotations were into a variety of sectors from small caps to value to non-US equities, so far the only one with staying power is US small caps, as shown in the chart below.

What does all this mean? We’re not sure how much of that July 11 catalyst was actually related to the political outlook, though of course the financial media can never resist the opportunity to say “Trump trade” as a lazy shorthand to describe things. On the political front quite a bit has happened since then, and quite a bit more is likely to happen between now and November, so our advice, as always, is to tune out the noise. There is definitely a high bar for corporate earnings performance in tech and related sectors, as Alphabet (Google) can attest to following a fairly strong Q2 report this past Tuesday that investors greeted with a five percent hit to the company’s stock price.

We don’t expect investors to be any more forgiving when other tech heavy hitters report over the next couple weeks. That being said, we remain unconvinced that there is real structural sustainability to the current small cap rotation, and with the big moves that have already taken place, we think any meaningful tactical moves in this area would be ill-advised. There will likely be reversions to the reversions. But there will also be important strategic decisions to countenance in the not too distant future.

A few week ago, we noted in our weekly commentary that it was “prove it” time for stocks claiming to have a big AI story front and center in their business propositions, observing as well that one of the key investment themes we wrote about in our annual outlook back in January was how the AI narrative was going to evolve from the hype and frenzy of 2023 to a more sober appraisal of its business use cases. Right on cue, a newfound sobriety in AI scrutiny appears to have found its way into the mainstream conversation among the financial chattering class.

The Trillion Dollar Question

Perhaps nothing says “financial mainstream” quite like Goldman Sachs, and so it is perhaps appropriate that a recent Global Macro Research report from that firm devotes its entirety to the question of whether Generative AI in particular is delivering on all the promises and, in particular, on all the dollars being spent on its development. This report, refreshingly, does not “talk the book” by pitching a single point of view, but rather invites a wide spectrum of opinion ranging from world-beating optimism to terse skepticism about what all that capital investment – reckoned to run to $1 trillion or so just in the next several years – is likely to accomplish. As Jim Covello, Goldman’s head of equity research, bluntly puts it: “What $1 trillion problem will AI solve?”

What New Thing?

The one thing that most people appear to agree on, and one of the key arguments we made in our January outlook, was that the so-called “killer app” has not yet appeared, eighteen months after the novelty of ChatGPT ignited the mania around GenAI. Yes – ChatGPT can write for you a Shakespearian sonnet in the humorous vein of Kevin Hart, if that happens to be what hits your fancy today. But GenAI has not yet reached anything close to a critical mass of adoption rates among businesses outside of a few very large players in a small number of business sectors. Prior generations of technology’s “new new thing” have had their killer apps: enterprise resource planning software in the 1990s, search and e-commerce in the first generation of the commercial Internet, and all the innovations and diversions, like social media, made possible by the rise of cloud computing in the 2010s. Not all these revolutions translated directly into increased productivity, but they all played a part in transforming the way we think, work and play in the 24-hour cycles of our quotidian existences.

Market Priorities

As we noted in our commentary a few weeks ago, this absence to date of a killer app has important implications for near-term equity market prospects, given the outsize role AI continues to play as a driver of market performance. The market seems to have taken note of the current chatter and second-guessing about AI, with some of the biggest outperformers of the past twelve months seeing significant pullbacks as investors rotate into other, long-suffering parts of the market like deep value and small caps.

These recent reversals are more likely technical and short-term in nature, rather than a more structural shift in fundamentals. Whatever the eventual contribution of GenAI to economic growth and productivity winds up being, there is scant evidence that the furious pace of build-out in AI infrastructure is going to slow down any time soon. That in turn suggests that the “picks and shovels” names, primarily the semiconductors and related businesses, will likely continue to show outsize sales and earnings growth. Companies that stand to benefit from the expected surge in demand for load from the power grid, such as utilities, may just be at the beginning of an uptrend (though this is likely to be a tricky area given the stringent regulatory environment in which utilities operate and the daunting challenge of building out sufficient capacity to meet the rise in demand).

How long this trend lasts will depend in large part on what happens downstream from the infrastructure and power generation activity – and that, of course, goes back to the question of when or if that killer AI app makes itself known. The more we learn about AI, it seems, the more questions we have about where it is all headed. It’s going to be interesting, to say the least.

