by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! S&P 500 futures are higher as investors remain optimistic about a Fed pivot. The USWNT boosted spirits with a crucial victory over Zambia, keeping their Olympic quest for gold alive. Today’s Comment will dissect the latest GDP data and its potential impact on Fed policy, explore why mega-cap stocks are offsetting gains from other companies within the S&P 500, and assess rising trade tensions between the US and Mexico. We’ll conclude with a snapshot of key economic indicators.

Soft Landing? The US economy is proving remarkably resilient in the face of elevated interest rates.

• In Q2, US Gross Domestic Product (GDP) expanded at an annualized pace of 2.8%, significantly outpacing the prior period’s 1.4% growth and surpassing the projection of 2.0%. This acceleration was fueled by a sharp increase in consumer spending, jumping from an annual pace of 1.5% to 2.3%. Specifically, households capitalized on declining prices by boosting purchases of automobiles and household furnishings. To address weakening demand over the past year, retailers have implemented price cuts on major appliances and motor vehicles.
• While the robust growth figures may temporarily alleviate recession concerns, they do not guarantee sustained expansion. Consumption, driven largely by big-ticket purchases, has propelled growth, but this may mask the underlying economic weaknesses faced by most households. A recent report from the Philadelphia Fed showed that credit card delinquencies have risen to their highest level in nearly 12 years. Moreover, despite a pickup in spending during the second quarter, consumption lagged the 3.0% annual pace recorded in the same period last year.

• The robust GDP figures suggest the US economy may be operating in a Goldilocks zone, balancing growth with price stability. This could embolden Fed officials to maintain their current interest rate stance to avoid the risk of prematurely loosening policy only to reverse course later. While inflationary pressures have remained surprisingly subdued in recent months, concerns persist about a potential resurgence similar to the first quarter’s spike. Although a July rate cut cannot be entirely ruled out, a pause until the Fall meetings seems more probable.

The S&P 493: While the S&P 500 has declined sharply this month, most of the losses have been concentrated among the Magnificent 7 (M7).

• In July, the stock price index for the Magnificent 7 declined by 6.5%, while the remaining 493 within the S&P 500 increased by 1.2%. This divergence began in mid-July following the CPI report, which indicated that month-to-month inflation turned negative for the first time since 2020. The gap expanded over the past two weeks as investor skepticism intensified regarding the pricing of large-cap tech firms and the profitability of AI initiatives.
• The recent pullback is benefiting the broader market, which has become heavily concentrated over the past two years. Despite a decline in the index, nearly 300 S&P 500 companies have advanced, with industrial and financial services leading the way. These companies’ performances were overshadowed by the dominance of the Magnificent 7, which collectively account for nearly a third of the index. The relative performance of the M7 and the other 493 companies shows that mega-cap companies have lost a lot of ground to their smaller, large-cap peers.

• While the recent rotation away from big tech has gained popularity, it has been anything but smooth sailing. The VIX Index, a measure of market volatility, has surged to its highest level in three months and currently hovers just below 20, indicating heightened investor anxiety. The index may begin to cool over the coming months as investors gain greater certainty about the path of interest rates and the likely winner of the presidential election. As a result, investors should be careful not to overreact to sudden changes in the market.

US vs Mexico: Concerns about a potential trade war with the US have cast doubts on Mexico’s ability to capitalize on nearshoring opportunities.

• Earlier this week, Mexican President Andrés Manuel López Obrador (AMLO) dismissed threats stating that the US would consider banning cars made in Mexico. His comments followed remarks made by Tesla CEO Elon Musk, who said that his company is putting plans to build a factory in the country on hold until after the US election due to political uncertainty. Musk was referring to former President Trump’s pledge to impose tariffs on Mexican-made cars due to concerns that Mexico was aiding China’s efforts to evade tariffs by building factories there.
• The dispute over tariffs unfolds amid a deepening economic interdependence between the United States and Mexico. In recent years, the US has dramatically increased its reliance on Mexican goods, surpassing China as its top import source in 2022. Concurrently, Mexico has experienced a surge in foreign direct investment (FDI), including from China, as businesses seek to establish supply chains closer to the US market to mitigate geopolitical risks. According to the United Nations Conference on Trade and Development (UNCTAD), Mexico ranked as the world’s ninth largest FDI recipient.

