Fed Moving Closer to Rate Cuts
What happened last week?
The US labor market showed signs of cooling with initial jobless claims rising to their highest level in almost a year and continuing jobless claims reaching their highest level since November 2021. On Friday, news came that the economy created fewer jobs than expected in July, +114K, and the unemployment rate rose to 4.3%, the highest level, ex-COVID, since 2017. The 10-year Treasury yield fell by 40 basis points last week to 3.80%.
Volatility can create opportunity. For answers to some of the most frequently asked questions we’re receiving of late, please click here for our weekly CIO Strategy Bulletin, or read on.
What does this mean for investors?
Following this week’s announcement by the Federal Reserve, we believe investors should seek to maintain duration of around 5-6 years (the “belly” of the yield curve) for their overall fixed income portfolio. While we think short-term rates will decline, longer-end Treasury yields may not move lower as quickly as intermediate Treasury yields once rate cuts begin.
3 Things to Know
The US Economy Is Not at a Major Turning Point
With a poor manufacturing reading and a below-consensus gain of 114,000 for US hiring in July, market fears of a new downturn have also resurfaced.
While a “growth panic” is unnecessary in our view, we should be clear that market conditions have been ripe for a pullback for the reasons cited above. We continue to expect high single-digit EPS gains this year and next while US equities — particularly large cap tech — have delivered double-digit gains.
Geopolitical news and election uncertainty also provide excuses for short-term traders to shift.
For the economy, we do not believe we are at a major turning point. We have long stated that the growth rate of employment would slow.
Job gains were strong even as business output languished. This was driven by the “late start” for broad services hiring delayed by the pandemic.
We do not think it is too late to avoid a recession because business output has been restrained. Interest rate-sensitive sectors have been weak already and are poised to recover as interest rates fall.
Tax Cuts Only if the GOP Sweeps November
Unlike tariffs which can be evoked by the President for national security grounds under, as an example, Section 232 of the Trade Expansion Act of 1962, tax cuts require the support of Congress.
It would be hard to push tax rates lower than they are today without a Republican sweep of the Presidency, Senate, and House in the fall. What’s most realistic, in our view, would be an extension of the sunset provisions at the end of 2025 in the 2017 Tax Cuts and Jobs Act, which was the largest US tax code overhaul in three decades.
Back then, no Democratic Senators or House members voted for the legislation. In fact, preventing tax increases at end 2025 will likely require some support of Democrats even under a scenario of a red sweep.
Compromises between the majority and minority parties will likely craft the actual legislation which could include a variety of differences from the 2017 legislation.
The chances of a Republican sweep have moderated in recent weeks.
In our view, many voters would see extending the sunsets as maintaining the status quo while letting them expire would be viewed as a tax increase, although policy makers and government scorekeepers may quibble.
The Congressional Budget’s Office (CBO) estimates that merely extending the sunset provisions would help keep the deficit historically high as a share of GDP and add to the national debt.
Credit Card Debt Covered by Higher Personal Wealth
This is a question we get very frequently, and it is no surprise because on the one hand it is absolutely true that credit card debt is at record highs, but on the other hand, it is absolutely irrelevant.
But in an industry where fear sells, these sorts of observations make headlines and drive clicks, even if they shouldn’t impact portfolio decisions. To see why, we have to remember that credit card debt is measured in nominal dollars (meaning no adjustment for inflation, nor the size of the economy).
To see why this matters, imagine everyone’s debts and incomes doubled over a period of time due to inflation and at the same time the population doubled. In this scenario credit card debt would be up 400%, but what actually matters, credit card debt to income (which by being a ratio removes the nominal dollar problem, and the increasing population problem) would be unchanged.
In reality, to a great degree this is what has happened. Credit card debt when measured against income has only been lower than it is today in the wake of the helicopter money period of Covid.
But saying credit card debt is near record lows does not drive clicks and fear. The fear then moves to possible concentrated risk at the bottom of the economic pile, and higher income Americans with their stock market gains are overshadowing a rising problem at the bottom.
Here the story is less sensational, with credit card debt for the bottom 50% of households actually declining (measured in real dollars as opposed to nominal dollars).
Most of the increase in credit card debt has actually been in the middle class (wealth in the 50th to 90th percentiles), and this makes sense as that group, which tends to own their own houses, has had a major increase in net worth from inflation pushing down the value of mortgages and strong home prices.
So, the only way to act on this increased sense of wealth is through credit card debt, but they have plenty of assets to cover the increase.
See our weekly CIO Strategy Bulletin for more details