One day does not a trend make. But yesterday was a doozy of a reversal in the fortunes of large cap growth stocks and their long-suffering compatriots in large value and small caps. That, necessarily, begat a flood of chatter about one of the most beloved themes among financial talking heads – The Rotation. We have seen this movie before, and more often than not it proves to be a head fake rather than a sustained development. But given how long growth’s outperformance has been going on, and how expensive many of these stocks have become, it’s worth at least delving into the whys and the wherefores. As the chart below shows, the small cap frenzy in particular is continuing unabated in the early hours of trading this morning.

CPI Tailwind

Yesterday’s big move was not without a catalyst. The June Consumer Price Index (CPI) report came out an hour before trading commenced and delivered the pleasant surprise of lower than expected price gains for the month of June. The all-items headline number actually fell by -0.1 percent, thanks largely to a decline in gasoline prices. The more Fed-relevant core CPI gained 0.1 percent, lower than the 0.2 percent predicted by economists, bringing year-on-year core CPI down to 3.3 percent. This marks the third month in a row for a reasonably benign CPI, after the unexpectedly high readings earlier in the year.

All well and good, but why should lower inflation have an outsize impact on small cap stocks? The easiest and probably most relevant answer to that question is that lower inflation increases the likelihood that the Fed will start cutting interest rates in September. The market promptly priced in a 95 percent probability of that following release of the CPI report. Lower interest rates can be particularly beneficial for smaller companies which are more sensitive to changes in operating leverage – interest is a fixed expense you have to pay regardless of whether your revenue is going up or down, so it can eat into profit margins, which is especially important when economic conditions are slowing, as they have been recently. As long as the slowdown stays within the parameters of “soft landing” and doesn’t turn into something worse, lower interest rates will help smaller companies keep their profit margins from turning dramatically lower.

What About the Other Side?

Of course, 3.3 percent core inflation is still not 2.0 percent core inflation, and all it would take would be another sticky CPI report showing monthly gains of 0.4 percent, like the January and February readings, to throw a wet blanket over yesterday’s good cheer. So we will watch and wait before forming any deep convictions about the durability of this rotation. But there is another question as well, and that pertains to the large cap growth stocks that got dumped yesterday. Was it just some reflexive tactical reallocating of portfolio weights, or are there reasons to be more skeptical of this asset class’s recent run of good times?

We will have a more in-depth look at this question next week, when we revisit a theme we brought up several weeks ago about the business case for generative artificial intelligence. In the storied annals of stock market history there are a handful of variations around the theme of “X looked great, until it didn’t” where “X” at different times has been railroads, industrial chemicals, automobiles, oil production, e-commerce…you get the picture. At some point, many of today’s darlings are likely to become part of this colorful history. But (to give a little preview of next week’s topic) that day of reckoning may still be some ways away. See you next Friday!

We received a few more data points this week validating the increasingly consensus view that the economy is slowing – gently, perhaps, but still slowing. On Wednesday the Institute of Supply Managers (ISM) Services index showed an unexpected slip into contraction territory, coming in at 48.8 versus economists’ expectations of 52.5 (a figure of 50 or more represents expansion, while below 50 signifies contraction), That same day the ADP Employment Survey was a tad below the consensus forecast, at 150,000 versus 163,000. The GDPNow estimate published by the Atlanta Fed, an estimate for real GDP growth, has been falling steadily over the past two weeks and now sits at 1.5 percent, with a softening outlook for consumer spending the key influencing factor. Finally, today’s jobs report from the Bureau of Labor Statistics showed unemployment ticking up slightly to 4.1 percent – not a big month-to-month change but 0.5 percent higher than the 3.6 percent level one year ago. And while June payroll gains of 202,000 came in a bit higher than expected, downward revisions to April and May amounted to a 111,000 reduction in job gains for those months.

Comms and Tech Front and Center

Attention now shifts to the corporate sector, with the second quarter earnings season getting underway next week. Here is where estimates are not being revised down; the projected earnings per share growth rate for S&P 500 companies stands at 8.7 percent, not far from previous estimates. Top line sales are expected to grow by around five percent. Operating profit margins are looking healthy, if the analysts covering the companies are to be believed.

Perhaps unsurprisingly, information technology and communications services companies are at the forefront of the growth projections. Analysts expect to see revenue growth of 9.3 percent and earnings per share of 15.7 percent for the tech sector, with growth rates of 7.3 percent / 18.7 percent respectively in the communications services sector. Large dollops of capital expenditure on AI-related projects continue apace (although there have been some questions recently in the financial press about the extent to which all the new AI capacity is finding its way into the broader economy in a practical sense.