• It is important to note that Trump had a relatively good relationship with AMLO during his first term in office. Despite his initial skepticism about Mexico, Trump ultimately bridged his differences in order to play a pivotal role in renegotiating NAFTA, now known as USMCA. This collaboration suggests that there may be some validity to AMLO’s claims that concerns about tariffs on Mexican cars are being overblown. Nevertheless, the dispute over China is likely to remain a significant source of tension between the US and Mexico, regardless of the November election outcome.

In Other News: North Korean hackers are intensifying cyberattacks targeting US military secrets amid renewed nuclear ambitions. This escalating digital threat underscores a growing risk to US national security. Separately, a cyberattack crippled France’s railway system just hours before the opening ceremony of the Olympics. The attack raises concerns about other possible disruptions during the event. Barack and Michelle Obama endorsed Kamala Harris as the Democratic nominee for president, which is a further sign that the party has rallied around a candidate.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! The S&P 500 is off to a sluggish start as investors digest recent earnings reports. In sports news, Morocco’s men’s soccer team was almost robbed of its Olympic victory over Argentina. Today’s Comment will explore the possibility of a Fed rate cut in July, analyze the disproportionate impact of the recent market downturn on large companies, and delve into the reasons behind the yen’s recent surge. As always, our report concludes with a roundup of international and domestic economic data.

A July Cut? A sudden turn by a former Fed official and weak economic data fueled further speculation that the Fed may cut imminently.

• Former New York Fed President William Dudley called for an immediate interest rate cut on Wednesday, warning that the Federal Reserve may be running out of time to prevent a recession. While acknowledging the benefits of low mortgage rates and a buoyant financial market for the wealthy, Dudley emphasized the broader economy’s struggles. He argued that maintaining current interest rates unnecessarily increases recession risks. Dudley is not alone in this opinion as former PIMCO Chief Mohamed El-Erian also expressed concerns about Fed cautiousness and suggested that the Fed may be two meetings away from a mistake.
• His comments come at a time when the Federal Reserve is presenting a united front, yet also showing signs of growing divisions. During his tenure as Fed Chair, Jerome Powell has experienced the fewest dissents since Marriner Eccles held the position from 1948 to 1951. However, Fed speeches reveal significant divergence among policymakers regarding the appropriate policy path with officials making the case both for and against rate cuts. The March summary of economic projections underscored this disparity, with some members of the FOMC advocating for no rate cuts while one proposed as many as four.

• The Fed will make its next policy rate decision next week. While not a voting member, Dudley’s comments are likely to influence discussions as policymakers navigate the path forward. If inflation continues to moderate and labor market conditions worsen, the Fed may signal the potential for multiple rate cuts before year-end. However, a surprise rate cut, which can’t completely be ruled out, could prompt the central bank to indicate a pause on further reductions until after the election in order to avoid perceived political bias.

Market Friend or Foe: The unwinding of the AI tech rally is a reminder of why it is risky to make investments based on momentum.

• The AI-related stock sell-off has gone global. The Stoxx Europe 600 Technology Index plunged 2.8% on Wednesday, fueled by steep declines in chipmakers like Netherlands-based ASML and Germany’s Infineon. The rout extended to Asia, with SK Hynix, a key Nvidia supplier, plummeting 8.9% on Thursday despite reporting robust chip sales. This market downturn was triggered by Alphabet’s earnings call, during which the company signaled increased expenses due to hiring and infrastructure costs, raising concerns about the ability of tech companies to improve profit margins.
• This sell-off serves as a stark reminder of the risks associated with momentum investing. While riding market trends can be profitable, it’s essential to recognize that such strategies are inherently cyclical. The underperformance of momentum stocks coincided with a confluence of negative factors, including declining inflation and interest rate expectations, as well as growing pessimism about consumer spending. The reversal of these trends has led to a sharp increase in market volatility as investors plan for the next move, with value stocks emerging as an attractive option.

