by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! S&P 500 futures are trading higher this morning as investors await the Fed’s rate decision. In sports news, Simone Biles led the US women’s gymnastics team to gold at the Olympics. Today’s Comment will delve into the Federal Reserve’s interest rate decision, examine the cooling AI hype, and analyze the Bank of Japan’s latest policy move. We will conclude with a review of key domestic and international economic data.

Is it Pivot Time? The FOMC is set to conclude its two-day meeting today, with investors eagerly awaiting clues about potential rate cuts.

• Federal Reserve policymakers are expected to announce a shift in their focus away from inflation and toward employment to achieve greater economic balance. Concerns are growing amid four consecutive months of rising unemployment, which could trigger the Sahm Rule if the trend persists in July. This rapid labor market deterioration has prompted prominent economists, including former New York Fed President William Dudley and former PIMCO CEO Mohamed El-Erian, to push for an immediate rate reduction within the next two Fed meetings in order to avert a policy mistake.
• While Fed officials have signaled increased confidence in inflation’s downward trajectory, concerns persist about the potential resurgence of price pressures. Richmond Fed President Thomas Barkin recently expressed skepticism about the current restrictive nature of interest rates, noting that inflation, though improved, remains above pre-pandemic levels. The core PCE price index rose 1.6% in the first half of 2024, a deceleration from the 2.0% pace in the same period of 2023 but still significantly higher than the 0.9% average seen in the three years preceding the pandemic.

• Despite mounting pressures for an immediate rate cut, the Fed is expected to maintain its current policy stance at today’s meeting. The central bank is likely wary of potential inflationary pressures during the typically quiet summer months, which would delay any rate reduction until September or beyond. Although unemployment has risen sharply, it remains within a range typically associated with economic growth. As a result, the Fed is expected to adopt a cautious approach, potentially keeping rates unchanged for an extended period. If this occurs, it could impact the rotation trade.

Magnificent 7 in Focus: Microsoft is the latest tech company to disappoint investors following its earnings reports, as investors start to question AI profit expectations.

• While Microsoft surpassed overall earnings expectations, its Intelligent Cloud division fell short. Revenue for the highly touted segment climbed 19% to $28.5 billion but missed estimates by $200 million. The company attributed the shortfall to a weak European market and capacity constraints, as it struggles to keep pace with surging AI demand. These challenges coincide with recent service outages, including CrowdStrike’s software failure and a cyberattack yesterday, which will now lead to concerns about the company’s overall technical infrastructure.
• Microsoft is the third of the Magnificent 7 to disappoint investors this month, following in the footsteps of Alphabet and Tesla. Their bleak outlooks have contributed to a broader tech sell-off, as investors seek more attractive valuations in other equity sectors. The S&P 500 is down 0.7% so far this month, while the NASDAQ 100 has plummeted over 5%. Hardware companies have taken the brunt of the downturn as investor are not sure whether these stocks have any more room to grow from their current valuations.

• Four Magnificent 7 companies remain, and Nvidia’s August 28 report will serve as a crucial test for the AI rally. The chipmaker’s triple-digit revenue growth and earnings beat have made it the index’s sole standout. A disappointing result could dampen investor enthusiasm for AI and accelerate a market shift towards smaller companies, especially if the Fed maintains a dovish stance today. AMD’s recent earnings report, boasting strong sales and a bullish outlook, suggests sustained spending on AI chips. This could bode well for Nvidia given the similar landscape.

Hawkish BOJ: The Bank of Japan unexpectedly raised interest rates in a sign that the central bank is looking to normalize policy after decades of policy accommodation.

• The Bank of Japan (BOJ) has raised its benchmark interest rate to 0.25%, its highest level in over 25 years, from a previous target range of 0-0.1%. This move is intended to bolster the weakening yen (JPY) and stimulate economic growth by mitigating inflationary pressures from rising import costs. Additionally, the central bank revealed that it would gradually reduce its bond purchase program by half to 3 trillion JPY a month by early 2026, or the equivalent of about $20 billion.
• The Bank of Japan’s recent policy adjustments signal a determined effort to normalize monetary policy and strengthen the yen. Prior to its latest meeting, concerns mounted over Japan’s economic slowdown, with GDP failing to surpass its Q2 2023 peak. Governor Ueda defended the policy shift, arguing that a stronger yen could invigorate growth by fostering consumer confidence through stable import prices. Although Japan’s inflation rate has peaked, it remains a persistent issue. Headline CPI, which includes volatile energy and food costs, continues to exceed the 2% target, amplified by the impact of dollar-denominated commodities.