As always, observers will be paying close attention to forward guidance as management teams report, with “macro uncertainty” having been an often-heard phrase in the recently-concluded first quarter season. And given the ceaseless pace of geopolitical developments at home and around the world, we expect that mentions of “political uncertainty” will be increasing as the weeks go by.

July Is the Kindest Month

For investors wondering what these various trends may mean for market performance, there is perhaps some solace in the historic market trends for the month of July. A recent analysis by Goldman Sachs noted that the first 15 days of July have been the best two-week trading period of the year going back to 1928 (we would remind our readers that time series averages do not give any degree of certainty for what might happen in any given year). That same analysis also offered up the cheery observation that the S&P 500 has been positive for the past nine Julys, and the Nasdaq’s record in this regard stretches to 16 years). Money that has been sitting on the sidelines for the first half of the year often moves in the early days of the second half, explaining in part this favorable seasonal trend.

We shall see. It would be nice to have some favorable tailwinds for at least a few weeks, because we will have a full plate of macro news, earnings reports and geopolitical tectonics to deal with soon enough.

No, that headline is not referring to presidential debates. The first half of 2024 is drawing to a close today, and we have one more half year to go. Six months hence and we close the book on the fourth year of the Twenties (at least based on the evidence so far, we feel fairly confident in projecting that this century’s third decade will not come to be known by the history books as another Roaring Twenties – thoughts?). So what might the second half have in store for us?

No More Rate Cut Unicorns, But Maybe a September Pony

The first six months of the year were perhaps most notable for steadily weaning the bond market off its fantasies of multiple rate cuts. Recall that in December 2023, after a couple good inflation reports and some positive vibes from the Fed’s December FOMC meeting, the bond market was pricing in six rate cuts for 2024 (recall also, dear reader, our oft-repeated observation at the time that this viewpoint was on the far end of the delusional spectrum). It took three months of higher than expected Consumer Price Index reports, from January through March, to bring the bond market back to Earth One and the realization that doubling down on the Fed’s own best guess about rates (three rate cuts) was just a tad inadvisable. In fact, those sticky inflation reports forced the Fed to reevaluate its own assumptions. Now, two and a half years after monetary tightening began in March 2022, the Fed and the bond market are finally more or less aligned – if not happily than at least resignedly – one the more likely outcome of one rate cut before the year ends.

The pony for the markets is that, based on the latest inflation read this morning, that cut may come by September rather than December. The Personal Consumption Expenditure index less food and energy (core PCE), which is the Fed’s preferred inflation metric, rose by just 0.08 percent in May for a year-on-year gain of 2.6 percent – the lowest level since March 2021.

The month-on-month number is what we have been focusing on for clues as to when the Fed might feel comfortable pushing the button. Anything less than a 0.3 percent monthly increase is good news, and the May gain of 0.08 percent follows April’s 0.26 percent rise. If we get another two months of a sub-0.3 percent core PCE reading in July and August, all else being equal we would think the odds are better than not for a September cut. That in turn could set up a nice tailwind to get through the often bumpy early weeks of the fourth quarter into the holiday season and a strong finish.

How Much More for AI?

The other big trend in the first half, of course, was the continued outperformance of the AI narrative (which we talked about in some detail in our commentary last week). That tailwind turned into a headwind of sorts over the past few days, though we would imagine more from investors trimming positions and taking some money off the table than from any fundamental change in the dynamics of the sector. The performance bar was set very high for AI-centric companies like Micron, which reported strong earnings earlier this week but took a beating anyway as the market determined that “strong” isn’t the same as “super-awesome barnstormingly ga-ga strong” with regard to the company’s forward revenue guidance. Whatever. We are seeing genuine AI use cases showing up in an increasing number of earnings reports across a wide spectrum of industry sectors, and lots of related capital expenditure outlays, which suggests that this narrative has some ways to go before it burns itself out.

Landing the Plane, Ever So Softly 

As for the general economy, nothing we can see in recent data releases suggests a change to the assumption for a slowdown, with growth remaining modestly positive. The latest consensus from the economist crowd at Blue Chip Economic Indicators has a median forecast of 2.0 percent real GDP growth for the second quarter, the report for which will come out in late July. Recent data points from the labor market to durable goods and retail sales all point to a moderation in the hitherto torrid pace of consumer spending, with little to suggest that the slowdown will turn into a recession. And thus will the storied predictive powers of the inverted Treasury yield curve be forever put to rest. Sic transit gloria mundi.