• Market fundamentals suggest a potential rotation from large-cap to small-cap stocks. However, unforeseen challenges like a more hawkish Fed stance or an economic downturn could derail this trend. Nevertheless, a bounce back for AI-related stocks cannot be ruled out entirely. A strong earnings report from Nvidia next month could potentially bolster the broader tech sector, including mega-cap companies. That said, we remain optimistic about companies that have yet to fully participate in the market rally, particularly mid- and small-cap stocks.

The Yen’s Comeback: The Japanese yen (JPY) has strengthened as the Bank of Japan’s monetary policy appears relatively more hawkish compared to its G7 counterparts.

• The JPY has strengthened 3.1% against the dollar over the past five days, surpassing the psychologically significant 152 level. This appreciation follows a series of dovish policy actions and statements from other central banks aiming to stimulate economic growth. On Wednesday, the People’s Bank of China reduced its one-year medium-term lending rate by 20 basis points. Simultaneously, the Bank of Canada lowered its benchmark interest rate by 25 basis points for the second consecutive month, while the European Central Bank is mulling another cut in September.
• While global central banks lean towards easing monetary policy, the Bank of Japan (BOJ) is charting a divergent course. At their upcoming policy meeting, policymakers are expected to discuss potential steps to unwind their expansive stimulus program. BOJ officials are considering a potential rate hike and halving their bond purchase program. Their decisions will likely hinge on expectations for future consumption and inflation. While inflation has shown signs of stickiness, with the core CPI above its 2% target, domestic consumption has weakened.

• The strengthening of the JPY is likely to be a sustained trend. For years, Japan has been signaling its intention to normalize monetary policy after a prolonged period of negative interest rates. This policy shift is expected to impact carry trades as investors may hedge their JPY exposure, which proliferated during the BOJ’s ultra-loose monetary policy era. Clear communication from the BOJ regarding its policy exit should mitigate the risk of a significant market disruption. Additionally, it should provide some resistance to the USD.

In Other News: Former President Trump is set to be the keynote speaker at a crypto conference in Nashville later today. Speculation is rife that he may be considering building a strategic bitcoin reserve, a move that could potentially usher in a bitcoin standard. Russia and China participated in a joint mission near Alaska in a sign that their rivalry with the West is intensifying.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! S&P 500 futures are indicating a subdued open as investors digest earnings. In sports news, Team USA’s basketball team defeated Germany in its final Olympic tune-up. Today’s Comment begins with our analysis of why the Magnificent 7 companies might be declining in popularity, followed by an explanation of why bond liquidity is becoming a big problem. We will then discuss how a potential economic slowdown in the EU could shift the central bank’s focus from inflation. As usual, our report concludes with a summary of international and domestic data releases.

Big Tech Fades: Two Magnificent 7 companies have underwhelmed investors this earnings season as the market demands concrete evidence of profitability.

• Google’s parent company, Alphabet, topped second-quarter earnings expectations on Tuesday, but failed to reassure investors about the impending returns on its AI investment. The company’s AI spending surged to $2.2 billion, doubling the previous year and pushing back the timeline for substantial profits to 2025 or 2026. Adding to investor woes, Tesla reported disappointing earnings and pushed back the launch of its highly anticipated robotaxi by two months. These setbacks, coupled with slowing demand for electric vehicles, signal broader challenges for the company.
• The recent decline of the Magnificent 7 was anticipated. Two months ago, we highlighted that several of the companies were attempting to bolster investor confidence through dividends and buybacks to help justify their stocks’ lofty valuations. While these actions temporarily lifted sentiment, they did little to alter the fundamental reality: AI remains in its early stages. Nvidia, a key beneficiary of the AI frenzy, has been under our close watch. Given the company’s history of exceeding earnings expectations, a miss could lead the recent decline in the Magnificent 7 Total Return Index to deepen.

• The Magnificent 7 initially captivated investors with their scale and AI focus, propelling their stock prices to extraordinary heights over the past two years. This rally coincided with a sharp rise in interest rates on government bonds, making investors wary of smaller, riskier companies due to tighter financial conditions. However, much of these tech giants’ future growth appears priced in, limiting their upside potential. While it’s too early to declare a long-term trend, the outperformance of small and mid-cap stocks suggests a potential shift in investor sentiment may be underway.

