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Brian Pietrangelo:
Welcome to the Key Wealth Matters weekly podcast, where we casually ramble on about important topics including the markets, the economy, human ingenuity, and almost anything under the sun, giving you the keys to open doors in the world of investing. Today is Friday, July 12th, 2024. I'm Brian Pietrangelo and welcome to the podcast. And we welcome you back from being off last week where we celebrated the 4th of July and did not have the podcast on July 5th. So hope you had an opportunity to spend time with family and friends just like we did and are enjoying the summer.
I'd like to introduce our panel of investing experts here to share their insights on this week's market activity and more. George Mateyo, chief investment officer, Steve Hoedt, head of equities, and Rajeev Sharma, head of fixed income. As a reminder, a lot of great content is available on key.com/wealthinsights, including updates from our wealth institute on many different subjects and especially our Key Questions article series addressing a relevant topic for investors each week. In addition, if you have any questions or need more information, please reach out to your financial advisor.
Taking a look at this week's market and economic news, we've got three updates for you. But, we're going to start by going back to last week when we are off for the podcast because there was a pretty important report coming out of the Bureau of Labor Statistics around employment. So we'll cover that as part of our update. So first on that update, the Employment Situation Report came out on July 5th and showed us two updates. One, new non-farm payrolls rose by 206,000 in the month of June, which was a good number, above expectations and still remain positive. However, if we go back to the prior two months of April and May, those data points were revised downward combined for 111,000 lower than previously reported. So a little bit of a mixed review in terms of that, but still up and up, net net probably on a positive basis.
In addition, the unemployment rate overall for the United States ticked up one 10th to be 4.1% for June, and that is the third consecutive months that we've seen some increase in the unemployment rate. So again, a little bit of a mixed signal. In addition, we also have the update on the initial unemployment claims, which is not part of that same report from July 5th, but comes out every Thursday. So the week ending July 6th showed that initial weekly unemployment claims were at 222,000, which was down from the prior week by 17,000, which was again a good number because it's showing that the jobs market remains resilient and is not yet escalating to the point that we would have worry.
And second, the chair of the Federal Reserve. Jay Powell, was in Washington D.C. giving his semi-annual testimony to both the Senate and the House known as Congress. And from that perspective, we'll get a read from both George and Rajeev on what he said and what it means for future rate cuts coming up. But again, his headline report, basically the markets are coming into better balance in terms of employment and inflation.
And third, speaking of inflation, probably the biggest report for the week was the consumer price index measure of inflation that came out on Thursday and showed us that the was a decline in the overall year-over-year measurement of inflation. May's report for 12 months was 3.3%. June's report that just came out yesterday was 3.0%, so heading in the right direction, and that's based on a little bit of a deflationary presence month over month in June, which is helping that number go down if we exclude food and energy, which is the important core CPI number. We're also seeing some declines. Again, May's year-over-year number was 3.4% and June's number was 3.3%. So again, heading in the right direction again, moving modestly down each particular month. Again, we'll get that forecast for what it might mean for the Fed and the potential to cut rates as we talk to our panel later on in the podcast. So with that, let's turn to George for your reaction on that economic data and see what it might mean. George?
George Mateyo:
Well, Brian, you're right to bring our focus back into the employment situation from a few weeks ago since most people were off for the holiday, but the government was still open and they did report employment information for the last month. And as you suggest, there's some moderation there. We've been thinking about that for quite some time and anticipating that the slowdown would take hold and it seems like it is taking hold. I think it's probably fair to say that the situation as it relates to the job market is going to be kind of front and center. The other thing that we got this week was the fact that you referenced, which is inflation's cooling a bit more than people expected. We're actually now seeing moderation in the housing sector. To be fair, it's still pretty elevated, but it is coming down and now we actually see the slowest rate of inflation in quite some time.
Arguably, people probably look at inflation in different ways. We can't just look at the overall year-over-year increases, which is what most economists look at, but most consumers probably still feel that inflation's too high because they pay prices every day that are higher than they were a year or so ago. So I think it's still a tricky situation, but the job market is going to probably be more of a focal point going forward. And certainly Jay Powell is quick to reference that when he was on the Hill this week testifying in Congress as he wanted to do. I think it's interesting to note that he himself recognizes that shift.
We talked about on these calls as well, the sense that some people in the Fed are calling for maybe an inflection point with respect to the labor market, meaning that it's been so strong for so long, maybe it's starting to show some cracks. We didn't quite see that crack show up in a big way this week, but it is right to say that I think the Fed is probably more focused on that going forward. He himself talked about the fact that inflation has cooled quite a bit, and the labor market is starting to cool as well. So it's probably a concern of theirs that they're going to have to spend more time thinking about.
One thing that we've kind of thought about also is that the Fed may be starting to think about cutting rates, which is something that it's been kind of an on again off again story for much of this year, but with the slower inflation print that we got this week, it now does look like the Fed might start thinking about talking about rate cuts again. So Rajeev, if you think about this altogether, how do you think the fixed market is responding to this, and is it right to say that rate cuts are coming?