In summary, we do not see much right now that would cause a major rethinking of where we are positioned in our portfolios. That is not to suggest that it will be a smooth ride for the next six months, or free of surprises. We imagine there will be a few of those lying in wait. But in the meantime we will take it one week at a time.

Artificial intelligence has never been far from the center of debate about what is driving the stock market in 2024; in fact, there is precious little else that has come to mind recently on the subject. This week saw three companies jostling and elbowing each other for the pole position as Most Valuable Player in the S&P 500 (and, by extension, the world) – Nvidia, Microsoft and Apple, all of which have a strong case to make as a center of AI excellence (Apple has been a bit late to the game, but arguably could be the company that most directly pushes generative artificial intelligence into the bloodstream of the American consumerati). Nvidia, in particular, has had a stunning run on the basis of its dominant position as supplier of the graphic processing units (GPUs) needed for the vast language learning modules and related technologies developed in AI data centers. Even more impressive than the company’s tripling of value in the past twelve months is that, thanks to triple-digit growth over the same period, its price-to-earnings ratio is less than half what it was one year ago.

Earnings Call Hype

Outside the rarefied world of the top few companies, however, the AI narrative is not quite the no-holds-barred hype machine that is was last year. In 2023, as share prices soared for anything that seemed to have an AI theme attached to its business model, companies across the full spectrum of industry sectors fell over themselves telling analysts on their quarterly earnings calls about how central generative AI was to their plans for the next twelve months. Investment firms took note: Citi put together something called an “AI Winners Basket” while the likes of BlackRock and Invesco crafted AI-centric exchange traded funds (the “Robotics and Artificial Intelligence” ETF and “AI  and Next Gen Software” fund respectively).

Those funds have hit a rough patch this year, relatively speaking. About 60 percent of S&P 500 stocks are up for the year to date, and roughly the same proportion holds for names in the information technology sector of the index. But around 60 percent of the AI Winners Basket stocks are down for the year, and more than half of the BlackRock and Invesco vehicles are also in negative territory since January. This suggests that investors are taking a more critical approach to evaluating AI business cases, and not just buying up whatever management teams are hyping up on their earnings calls. We see this as a positive development. For companies able to prove that proprietary AI technology is embedded in their strategic business models, the growth scenarios justifying expensive valuations can be plausible. For others, the sooner they come down to earth, the less likely the AI hype metastasizes into a dot com-esque bubble.

The Hype and the Power

Outside the spotlight of glitzy AI storytelling, there is a much less sexy corner of the market that is starting to see its financial prospects improved by the needs of AI-centric Big Tech. Specifically, the need for power – lots and lots of power. The so-called “AI factories” buying tens of thousands of Nvidia GPUs to crunch massive amounts of data into their language learning modules have a seemingly bottomless need for power in whatever form they can obtain it from the energy grid. Wonder why the dowdy utilities sector – traditionally the home of high-dividend stocks with snails-pace growth – is up more than 11 percent this year and trailing only information technology and communications services sectors among S&P 500 sectors? Demand from AI is also giving a boost to fossil fuels companies even while tech leaders like Microsoft scramble to develop and commercialize experimental clean-energy technologies. For now, a significant clean energy breakthrough at sufficient scale seems far off. For the sake of our planet, not to mention not busting the energy grid’s current capacity to service our homes and offices, we hope that happens sooner rather than later. Meanwhile, there does not appear to be an end in sight for the energy demands of AI.

Of all the consequential elections taking place in 2024, who would have thought that the European Union parliamentary contest would be the one to unleash a volatile pulse of Sturm und Drang into regional financial markets? Typically, the EU-level elections have served as an arena for demonstrative flamboyance, perhaps not unlike the over-the-top histrionics of Eurovision musical performances, in which the good citizens of Europe register their dissatisfaction with the status quo without doing anything they figure might have a practical impact on their quotidian lives.

A Lightning Bolt from Jupiter

One might have said that this year’s elections were true to form in this sense, until French president Emmanuel Macron, whom the local press christened “Jupiter” after his meteoric ascent to the pinnacle of the French political system in 2017, threw a lighting bolt worthy of his nickname and called for snap national elections to be held at the end of this month. Macron’s centrist alliance was trounced in last Sunday’s EU elections by the far-right National Rally party, which gained 31.4 percent of the vote compared to just 14.6 percent for the Macron alliance. French financial markets were not amused, to say the least. In addition to the plunge in the CAC 40 domestic stock index (shown below), the spread between French and German 10 year sovereign bonds widened to its widest level in seven years.