• Assuming interest rate expectations remain stable, the recent policy shift is likely to contribute to dollar weakness. The Bloomberg Dollar Spot Index has already fallen by 0.4% in response to the decision by the BOJ. We anticipate a convergence of US interest rates with those of other G7 nations over the coming months. This shifting interest rate environment is expected to exert downward pressure on the dollar initially, although other factors will increasingly influence the currency’s strength going forward, which include GDP growth expectations and capital flows.

In Other News: An Israeli strike on Beirut reportedly killed a top Hezbollah commander, signaling a potential escalation of tensions in the Middle East. Meanwhile, China’s manufacturing sector contracted for the third consecutive month as the country grapples with declining industrial output.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with new data on economic growth in the eurozone and the prospects for more interest-rate cuts by the European Central Bank. We next review several other international and US developments with the potential to affect the financial markets today, including emergency spending cuts to bring down the UK’s budget deficit and a preview of the Federal Reserve’s latest policy meeting, which starts today.

Eurozone: In an initial estimate, second-quarter gross domestic product rose by a seasonally adjusted 0.3%, beating the expected increase of 0.2% and matching the first-quarter growth rate. That translates to an annualized growth rate of only about 1.2% in each quarter, and the region’s GDP in the second quarter was up just 0.6% from the same period one year earlier. The figures do reflect a modest improvement in the eurozone’s economy in 2024, but they remain weak enough to suggest the European Central Bank will continue to cut interest rates.

United Kingdom: The new Labour Party chancellor, Rachel Reeves, yesterday revealed a series of emergency spending cuts to help plug what she called an undisclosed 22-billion GBP budget hole left by the previous Conservative Party government. The spending cuts include measures to end winter fuel subsidies for higher-income pensioners and eliminate outlays on roads and hospitals. The measures are being seen as a prelude to tax hikes in the next fiscal year budget, due to be released on October 30.

Japan: Global investors continue to brace for the Bank of Japan’s latest policy decision tomorrow. After the central bank ended its previous policy of negative interest rates in March, market indicators now suggest investors see about a 40% chance that the BOJ will lift its benchmark short-term interest rate further to 0.25%. It is also expected to release a plan for starting to unload its $3.8 trillion in Japanese government bond holdings (JGB). (See our preview of the Fed’s Wednesday policy decision below.)

• Amid investor anticipation of the BOJ’s rate hike and bond sales, the yen (JPY) has appreciated and JGBs have depreciated sharply so far this month.
• Since the JPY is used globally as a funding currency, the recent currency moves and investor repositioning has also fed an increase in volatility in global markets over recent weeks.

China: At the Communist Party’s latest Politburo meeting yesterday, top officials reportedly decided to implement aggressive new economic measures to boost China’s consumer spending and corporate investment. However, the announcement in state media offered few specifics.

• Any new measures would supplement the central bank’s interest-rate cuts last week and a range of other modest measures implemented earlier, such as easier rules for home purchases and subsidized appliance trade-in programs.
• All the same, General Secretary Xi and his top officials have shown little inclination to adopt the wide-ranging, consumer-oriented reforms that many economists believe are necessary to reignite Chinese growth. Going forward, we suspect Chinese economic growth will continue to be held back by factors such as weak consumer demand, excess capacity and high debt, poor demographics, disincentives from the Communist Party’s interventions in the markets, and decoupling by the West.

China-Philippines: Following a recent deal by Beijing and Manila, the Philippine military has reportedly carried out a resupply mission for the marines it has stationed on an old, grounded naval vessel in an area of the South China Sea claimed by both countries. According to Beijing, the Philippines allowed China to inspect the shipment beforehand, but Manila denies it gave up its sovereignty in such a manner.

