Are the Shaky Markets On The Verge of a Meltdown?
As of this writing on July 26th, the markets have been roiled. The Nasdaq had its steepest selloff two days ago since 2022 declining 3.6%, stoking investor fears. Disappointing corporate earnings, concerns of an AI bubble, an overvalued stock market, and election uncertainty are the key culprits to the stock market selloff. However, the resilient macroeconomic backdrop may stem the tide in the short-run, and that outlook may improve further with the likely prospect of Fed rate cuts. It’s not about Donald Trump or Kamala Harris regarding the economy. All eyes should be on Fed Chair Jerome Powell.
Fresh off the presses, Q2 US Gross Domestic Product increased at an annual rate of 2.8% according to the US Bureau of Economic Analysis. While this is a lagging indicator, GDP tends to decelerate over time before entering negative territory. 2.8% is comfortably above the recessionary watermark of negative growth.
In addition, price inflation continues to abate. The Consumer Price Index (CPI) fell by a seasonally adjusted 0.1% in June and rose 3% over the last 12 months. Remember, 3% inflation is a far cry from the June 2022 peak of 9.1%. As of this morning, the Core PCE Price Index — the Fed’s preferred gauge of inflation — stands at 2.6% year-over-year. and it continues to inch closer to the Federal Reserve’s (Fed) 2% inflation target. According to the Bureau of Economic Analysis, this is lower than the long-term average of 3.24%.
On that score, there is growing sentiment among economists that the Fed will initiate their first rate cut. According to a Reuters Poll, 82% of surveyed economists anticipate the Fed Discount Window (the rate at which commercial banks can borrow from the Fed) to be reduced 25 basis points (0.25%) in September.
While Chairman Jerome Powell and many of the Fed board of governors have remained hawkish to date, there is a counter narrative that further hesitation could trigger a recession. This has occurred in prior cycles. My professional opinion as a trained economist is that the Fed ought to initiate rate cuts soon to lower borrowing costs. This should prove a welcome reprieve for borrowers, and in turn could be a shot in the arm for the broader macroeconomy and financial markets. Unfortunately, the Fed has a history of responding too late, but growing pressure both inside and outside of the central bank may prevent this.
Nonetheless, with lower interest rates there will likely be positive downstream effects for both the stock and bond markets. Longer duration high quality bonds may be one of the biggest winners. It is critical to understand that bonds have an inverse relationship to interest rates holding all things equal. As interest rates fall, the underlying value of the bond increases. For example, if interest rates fall by 1%, a 10 year highly rated bond (investment grade) such as a Treasury Bond could appreciate by as much as 10%. While the last couple of years have been rough for bond investors, we may be on the verge of one of the best bond markets in decades. My general sentiment is to overweight intermediate and long-term bonds and to stick largely with investment grade bonds. High yield bonds (junk bonds) pose outsized risk with lower upside in this market. High yield bonds can be great for income, but investors should be cautious. If there is recession in the next couple of years, these debt offerings have a much higher risk of default relative to investment grade bonds.
While bonds are attractive, stocks may prove even more attractive in the coming months. Historically, In the 12 months after the Fed initiates rate cuts, the average return for US stocks has been 11% according to Schroders. In other words, despite the recent selloff, I am doubtful we are on the verge of a bear market based on historical precedence. Again, all eyes should be on the Fed.
The reality though is that many investors are distracted by politics. Much of the legacy financial media are hyperventilating over who will be the next president, but history shows that elections have very little near term impact on the markets. The average rate of return of the S&P 500 from 1928 to 2016 was 11.3% during election years according to a study from Morgan Stanley, using data from Morningstar and Ibbotson Associates. There were some ugly markets during election years such as 1932 and 2008, but in both of those cases it had all to do with macroeconomic shocks to the system, not who the president-elect was.
Also, we have seen a few bad trading sessions in anticipation of a Trump presidency that I will dub as the “Trump Dump.” Polls and betting odds have Donald Trump as the likely next president of the United States. We still have a long election cycle ahead and anything can happen, but the markets are already starting to price in Trump’s policies. This is misguided.
Countless financial articles have bemoaned Trump’s trade polices of high tariffs. First off, Trump views those as bargaining chips and not as the end goal. Ideally, based on his rhetoric and past actions when he was president, his goal is to pressure trading partners such as China to lower their tariffs. It’s an economic cold war with the goal of deescalating. Many disagree with this tactic, but there is the prospect that it may lead to all tariffs coming down for all parties. You may be skeptical of the efficacy of such a move, as am I, but a fairer assessment of his actual policy aims needs to occur. But the fact remains that tariffs could remain elevated if he is elected.
Furthermore, President Joe Biden, and conceivably Kamala Harris, have a near identical vision for tariffs and protectionism. Not much will change in my estimation — regardless of who is elected. The financial media’s fear is that these policies will lead to further inflation which could upend the Fed’s plan to lower rates, but inflation was low during Trumps four years in the White House with CPI averaging 1.925% per year (2017-2020). Inflation was predominantly driven by the Fed’s aggressive expansion of the money supply by 5 trillion dollars during the Covid-19 pandemic which ramped up the M2 money supply (money in circulation). Also, excessive federal spending further exacerbated inflation. When too many dollars chase too few of goods, you get price inflation. The Fed has moved aggressively by raising short-term rates and reducing their balance sheet. Tariffs had little to do with driving inflation.
Lastly, even if Trump continues with heightened tariffs, you need remember that every administration is a mixed bag when it comes to economic policies. While I have concerns about heightened tariffs provoking an economic slowdown, Trump is also likely to lower regulations and to keep tax rates lower, policies that have historically bolstered economic growth. Let’s stop being myopic regarding a platform and look at the whole picture. And again, we don’t know who the next president will be. Likewise, the Democratic platform is also a mixed bag.
One final brief note that I think bodes well for the economy, and it is not getting near enough attention. The Supreme Court recently overturned the most consequential economic legal precedent in our lifetime, the “Chevron Doctrine.” This will powerfully restrict the administrative state’s ability to craft rules for the private sector, and it could lead to significant deregulation. But at minimum, it will likely stem the flow of onerous rules from agencies like the Department of Labor. I will address the significance of this ruling in a future article.
As an investor you should probably prepare for some choppy waters with occasional dips until election day, but there are plenty of signs that the economy still has some life in it for the next 12 months. It’s also important to remember that the stock market experiences a 10% peak to trough pullback each year on average. Intra-year volatility is par for the course, and this does not necessarily portend an inevitable bear market. My sense is that the market is simply taking a breather. Of course, I cannot see into the future and exogenous shocks (like COVID or 9/11) can change everything in a second. But now is not the time to panic.
By: Drew Benson, CFP®, AAMS™
President & Founder, Benson Wealth Management, LLC
Senior Wealth Advisor, RJFS
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