The thinking behind Macron’s decision to call snap elections, as far as anyone can figure, is that when French voters are presented with the choice of entrusting their own government to the far-right party led by long-time provocateur Marine Le Pen, they will do as they have done in past elections and revert back to the center. In other words, Macron’s take on last Sunday’s outcome is just as we described above: voters take out their frustrations in the EU-level contests, but when it comes to choosing the national government that will make policies affecting their own lives, they will choose the safe outcome. Unfortunately for Macron – as well as for investors who were long French exposure going into last weekend – that playbook appears to be in serious jeopardy. Polls and related analysis this week suggest that, not only is the far-right RN party likely to do well on June 30, but a newly-formed alliance of four left-wing parties may wind up coming in second in many of the regional races. That could mean that when the second-round runoff between the top two candidates takes place, a week after the first round on June 30, in many cases neither candidate will be representing Macron’s centrist bloc.

Markets Hate Surprises

Is there a larger lesson to be learned from the troubles in France? Should investors be thinking through defensive strategies as the election season here at home heats up? If you are a regular reader of our weekly commentary, you can probably guess that our answer to the second question is no: it is not a good idea to try to translate whatever scenario you have in mind about November 5 into a tactical investment program. Markets tend to abide politics, even when the politics are messy. What markets really, really do not like, however, is being surprised. The fallout in French markets this week, which has bled into other European markets, arguably has more to do with the surprise factor than with anything else. Macron’s political weakness is nothing new; his party has been faring poorly for some time now. But his own term as president does not end until 2027. Calling snap elections now only means that his last three years in office could be even more hamstrung by opposition than they already are.

By contrast, the contours of the November elections here in the US are already well-known. Barring something very unexpected (which can never be completely ruled out, of course), we know who the candidates are, we know more or less what their political platforms are, and between now and November we will have thousands upon thousands of pages and speeches and slide decks and polls and whatever else to saturate our cognitive mechanisms. There will be practical consequences depending on the outcome, and at some point in the future those consequences will have an economic impact. But trying to anticipate all these unknown variables ahead of time is a fool’s errand, and we would caution against trying. One may have a cause-effect scenario in mind that is viable and rational. The market, however, is seldom rational in the short term, and it can stay irrational longer than one’s position can stay solvent.

We don’t often think of Europe as leading the way when it comes to the doings of the global economy, but this week the European Central Bank made the first decisive move in the transition away from monetary tightening. The ECB lowered its benchmark deposit rate by 0.25 percent to 3.75 percent, its first rate cut in five years. With neither the Fed nor the Bank of England likely to be moving off their peak rates in the near future, the ECB is for now alone among the major central banks. There are questions, though, as to whether this is the beginning of a trend or a one-off.

A Hawkish Cut

The rate cut was not a surprise; ECB head Christine Lagarde and her colleagues have been telegraphing it for most of the time since the bank’s previous meeting earlier this spring. As for what comes next, Lagarde et al were fairly circumspect and tight-lipped. German Bundesbank head Joachim Nagel cautioned that the ECB is “not driving on autopilot” when it comes to future rate cuts. Nagel and other typically conservative national bank chiefs, including those from Latvia and Estonia, warned that the fight against inflation, though largely on the right track, is not over. Recent strength in the Eurozone economy, including a higher than expected growth rate in hourly wages published today, suggests the lack of a pressing need to start cutting rates aggressively. The ECB’s own forecast for inflation in 2024 ticked up to 2.8 percent from 2.7 percent. Prior to Thursday’s meeting, futures markets had put a 70 percent probability on a second rate cut happening before September; that likelihood now stands at 56 percent.

Growth On The Margins

Is the European economy all that strong, though? Among the data points trickling out this morning is a weaker than expected figure for industrial production in Germany, the EU’s largest national economy, which came in at minus 0.1 percent. Recently the Eurozone has been teetering on the edge between growth and recession, picking up slightly in the first quarter of this year after being negative for the fourth quarter of 2023. Nothing much has changed in the core economic model of the region, which remains heavily dependent on manufacturing and exports. High-value goods exporters like Germany have been hurt by ongoing weakness in China, one of its main export destinations. In key global growth sectors like artificial intelligence and cloud computing, Europe remains well behind the US as well as Asian economies including China, Taiwan and South Korea. One of the key reasons for the chronic underperformance of European equities – a theme we have covered extensively in our commentaries – is the relative absence of business leaders in these high-growth sectors.

