Record High Equity Markets Looking Past Stagflationary Signals
U.S. equity markets continued their ascent in July with the S&P 500 marking fresh all-time highs on continued optimism from a combination of solid corporate earnings, tariff exemptions for tech, easing geopolitical tensions, and growing hopes of U.S. interest rate cuts. U.S. bond yields were volatile throughout the month amidst a tug-of-war between fears of further inflationary pressures seeping into the economy, and surprisingly weak payrolls data.
The July nonfarm payroll report disappointed with Fed Governor Lisa Cook categorizing the data as “concerning” and “somewhat typical of turning points” in comments on Wednesday. At its July meeting last week, the Federal Reserve voted to hold the federal funds rate steady at a range of 4.25% to 4.5%. The decision, however, was not unanimous as two members dissented, voting to cut by 0.25%. During the press conference, Fed Chair Jerome Powell’s comments leaned hawkish. He reiterated that the Fed is in no rush to reduce borrowing costs and reaffirmed his commitment to keep inflation contained.
While inflation has improved substantially since its post-pandemic peak, the growth of core PCE (the Fed’s preferred measure of inflation) has accelerated. Two-year inflation swaps have been climbing all year, accelerating in response to a series of tariff announcements, and inflation expectations over the next 5-10 years have risen to the highest levels in almost two years, at an implied rate of 2.44%. ISM Services Price Paid for July shows that inflation pressures in the service sector are intensifying, pointing to upside risks to CPI over the coming months. The culprits behind the stagflationary backdrop are primarily attributed to the tariffs and a depreciating dollar. This presents a problem for the Fed. In the wake of the poor jobs report last week, market expectations of a Fed cut at the September meeting shot up to over 90%. The market is clearly expecting cuts, but the upside risks to inflation becoming unanchored are meaningful.
Another market-based indicator of growth to watch is the copper to gold ratio. The ratio provides insight into global economic health as copper is a key industrial metal in an array of applications, while gold is widely recognized as a safe-haven asset. A higher ratio points toward a positive outlook for economic growth, while conversely, a lower ratio may suggest a flight to quality and broader market fear. The most recent move in the ratio was driven by a 50% tariff on most types of copper imports, but the trend has been lower for some time.
While Friday’s employment report was a clear signal for yields to move lower, given the current policy mix, it is likely that rates will stay volatile. Weak auctions of $42 billion in 10-year notes and $25 billion of 30-year bonds on Wednesday and Thursday respectively remind markets of the technical overhang that will persist. We remain cautious on stocks given the move from the April bottom. The S&P 500 has historically struggled in the months of August and September, falling on average 0.7% in each month, compared with a 1.1% gain on average across other months over the last thirty years according to data compiled by Bloomberg. In fixed income, we continue to favor quality over absolute yield. Municipal bonds offer one of the more attractive opportunities in the space. All eyes will be on Tuesday’s CPI release for July as the next piece of the puzzle for the timing and magnitude of future Fed policy.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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