Treasury Auction: The expectations of lower interest rates have helped fuel demand for US government debt, even as liquidity remains an issue.

• Tuesday’s $69 billion auction of two-year Treasury notes yielded a strong result, with a yield of 4.434%, more than 2 basis points lower than the previous record-matching auction. Surprisingly, the overwhelming majority of the issuance was absorbed by just two bidders, leaving a mere 9% for primary dealers — a historic low for these buyers who are typically responsible for picking up excess supply. This robust investor demand likely reflects a desire to lock in yields ahead of the anticipated Federal Reserve rate cut in September.
• One of the most pressing questions facing the US government is how to address its ballooning deficit. While the Treasury market has historically proven to be a reliable outlet for government debt, concerns are growing about its capacity to absorb future issuances. A liquidity index that tracks US government securities is showing signs of deterioration. In fact, it suggests that liquidity conditions are now worse than both the COVID crash in 2020 and the European Debt Crisis in 2011. This erosion appears to be on track to continue as long as the government struggles to deal with its growing fiscal imbalances.

• We have long suspected a coordinated policy approach between the Federal Reserve and Treasury to manage the nation’s growing debt burden. While we are skeptical of market projections for aggressive rate cuts in the near term, we acknowledge the potential for heightened Fed intervention in the Treasury market. If economic conditions deteriorate and inflation persists, the central bank may need to play a more active role to avert a crisis, which could include a sooner-than-expected end to quantitative tightening and a possible return to quantitative easing.

Europe’s Growth Problem: A slowdown in economic activity could complicate efforts by the ECB to balance growth and inflation concerns.

• The S&P Global Purchasing Manager Index (PMI) for the EU fell from 45.8 to 45.6 in July. A reading below 50 is a signal of contraction. The reading was below estimates of an increase to 46.1. The problem was really pronounced in the two largest countries within the bloc. Germany’s manufacturing PMI fell from 43.5 to 42.6, while France’s manufacturing PMI fell from 45.4 to 44.1. Although service activity was stronger throughout the regions, (particularly in France, which has benefited from the Olympics) there does seem to be a loss of momentum.
• The slowdown in economic activity could shift the European Central Bank’s (ECB) focus from solely targeting inflation toward supporting growth. Despite acknowledging progress in curbing inflation toward its 2% goal, the ECB has maintained a cautious approach to interest rate cuts. Following a 25-basis-point reduction in June, the bank opted to hold rates steady in July, pending further evidence of sustained disinflationary trends. In June, overall inflation in the eurozone held steady at 2.9%, while core inflation was roughly unchanged at 2.6%.

• Despite economic growth concerns, the ECB is likely to delay further rate cut commitments until the Federal Reserve’s monetary policy becomes clearer. Widening interest rate differentials have been a primary driver of recent currency fluctuations. This poses a challenge for the eurozone as it seeks to contain inflation, given the region’s heavy reliance on dollar-priced imports. As a result, while future price cuts cannot be ruled out, we think a potential hawkish shift by Fed members could alter the path of future ECB policy.

In other news: Democratic candidate Kamala Harris has announced that she has locked up enough delegates to secure the nomination as president. The move sets up a showdown between her and former President Donald Trump. Home prices hit a new high in a sign that shelter prices may continue to be a problem for inflation. The US has become increasingly concerned about Russia and China’s activities in the Arctic. This concern likely reflects the growing tensions between the West and these two nations.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with a new update on the Summer Olympic Games, which begin on Friday. Importantly, there are reportedly hundreds of thousands of tickets still available. We next review several other international and US developments with the potential to affect the financial markets today, including hints that Mexico is getting ready to crack down on its unbalanced trade relationship with China and several notes on US industry developments.

