The key issue now is “Fed-growth-inflation”

The four themes

There are four themes that shape the performance of the S&P 500 (SP500) in the short term:

1. First, the GenAI bubble burst. Big tech companies have been investing heavily in Gen AI, but it seems that the return on investment in Gen AI Capital expenditure may be too low, at least in the short term. Moreover, according to Nvidia's latest earnings report, growth is slowing, which does not justify the high valuations.
2. The second theme is the Fed's unfolding growth-inflation story. Specifically, in light of the weakening labor market, it looks like we could be looking at a recession imminent. As such, the Fed is expected to cut interest rates aggressively over the next 12 months. Since we are not yet in a recession, some expect the Fed's cuts to actually stave off a recession. That's the soft landing scenario, where the key assumption is that inflation continues to fall toward the 2% level by 2020. allow the Fed to cut.
3. The developing geopolitical situation. We are currently facing a worsening geopolitical situation in the Middle East and Russia, and both situations could spill over into regional wars involving NATO.
4. The yen carry trade is breaking out. The Federal Reserve is expected to cut interest rates, while the Bank of Japan is still expecting to raise them, which could boost the value of the Japanese yen and therefore force hedge funds that borrowed yen to liquidate their yen-funded positions.

The interaction between these themes will determine the price action of the S&P500 in the short term or over the next 6 months.

The key assumptions are:

1. The geopolitical situation will remain under control until the price of crude oil (USO) does not skyrocket. Rising crude oil prices could increase inflation and prevent the Fed from cutting interest rates, despite the weakening labor market; this would be stagflationary and therefore very negative for the stock market. However, this is also a situation that can be controlled, at least until the US elections in November.
2. The BOJ and the Fed can keep the yen's rise under control, so another episode is unlikely if the yen carry trade explodes.
3. The bursting of the AI ​​bubble may be delayed as long as overall sentiment remains positive, and at least until the next earnings season. Large-cap AI tech companies will start reporting their results in mid-October; until then, the Nasdaq 100 (QQQ) could only fall gradually and even remain stable.

Now it's all about the Federal Reserve

Therefore, the key theme driving markets in the near term will likely be the Fed and the related growth and inflation environment.

The Federal Reserve is expected to begin cutting interest rates in September, reduce them at each meeting in 2024, and continue cutting them in 2025 to around 3% federal funds rate.

These expectations are consistent with a recession: this is the only time the Fed has cut interest rates by more than 2%. So, if these expectations are correct, we should be getting more data confirming an imminent recession, especially in the labor market.

The latest data have not yet confirmed an imminent recession.

Initial jobless claims have risen to the 250,000 level, but in the past 3 weeks, claims fell to the 230,000 level. The trend is still bullish, so further weakness is expected. However, in the past 3 years we have had two previous episodes where claims spiked to the 250,000 level and then fell back to the 200,000 level. In these cases, a recession was avoided. What will happen in the current situation?

For a clear signal of an impending recession, claims must reach the 250,000 level and continue to rise.

Similarly, jobless claims remain at a three-year high, but have plateaued over the past three weeks. We need to see a rise above the two-month level to confirm an impending recession.

The labor market is weakening and the Sahm rule has been triggered: the unemployment rate has risen to 4.3%, well above the low point of 3.4%. However, at the moment, the increase in the unemployment rate is mainly due to an increase in labor supply, due to immigration and an increase in participation, and not to job losses. We need to see real job losses to confirm a recession, and that is not the case at the moment.

The next issue is inflation. The Fed needs to be confident that inflation is falling toward the 2% level in order to begin cutting interest rates in September. Core PCE has been “stuck” at 2.6% for the past three months, and monthly core PCE inflation for July rose 0.2%.

Based on base effects, the core PCE is likely to remain at 2.6% through the end of 2024 and start to really fall in 2025 toward the 2% level, which could be reached next summer. That is assuming the core PCE continues to rise by 0.2% per month.

The problem for the Fed will be if the unemployment rate remains at 4-4.3%, meaning that everyone entering the labor market is hired while no jobs are lost, and thus housing inflation does not moderate as housing demand continues to rise. This could therefore push up the core inflation rate and prevent the Fed from cutting rates. The Fed's inflation forecast sees core CPI potentially reaching 0.3% in August. This would make it more difficult for the Fed to cut rates in September.

Transcendence

The medium-term baseline scenario remains that we are facing an imminent recession and therefore the S&P 500 is facing a recessionary bear market, accelerating the bursting of the AI ​​generation bubble. However, we need data to confirm this idea.

If labor market data remains strong and the Fed still begins to cut interest rates in September, positive sentiment may keep the market from falling, at least until next earnings season.

So, the next few weeks will be all about growth and inflation data and the Federal Reserve. That's assuming there are no geopolitical shocks, which is a weak assumption.