• Given that Philippine President Ferdinand Marcos Jr., is so politically skilled and probably intent on avoiding a conflict, it would not be surprising if he has secretly shown some flexibility with the Chinese demands for control over the situation. (For an in-depth discussion of Marcos’s background and character, see our Bi-Weekly Geopolitical Report from July 22, 2024.) Indeed, Manila has admitted to an “exchange of information” with the Chinese prior to carrying out the mission.
• All the same, to the extent that Manila is willing to overtly or secretly bow to China’s demands, it could potentially be a sign that the Philippines has lost some faith in the strength of its alliance with the US and the US’s commitment to its defense. If that is true, and if the sentiment spreads among other US allies, it would reflect a worrisome weakening of the US alliance system in the Indo-Pacific region.

Russia: President Putin has reportedly signed a decree allowing military equipment designers to utilize foreign intellectual property without the owner’s consent, bypassing traditional patent protections. At one level, the move highlights Russia’s desperate attempt to catch up to Western technological advances as it faces greater sanctions over its invasion of Ukraine. The move also shows how Russia has become a rogue state that no longer operates under accepted economic rules, which will likely further cut it off from Western trade and capital.

North Korea: In a report to lawmakers yesterday, South Korea’s intelligence service reportedly said North Korean Supreme Leader Kim Jong-un has chosen his pre-teen daughter, Ju-ae, to be his eventual successor. According to the intelligence service, the younger Kim is being educated specifically to take over the reins of power, although there is still some chance that a sibling could displace her.

Venezuela: A day after President Maduro claimed he won a third term in office in the weekend election, mass protests have broken out in Caracas and other cities across the country. The US, the European Union, and several Latin American nations also criticized the apparently fraudulent outcome, prompting the Maduro government to sever diplomatic ties with Argentina, Chile, Costa Rica, Peru, Panama, Uruguay, and the Dominican Republic.

• As we noted in our Comment yesterday, the apparently fraudulent outcome is likely to further isolate Venezuela. It could also lead to a snap back of economic sanctions on the country, including on its energy sector.
• On top of that, the size of the popular protests suggests Maduro could also face rising internal dissent and increased political instability. That could further harm the Venezuelan economy and push even more of its citizens to emigrate, including to the US.

US Monetary Policy: The Fed today begins its latest two-day policy meeting, with its decision due tomorrow at 2:00 PM ET. Despite growing calls from some observers to start cutting interest rates now, the more likely course is for the officials to signal an initial cut in September. Recent data has certainly shown the economy is cooling and price pressures have fallen, but the officials still say they want to see more evidence that those changes will be sustained, despite a risk that continued high rates could spark an economic downturn.

US Energy Industry: British energy giant BP today said it will start drilling a new oilfield in the Gulf of Mexico. The move is a reminder that the Gulf remains an important energy resource, despite the prolific expansion of onshore shale fields in places like the Permian Basin over the last two decades. The move also shows that traditional energy resources can remain attractive in an era of policy preferences for renewable energy, tough regulation, and shareholder demands for cash returns.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with a quick note on the renewed risk of a wider war between Israel and Iran-backed militants in Gaza and southern Lebanon. We next review several other international and US developments with the potential to affect the financial markets today, including a potential trade deal that the European Union might offer to former President Trump if he is re-elected in November and a preview of the Federal Reserve’s upcoming policy meeting this week.

Israel-Hezbollah: A rocket apparently fired from Lebanon by Iran-backed Hezbollah militants struck a soccer field in the Golan Heights on Saturday, killing a dozen Israeli children and teenagers. In response, the Israeli military launched airstrikes against militant positions across Lebanon yesterday. The retaliatory strikes by the Israelis have the potential to widen the continuing Israel-Hamas conflict into a regional war with bigger economic and security consequences for the world, as has long been feared.

European Union-United States: According to the Financial Times, European Union officials are planning a two-step, carrot-and-stick response if former President Trump is re-elected in November and imposes minimum 10% tariffs against all imports. Under the plan, the EU would approach Trump even before inauguration day to explore which US products the EU could import more of in order to forestall Trump’s tariffs. If no deal is reached, the EU would retaliate with tariffs of 50% or more against some US goods.

• EU officials reportedly estimate the minimum 10% tariffs floated by Trump would reduce EU exports by around 150 billion EUR annually.
• The EU plan clearly draws lessons from the so-called “Phase I” trade deal that the US and China sealed under Trump in 2020. Under that deal, China was supposed to dramatically boost its imports of certain US products, but ultimately fell far short, with few US complaints from either Republicans or Democrats.