France: Four days before the opening ceremonies of the Summer Olympic Games in Paris, unwanted tickets posted for resale online have topped 250,000, up from just 180,000 one week ago. Although a record 8.8 million tickets have been sold outright, hundreds of thousands are still available through the initial and resale channels, even for prestigious events such as Friday’s opening ceremonies (starting at 900 EUR) and the 100-meter sprint (ranging from 295 to 980 EUR).

United Kingdom: The new center-left government of Prime Minister Keir Starmer said it will ease and reform certain environmental-protection rules seen as inhibiting home construction and contributing to the UK’s chronic housing shortages. However, homebuilders say they haven’t yet seen details of the plan. It remains unclear whether the changes will indeed lead to greater homebuilding and, eventually, lower housing costs.

Mexico-China: At an event with top officials on Saturday, Mexican Finance Minister Rogelio Ramírez de la O complained that China-Mexico trade has become extremely unbalanced, with China exporting more than 10 times as much to Mexico as Mexico exports to China. The statement was echoed by incoming Economy Minister Marcelo Ebrard, who will take office in October when President-Elect Claudia Sheinbaum is inaugurated.

• The complaints by Ramírez de la O and Ebrard show how even less-developed countries have become alarmed by “China Shock 2.0,” in which Beijing has rechanneled massive resources into manufacturing, effectively flooding the world with exports at disruptive, fire-sale prices.
• Importantly, Ramírez de la O hinted that the Mexican government is considering changes to its foreign investment rules to address the risk that Chinese firms will set up shop in the country merely to export tariff-free to the US — at the expense of Mexican firms.

US Politics: New reports say Vice President Kamala Harris has gained voting commitments from more than half the delegates to the Democratic Party convention in August, putting her on track to lock down her nomination as the party’s official presidential candidate. Separately, the Financial Times today carries an interesting article predicting President Biden, now a lame duck, will use his remaining six months in office to focus on cementing his legacy in foreign policy, with a focus on the Middle East and Ukraine.

US Artificial Intelligence Industry: Nvidia, the AI chipmaker darling, said it is developing a new chip designed to be sold in China without violating the increasingly stringent US export controls against such sales. Nvidia has already designed several chips for the Chinese market, but its sales in China nevertheless dropped to 17% of total revenue in the year to January, versus 26% two years earlier. The new chip aims to boost the company’s Chinese sales, but ever-tighter export rules from the US could derail those plans.

US Cryptocurrency Industry: The Securities and Exchange Commission yesterday afternoon approved the first exchange-traded funds for spot ether, the second-biggest crypto token after bitcoin. The new ether ETFs are expected to be available as early as today.

US Healthcare Industry: The House Committee on Oversight and Accountability has issued a report showing pharmacy-benefit managers steer patients toward higher-priced medicines and affiliated pharmacies, even though they’re supposed to help consumers cut drug costs. The report, issued after a 32-month investigation, will be followed today by a committee hearing on the matter at which top PBM officials will testify.

• The report and hearing suggest Congress could eventually pass new regulations on PBMs.
• That could weigh on the stocks of top healthcare companies, such as UnitedHealthcare, Cigna, and CVS, which have large PBM businesses.

US Auto Industry: According to data firm Motor Intelligence, the average incentive package on a new vehicle sold in June was up 53% from the same month one year earlier. JD Power also said only about 17% of new cars sold above the manufacturer’s suggested retail price in June, versus 35% a year earlier. The weakening price dynamics for new vehicles suggest demand is waning in the face of high prices, high interest rates, and a weaker job market. The bright side is that weaker auto prices should eventually feed into lower inflation and interest-rate cuts.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with some initial comments on President Biden’s decision over the weekend to withdraw from the November election. We next review several other international and US developments with the potential to affect the financial markets today, including an apparent agreement between China and the Philippines to diffuse their dangerous tensions in the South China Sea and a statement by a former Federal Reserve official predicting that monetary policymakers could still cut interest rates as many as three times this year.

US Politics: Obviously, the key development to watch in the coming days will be the fallout from President Biden’s decision to pull out of the 2024 presidential election in favor of Vice President Harris. Polls suggest Harris might have a modestly better chance at beating former President Trump than Biden did. Keeping the White House in Democratic hands would have big implications for geopolitics, national security policy, international trade, fiscal policy, and other aspects of economic policy. It still seems too early to call a winner.

