Investment Insights

 — Steve Orr 

Bouncing Down

Need proof you are in a downtrend? Last week’s S&P 500 price action was a great example. On Wednesday, the big index had its first 1% up day, courtesy of Nvidia’s blowout earnings report. The graphics chip manufacturer has benefited mightily from the artificial intelligence mania. The stock market now values Nvidia at 8.8 times more than Intel and almost three times more than JP Morgan. Signs of 1999 dot.com anyone?

Back to the markets. A sign of market strength is when Bulls can grab an event like Nvidia’s earnings report and hold on to the gains. Sadly, Thursday the Bulls retreated, and markets gave back Wednesday’s gains. It was just enough, though, for the S&P 500 to eke out its first small gain in three weeks. We doubt the minor good news is enough to turn the tide in favor of the Bulls. Remember September and D.C. budget negotiations are in front of us. A technical point that meshes with late fall seasonality is when we see these failed rallies in a correction, returns over the next three months are actually better than average. 

Inflating hopes

For the last several weeks, traders’ fingers have gripped their keyboards ever tighter in advance of Chairman Powell’s speech at Jackson Hole. Remember, last year his short eight-minute speech set the stage for higher interest rates and higher pain in the stock market. Stocks did not bottom until mid-October when third quarter earnings came in better than expected. 

Last Friday, Powell again came to the stage at the Kansas City Fed’s summer conference. His message this time was “more of the same.” Noting that inflation was down sharply (9% to 3%), it remains too high, and their goal is still 2%. “We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level…” As if that was not enough, he also said that strong growth and a tight labor market could require a stronger response. Traders’ hopes were dashed for an end to the tightening cycle, and odds rose for at least one more quarter-point increase. Using the phrase “proceed carefully” the Chairman implied that the Committee may skip the September meeting and an increase may be more likely at the November 1 meeting. 

Powell stated that Fed policy has shifted to a more careful stance where “risk management” is “critical.” We interpret that statement to mean they are watching where in the economy the damage of higher rates will surface next. We would note that with mortgage rates above 7%, home purchase applications are at their lowest since 1995. 

Starring rates

For the first time in recent memory, the Fed chair mentioned the neutral rate of interest. A brief background is in order. Let’s start with an analogy. The percentage of the labor force not working divided by the working population is the unemployment rate. The unemployment rate would almost never reach zero, because someone somewhere is changing jobs, getting laid off, or just entering the workforce. The “natural” rate of unemployment is unknowable because economists cannot have perfect information about every worker’s status. 

In the 1980s, this rate was thought to be around 6%. Today it’s believed to be closer to 4%. If that is the case, then unemployment at 3.5% suggests a “too hot” economy for the Fed. The measure became known as the NAIRU, or non-accelerating inflation rate of unemployment. With unemployment at thirty-year lows and UPS workers getting a starting pay raise from $15.5 to $21 per hour, we may not be at NAIRU right now. 

Similarly, the neutral rate is unknowable. Policy wonks and economists call the neutral rate R* (“r star”). It is the real interest rate where demand of savings and investment in the economy is at equilibrium. Like NAIRU, when rates are at the neutral level, they neither restrict nor increase growth and inflation. The Fed has estimated the neutral rate to be 0.5% since 2019. Okay, let’s break down the Fed Funds rate. Today the bottom range for Fed Funds is 5.25%. Subtract 3% CPI and you have a real interest rate of 2.25%. That is well above the Fed’s 0.5%. A real interest rate of 1.75% above the neutral rate should be slowing the economy. 

GDP growth this year is rolling along in second gear, registering in the low 2% range. Estimates for the full year fall toward 1.5% to 1.75%. If that turns out to be the case, then the high real rate is helping slow the economy’s growth rate by almost half from two years ago. The real (pun) issue is that economists only know the neutral rate in hindsight. 

Leftover savings from shutdown stimulus, D.C. deficit spending and homeowners sitting on 3% mortgages may have the effect of temporarily raising the neutral rate. If so, then the Fed is not finished raising rates in its effort to slow the economy. 

Now for 12

September is just around the corner. Tradition holds that once portfolio managers come back from vacation, they clean house on their portfolios. We wonder if this is still true in the face of program trading and September D.C. shenanigans. All markets are likely to take their cues from Congress and another threat of budget shutdowns. There are only 17 calendar days where the Administration and Congress are both in town. The month starts this Friday with the August payroll and unemployment report. Expectations are for 170,000 net new jobs and an unchanged unemployment rate of 3.5%. 

Whether you have a technical or fundamental justification for September volatility, you arrive at the same place: The ninth month ranks last in performance for every major index except for the Russell 2000 Small Cap Index, which ranks eleventh. The average loss in September since 1950 is -0.8%. Following on our comments in July, the seasonal choppiness may give us some nice entry points.