September Pushes Higher – October Rough Start

Summer Volatility Quiets in September

August’s brief Black Swan event was triggered by Bank of Japan interest rate policy changes that led to a rapid unwinding of the Yen carry trade and a steep market selloff. The BOJ surprisingly softened its stance a few days later, halting further market damage and spurring a rapid world market rebound. Although September began with a half-hearted retest of the recent selloff, it reverted to a low-volatility climb to new market highs by month end, supported by the Fed’s half-point interest rate cut.

October Surprises Already Arriving

Although Iran’s threat to retaliate for Israel’s recent lethal strikes against Hamas and Hezbollah leaders was well known, it hadn’t materialized until this morning. As US markets opened, they quickly and steadily declined as news of Iran’s 180 missile attack on Israel sank in. Concern is very high regarding the involvement of other countries, oil production stability, and international shipping route safety. Other October monkey wrenches may include an escalation in the war for Ukraine or a lengthy US dockworkers’ strike that could halt half the nation’s ocean shipping.

Will We Climb the Wall of Worry?

The Fed recently reduced interest rates by 0.5%, its first step in a planned series of rate reductions as inflation, unemployment, and other economic measures (below) seemingly indicate its objective of “a soft landing” might actually be achieved. Notably, the Fed has a very long record of moving too slowly and triggering a recession instead. However, there may be two important differences this time: (1) the extra $Trillion of Federal spending that helps keep the party going, and (2) being on the leading edge of the AI technology boom that both creates economic excitement and stimulates private investment when building it out.

StormGuard Storyboard

The charts below tell the simple story of “steady as she goes.” While some of the heat has clearly come out of the market, all of the indicators appear stable – nothing declining. The comparatively lower value of the Value Sentiment Indicator suggests that relatively few stocks are responsible for the market’s performance. Meanwhile, the VIX market volatility indicator suggests confidence.

FRED: Federal Reserve Economic Data

Let’s briefly run through the diverse set of charts (below), from the Fed’s own data charting service, and evaluate them against its plan to orchestrate a soft landing (no recession) for the economy.

(2) Sahm’s Recession Rule has Triggered

When this chart indicates rising unemployment, it predicts recession. But is it also backwards? Can a few $Trillion & emergent AI technology keep the party going?

(4) Inflation is Almost Back to 2%

While inflation came back down quite a bit, it has paused and may be threatening to go back up. Notably, Cathy Wood of ARK believes AI will be highly deflationary.

(6) Federal Spending

During COVID, Federal spending increased $3 Trillion or more per year, and currently still runs $1 Trillion per year above the former trend. Guess who will pay the piper.

(8) Price Index Indicates Inflation

The step up in the producer price index reflects inflation. Manufacturing costs must always be passed along to the consumer for producers to continue to function.

(10) Consumer Confidence Falters

Although retail trade is matching inflation, when wage growth lags inflation, the household consumer budgets are strained to make ends meet and confidence declines.

Evaluating that Wall of Worry

Historically, regional wars, such as in Ukraine or Israel, have not measurably affected our markets. The US dockworker’s strike, while quite serious, will likely receive intense political pressure to ensure that the strike does not tip the scales in the coming presidential election. The outcome of presidential elections historically has had little effect on the overall markets. However, under the surface (at the sector level), a switch in political parties often causes a shift in sector leadership because changes in administrative policy inherently create new sets of winners and losers.

Perhaps the elephant in the room is the national debt, now at $35.4 Trillion and growing rapidly. While that may not end well, for now, excessive deficit spending may be a significant factor preventing a recession from taking root. Finally, the monetization expectations of AI seem to have both FOMO (fear of missing out) and a self-fulfilling prophecy going for it that could help keep any recession at bay.