France: Interior Minister Gérald Darmanin today said far-left radicals could have been behind the big sabotage attacks that disrupted high-speed rail service last week on the opening day of the Olympic Games in Paris. However, he also noted that the perpetrators could have been acting on behalf of other entities, keeping alive the possibility that the sabotage was ultimately inspired by Russia or its allies.

United Kingdom: In an effort to finally stop the periodic strikes by junior physicians in the National Health Service, the new Labour government of Prime Minister Starmer has offered them a pay hike of 22% over two years. That would still fall short of the 35% raise sought by the doctors, but it is much richer than what the previous Conservative government was willing to offer. Clearly, price inflation and labor shortages still have the potential to spark labor unrest and pay demands, even though the global surge of strikes has cooled over the last year or so.

Venezuela: With four-fifths of voting stations counted in yesterday’s election, the national electoral authority said President Maduro won with 51.2% of the vote. The authority said Edmundo González, the main opposition candidate, garnered only 44.2% of the vote, despite media reports saying he enjoyed strong, widespread support. There were also reports of voter intimidation and irregularities. The disputed results are likely to further isolate the Venezuelan government and possibly lead to new US sanctions, including on the national energy industry.

United States-Japan: In a new sign that the US and its allies are prepping for a possible conflict with China sometime in the future, the Pentagon yesterday said it will upgrade US Forces Japan to a joint force headquarters with expanded missions and operational responsibilities. With the change, the US’s roughly 55,000 personnel in Japan will be led locally, potentially by a four-star commander, rather than from the Indo-Pacific Command in Hawaii.

• Separately, US Secretary of State Blinken and Secretary of Defense Austin met with the Japanese cabinet to discuss measures clarifying the circumstances in which US nuclear forces could be used to deter a threat to Japan, from China or North Korea, for example.
• The officials also discussed further defense industrial cooperation, including having Japanese factories produce advanced US missiles to help get around the US’s current capacity shortfalls at home. The two sides also already have an agreement for Japanese firms to provide maintenance and repair services for US navy ships and aircraft.

US Monetary Policy: The Fed’s policy committee holds its latest meeting this week, with its decision due on Wednesday at 2:00 PM ET. Despite growing calls from some observers to start cutting interest rates at this meeting, we think the more likely course is for the officials to signal an initial cut in September. Recent data has certainly revealed that the economy is cooling and price pressures have fallen, but the officials still say they want to see more evidence that those changes will be sustained, despite a risk that continued high rates could spark an economic downturn.

• As investors anticipate rate cuts starting this fall, new reports show they have been pouring cash into exchange-traded funds focused on bonds.
• The data indicates that flows into bond ETFs and mutual funds accounted for almost 90% of all net fund inflows in the US in the first half of the year.

US Commercial Real Estate Industry: Data from MSCI shows lender portfolios of foreclosed and seized office buildings, apartments and other commercial property jumped 13% in just the second quarter, to a value of $20.5 billion. That marked the highest level of seized properties since 2015 and suggests many lenders have finally given up on those property owners struggling with high interest rates, weak demand, and low occupancy rates.

US Property Insurance Industry: New reports from rating firm AM Best indicate that property insurers in the US suffered a total net underwriting loss (premiums minus claims) of $15.2 billion on their homeowner polices last year. That marked their worst underwriting loss since at least 2000. The analysis shows the big losses stemmed from the increasing frequency and severity of weather events, rapid price increases for building materials, more people moving to disaster-prone areas, and regulators’ slow approvals for premium increases.

US Cryptocurrency Industry: In a speech at a bitcoin conference on Saturday, former President Trump made a strong pitch for cryptocurrency supporters. If re-elected, Trump vowed to sack Securities and Exchange Commission leader Gary Gensler over his efforts to restrict cryptocurrency investments. He also promised to end the Biden administration’s “persecution” of the industry. Meanwhile, reports say Vice President Harris’s advisors have reached out to key cryptocurrency leaders in an effort to reset relations.

• The Trump and Harris overtures show each side recognizes that younger voters have a more favorable view of cryptocurrencies and want to see the industry succeed.
• This suggests that the SEC’s current resistance to the industry will likely be dismantled following the election, no matter who wins the White House.

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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 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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