Over To You, Jay

Next up is the Fed. The Federal Open Market Committee meets next week and we will have the full buffet of post-meeting statement, press conference and the always popular “dot plots” next Wednesday. There is not likely to be much drama here, as the chances of a rate cut from the Fed are vanishingly close to zero. While there are ample signs of a consumer spending slowdown, as we have noted in some of our recent commentaries, there are countervailing data points as well. The BLS jobs report that came out this morning showed 272,000 payroll gains, a much higher than expected job growth figure (the unemployment rate notched up ever so slightly to 4.0 percent, but that arguably has more to do with a greater number of people actively seeking jobs than with a meaningful reversal of strength in the labor market). There is a growing chorus of economists arguing for action on rate cuts sooner rather than later, so as to ensure that a soft landing doesn’t turn into negative growth. For now, though, the Fed is unlikely to signal a divergence from the recent mantra of “higher for longer.” Thursday’s ECB rate cut may well turn out to be the only one of its kind until summer winds down.

Today is one of those round number days the market loves to get excited about. No, not the Nasdaq Composite index reaching 17,000 – that happened a couple days ago and since then the index has given back the prize, currently trading around 16,800 as we write this. Today’s round number action takes place in the bond market. The Treasury yield curve has been inverted between the 10-year and 2-year maturities for 500 days, as of today, and will in almost all likelihood be adding to that total in the days and weeks (and months?) ahead.

This round number event is particularly salient as it will prompt another session of opining among market pundits as to whether this marks the end of the inverted yield curve’s usefulness as a recession warning. Is it the end for this fabled signal of stormy weather ahead? We decided to look at the numbers, going back to all the US recessions that have happened in the course of our working careers. Our opinion: not quite dead, but not at all well.

Inversions By The Numbers

Here are the numbers. Prior to the current inversion, which started in 2022, the 10-2 curve has inverted on four occasions since 1987. Each of these occasions was followed by a recession (with one asterisk, which we will get to in a moment).

By one measure, the total number of days in which the curve stayed inverted, something does seem to be seriously off. The 500 days of inversion in the current environment includes 498 consecutive days beginning on July 5, 2022 (the other two days occurred in April of the same year, with the curve resuming its normal shape before inverting for good on July 5). That is far, far longer than any prior period. Prior to this, the maximum total number of pre-recession inversion days was 253, before the 2008 recession, and within that period the maximum number of consecutive days was 157.

By another measure, though, it still may be too early to conclude that the current stretch of 500+ days will end without a recession. Here it is important to note that, for example, the curve inverted for the first time nearly three years before the recession of 2001. That recession officially started on April 2, 2001. The curve first inverted ahead of that on June 10, 1998. It inverted almost two years before the Great Recession of 2008, on December 27, 2005 (the official start date for that recession was January 2, 2008). By this measure, we could perhaps mark a sell-by date of around April 2025. If a recession hasn’t happened by then, three years after the curve first went negative, we would be prepared to consign the predictive powers of the inverted yield curve to the graveyard of metrics past (perhaps alongside the value bias and the small cap factor…).

False Positives and Pandemic Distortions

Now we come back to that asterisk we briefly noted above. Prior to 2020, one of the selling points of the inversion signal was the absence of false positives. Look again at the above chart. In those long growth cycles of the 1990s and the 2010s there was not one single instance of a 10-2 inversion apart from the ones signaling a recession. But in August 2019 the curve inverted for an ever-so-brief period of time, a grand total of five days between August 23 and September 2. That generated a lot of discussion at the time about the potential imminence of a recession.

We did have a recession, of course, in 2020. But not for any reason that could have been anticipated in September 2019, since that was four months before the appearance of the SARS Covid-19 virus in Wuhan, China and the subsequent global pandemic, the pandemic being the one and only reason why that recession of March 2020 happened (and lasted all of two months, a record in brevity).

So that brief period of inversion was, in fact, a false positive. Meaning that if the current inversion winds up conclusively without a recession to name – which we think is more likely than not – it will not be the first false positive, just the longest one.

The pandemic left in its wake a good deal of human suffering, but it also did a number on economic statistics. The highest unemployment rate of the postwar period happened during this brief period, as did the sharpest decline in real GDP growth. Supply chain bottlenecks and a flood of fiscal relief to households and businesses produced the highest period of inflation since the 1970s. Interest rates were kept artificially low for an extended period of time, then abruptly raised by the Fed in order to tame that inflation. Perhaps it is simply asking too much for metrics that worked in a different world to keep serving as reliable signals. In a world of noise, those signals are faint and hard to detect.