August Market Insights Report
August was a very interesting month in the markets. The President and his administration leaned directly on the Fed to provide a reduction in the Federal Funds Rate at the upcoming September meeting. The challenge for the Fed is that inflation has remained stubborn, with Core CPI standing at 3.1% and the Personal Consumption Expenditures Index (PCE) holding at a 2.9% year-over-year increase. The Fed has a dual mandate to provide the economy with low inflation and full employment. We have been considering that the Fed might risk a higher unemployment rate to drive inflation towards, or even through, their 2.0% target for the PCE Index. While 2.9% doesn’t seem far off, the Fed would like to see inflation closer to its target.
Employment and “Frictional” Unemployment
The employment rate stood at 4.2% as reported in the last report. Unemployment has been hanging around the 4.0 - 4.2% rate for much of this year. For those who studied macroeconomics, you may recall that economists consider 4.0% unemployment as the economy reaching its full employment capacity. Economists often refer to this as “frictional” unemployment, which accounts for people who may be transitioning between jobs, leaving the labor force, or newly entering it. In short, economists consider 4% unemployment as the natural level of turnover within the labor market.
The Case for and Against Rate Cuts
While one can say that the unemployment rate is right on target, one could argue for cutting interest rates to continue supporting the job market and thus the economy as a whole. However, the challenge remains of stubborn inflation and the impact of artificial intelligence. We have seen several reports that companies are holding back on entry-level hiring as they evaluate how AI may enhance their productivity. Just as previous waves of computing power reshaped business structures, AI could similarly disrupt lower-level positions while creating new roles elsewhere in the economy.
Market Performance in August
For the markets, the S&P 500 returned 2.6% in August and 11.0% year to date through August 31st. Small-cap stocks, as represented by the Russell 2000, gained 7.0% and outperformed large-cap stocks for the month. The equity markets are pricing in a September rate cut, and the markets could become more volatile if the rate cut is not delivered. We also saw strength in international stocks and within the international equity arena, developed markets outperformed emerging markets.
Treasury Yields and Inflation Concerns
The 10-year Treasury started the year at 4.57% and ended August at 4.23%. Shorter-dated Treasuries saw yields decline in anticipation of a September rate cut. The 10-year yield hit a near-term high of 4.50% in July, then trailed down as inflation has slightly improved. However, inflation has not improved to the point that the Fed can set aside concerns. There also remains concern that if the unemployment market is slowing and prices are not declining due to tariffs and other factors, we could slide into a stagflation environment where growth is stagnant, and inflation is rising. Fed Chairman Powell noted at the Jackson Hole meeting that the shifting balance of risks may warrant adjusting the policy stance, which was shorthand to the market that a rate cut was coming. If inflation remains sticky, the Fed may not be so enthusiastic to cut rates and feed further inflation. More to come on this to be sure.
Mixed Signals in Housing and Spending
The economy has continued to perform well due to continued consumer spending. Housing was a mixed bag, with new housing permits falling but in-flight housing construction rising. This is not an easy time for the Fed to decide on a course of action because one can easily make an argument for standing pat and also for a rate cut. Ultimately, lower inflation is healthier for the economy long term, and the Fed needs to maintain credibility with market participants.
Geopolitical Headwinds
Geopolitics remains a significant headwind. Fighting in Ukraine continues while the ties between China, India, Russia, and North Korea seem to be tightening at the surface, though not fully united. Overall, these dynamics make the world less safe and could fuel market volatility. President Trump has expressed commitment to ending the fighting in Ukraine, but the Ukrainians justifiably do not want to cede land that they feel was illegally taken by the Russians. Putin seeks to project strength domestically, so he may have little incentive for a ceasefire that includes giving back the territory currently occupied by Russian forces.
Looking Ahead
As we enter the final month of the third quarter, all eyes will remain on the Fed as it meets to discuss the economy and the Federal Funds rate. If near-term economic data shows a slowing economy, the rate cut will likely happen. If inflation accelerates, the Fed may have less justification for a rate cut, despite the external pressure they may be receiving to lower interest rates.
The wall of worry remains intact, to be sure. We are always available to discuss your portfolio or market views.
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