• Until the dust settles, it wouldn’t be a surprise to see the “Trump trade” temporarily cool or go into reverse. Indeed, both the dollar and US Treasury yields are trading lower so far this morning.
• All the same, the betting markets, which have been reliable predictors of electoral outcomes in the past, are currently showing Harris trailing Trump substantially. Of course, this could change as Harris gets her campaign up and running. Again, it is too early to say who will win in November.
• Much will probably depend on whom Harris chooses as her running mate. A strong choice that helps the Democrats win a key battleground state would help keep the race wide open.
• Another key consideration is whether Harris and her eventual vice-presidential nominee can help the Democrats keep control of at least one chamber of Congress. Investors often look favorably on a divided government, in which no party controls both the White House and all of Congress.

China-Philippines: Manila yesterday reiterated it would not rely on US help to resupply its marines on an outpost coveted by Beijing in the South China Sea. The statement comes despite Chinese coast guard harassment of the resupply missions and an offer by US National Security Advisor Sullivan for the US to do “what is necessary” to make sure they succeed. Keeping the US at arm’s length suggests Manila understands how dangerous the China-Philippine standoff had become and is now trying to keep the dispute under control.

• Indeed, the Philippine Department of Foreign Affairs yesterday said Manila and Beijing have struck a “preliminary” deal allowing resupply missions to the outpost. However, Beijing has not yet confirmed such an agreement.
• If the agreement is confirmed and holds, it could help diffuse a crisis that we believe had become even more dangerous than China’s aggressiveness against Taiwan. After all, the Philippines has a mutual defense treaty with the US, so any armed attack by the Chinese against the Philippines could potentially draw in the US.

Brazil-China: Brazilian President Lula da Silva revealed late Friday that his government is drawing up plans to join China’s controversial “Belt and Road Initiative,” under which Beijing has provided more than $1 trillion in grants and loans to mostly less-developed countries for ports, highways, railroads, and other trade-related infrastructure. The revelation suggests Brasilia is again drawing closer to Beijing, despite the risk that doing so could worsen ties with the US and potentially invite trade or capital retribution.

China: The People’s Bank of China today cut several of its key interest rates in a new effort to spur the flagging economy. For example, the central bank cut its one-year prime interest rate by 0.1%, marking its first such rate cut since last August. The new prime rate is 3.35%. The central bank also cut its five-year prime rate, which is a benchmark for mortgage lending, by 0.1% to 3.85%. The years-long downtrend in interest rates reflects how the wind has come out of the Chinese economy because of challenges such as weak consumption and high debt.

India: As Prime Minister Modi works to develop his proposed budget for the upcoming fiscal year, the two regional parties brought into his coalition in June are reportedly demanding the equivalent of billions of dollars in new funding for their states. The demands threaten to derail Modi’s plan to bring India’s budget deficit back under control after it blew out during the coronavirus pandemic. Failure to rein in the deficit could undermine foreign investors’ faith in the Modi government and reduce foreign investment in the country.

France: We want to extend our condolences to anyone taking a summer jaunt to Paris this week. With the Summer Olympic Games starting on Friday, authorities have begun locking down large sections of central Paris, including installing metal barriers to block car traffic along about 6 km of the Seine. Opening ceremonies begin Friday evening with a procession of athletes in boats along the river — the first such opening ceremony outside of a stadium.

US Monetary Policy:  In an interview, former Federal Reserve Vice Chair Richard Clarida said there is “a real possibility” that the monetary policymakers could cut interest rates three times this year, due to rapidly cooling price inflation. We think that many cuts would be on the aggressive side, given that the Fed officials have expressed extreme caution about cutting too early and allowing inflation to rebound. The consensus among investors is still around two cuts, beginning in September.

US Airline Industry: Large numbers of US flights were canceled again yesterday and today as airlines continue trying to recover from last week’s global cybersecurity software glitch. Delta and United are reportedly the two most affected airlines. The cancellations have compounded the challenge of faltering consumer demand as the post-pandemic travel surge now seems to be petering out worldwide.

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