by Hubert Marleau, Market Economist, Palos Management
July 29, 2024
On Thursday, the Commerce Department reported the most important reading of the economy’s conditions before the upcoming FOMC meeting on July 30-31. Gross Domestic Product, expressed in current dollars, totalled $28.629 trillion (saar) in the June quarter of 2024, having risen at an annual rate of 5.1% from the previous quarter. Inflation accounted for 2.3% of the increase, while employment and productivity contributed 0.8% and 2.0% respectively, generating a robust and larger-than-expected pick-up in GDP growth to an annualised rate of 2.8%.
The surge in spending on equipment and continued investment in intellectual property are testaments that the U.S. economy is in the middle of a productivity boom. In fact, the Atlanta Fed’s initial GDPNow model estimate for real GDP growth in the 3rd quarter of 2024 is for another 2.8% and so does the New York Staff Nowcast.
Taken together, it certainly looks like the U.S. is in a good place and a good balance without any ostensibly stressful conditions. The economy is visibly chugging along, slowly transitioning toward a more sustainable 2-plus-2 scenario - 2% for inflation and 2% for growth - with no hard landing in the cards. Thus it seems awkward, if not impossible, for the Fed to contemplate a July or September interest rate cut.
Perhaps not, however, because the connection between real growth and inflation has been broken by productivity. Indeed, the dog days of summer will likely bring a surprise cut anyway, perhaps as early as this week, or lay the groundwork for one in September. The pace of productivity gains, coupled with the cooling of the labour market and the decline in personal savings, are forcing inflation down. The GDP price deflator printed a 2.3% annualised pace, lower than expected and down from 3.1% in Q1; and on Friday morning, the Bureau of Economic Analysis affirmed inflation had indeed fallen. The PCE inflation rate moderated to 2.5% y/y last month, rising 0.1% m/m , with a 3-month annualised rate of 1.6%, a slowdown from the 2.6% pace in May. Truflation, meanwhile, which encompasses more than 13 million data points to provide a daily update measure of inflation, is below the Fed’s 2% target at 1.7%. Unsurprisingly, the swap market for U.S. Treasuries are predicting that consumer inflation will run at less than 1.0% in a year’s time. Given that the policy rate at 5.25% - lower end of the 5.25% to 5.50% range - is either at 250 above the Fed’s estimated neutral rate of 2.75% or 1.25% above the market’s perceived one of 4.00%, monetary authorities must face the reality that a broad consensus wants a shift in their monetary stance, and the start of a new policy cycle.
Although there’s every reason to believe that the Fed will eventually yield to the demanding pressure of the populace to pivot, which by ricochet should satisfy investors' greed, something seems wrong. This has to do mainly with the perceived stretched valuation of the Big Technology Names. From July 16 to July 25, the S&P 500 fell from an all-time high of 5667 to 5399, down 4.7%, versus 7.9% for the NASDAQ and 9.0% for the Nasdaq 100. In other words, the proximate cause of the decline was a valuation-led selloff triggered by mega-cap tech shares. There is no argument on my part that the Mag 7 is priced for perfection and is an overcrowded trade. The thing is that these guys make an awful lot of money, enabling them to make huge investments for the future. Goldman Sachs reported in a note to their readers that hedge funds had stayed put during this market slide, largely holding onto their tech stocks. They don't think that the tech sector is about to burst and end in tears. AI is a transformative technology that resembles the internet boom of the 1990s, which is not likely to end before 2026.
The fresh bullish reading on inflation restored confidence quickly, pushing the 2-year Treasury yield to 4.38%, near a new low for the year, which in turn allowed the S&P 500 to claw back some of the earlier losses, finishing the week at 54448, and registering a weekly decline of only 1.0%.
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