Rajeev Sharma:
Well, George, we have seen a very soft CPI reading yesterday even lower than the Maze report that Fed Chair Powell came out and said that was, quote unquote, "really good." So add that to the jobs report we saw last week, and you have a combination that brings market expectations of a September rate cut back on the table and not just on the table. Probabilities of September rate cut have gone from 70% before the CPI report to 95% currently, despite the fed narrative that many policy makers have been saying that the market needs to be patient, they're urging patients for the market. What the market is really doing is they're stringing together a strong argument for the Fed to act on rate cuts. We have two inflation reports. We have two job reports that are all going to come out before September 18th's FOMC meeting. If these reports continue to point towards disinflation and the slowing labor market, you do have what you need for the Fed to cut rates.
Bonds rallied on that CPI report and real money investors, they really started buying in the front end of the yield curve anywhere from two year to five year treasuries, they were being purchased nonstop yesterday after that CPI report. Traders are seeing the possibility of as much as 60 basis points of rate cuts this year. So that's the anticipation of at least two rate cuts and there is a possibility of a third rate cut. So those two rate cuts would be September and December. And if you look at the probabilities, you actually have a probability of a November rate cut that is over 50% for the first time since inflation surprise on the upside back in March. The impact of this can be seen on the yield curve. We've seen yields falling faster on the two year compared to the 10 year. So that means the yield curve is steepening.
So you're having more attention in the front end of the yield curve, which is most sensitive to fed rate policy, but the curve remains inverted. We're still inverted on the twos, tens to the order of 30 basis points. Another thing that's kind of keeping rates a little higher is we've had to deal with a lot of treasury supply that's been hitting the market through auctions. The recent auctions have fared pretty well, so you do have a buyer stepping in, but these auctions will keep treasuries to trade in somewhat of a range. As long as the supply keeps hitting the market, you're not going to be able to see treasuries really start to rally towards the low side on a yield basis.
The one auction that did not do pretty well was the 30-year treasury auction that we saw this week. Investors did not really show up for that auction. It was a kind of auction where you're talking about longer duration on the yield curve. A lot of investors are still shying away from really adding duration to their portfolios, especially when you think about 30 year duration. And when we that CPI print, most treasuries rallied after the print. So already it became too expensive to participate in that 30-year treasury option.
So not only did the market move on the CPI print, as you mentioned George, we also had Fed Chair Powell providing testimony to Congress this week, some notable points that Powell made were, one, he acknowledged the progress made on inflation. He pointed towards a Fed that would be ready to cut rates if the data continues to trend towards 2% on inflation. He also stated that quite a bit of progress has been made on reducing the Fed balance sheet. In fact, the Fed has reduced its holdings by about 1.7 trillion so far, and officials expect to reduce the balance sheet substantially further, but they're going to be very careful. They don't want to start reducing when you start seeing rates move down the way they're going down, they're going to be very prudent. They're continue to reduce the balance sheet, but they're going to move very carefully from now forward and they're going to move further than they expected to. So I think you're going to see more balance sheet reduction, but it's going to be very, very prudent on what the market conditions are for the Fed.
George Mateyo:
That's awesome, Rajeev, thanks for the insights of the intel for sure. There's a lot of moving parts there. There's also I think still a lot of moving parts in the equity market. And of course today marks the kickoff for, was it Q2 earnings, I guess, and we'll start to see a couple of reports trickle out. But what are your expectations for earning season this year? It seems like every earning season is the most important earning seasons ever, but you think this one's going to be met? Is it going to matter much or what are your expectations for earnings this quarter?
Stephen Hoedt:
George earning season? It seems like this time it is a fairly important one, but we say that every quarter. So I kind of feel like we're just repeating something that really doesn't have a lot of utility anymore when we talk about it. But as long as the trend continues up and to the right, we should be fine. We have seen some numbers though from some of the early releasers that they give us some pause. So whether it's Delta Airlines or some of the reaction we've seen to the bank numbers this morning, it remains to be seen how the market is going to be positioned as we go through. At the end of the day, the AI theme companies are really going to be the ones that are going to carry the water because they've carried the water all year. And those don't really report until deeper in the earning season. So we'll have to see how it goes.
When you think about what the market is doing so far year to date, if you look at where we were at through a couple of days ago, close, I mean we were up over 19% through, I think it was through a Wednesday. And when you think about what this means in terms of performance for the second half or whatever, historically you see good performance in the second half of the year after you've had a good first half of the year. Whether we get that or not this year is a different question. What I can tell you is that as we think about our second half outlook, we continue to look for an increase in volatility and we see a continued falling correlations across the large cap investment universe, which is where we tend to play.
And what that tells us is that we're in a classic kind of stock pickers market. I know people like to use that phrase all the time, but we truly believe that's where we're at right now. And from our perspective as professional investors, this means that we want to be adding the areas where we have the highest conviction at this point in time and taking money off the table in other areas. And I'll be honest with you, we've had some portfolio action in our proprietary strategies that we've been running this week, and one of the things that we've decided to take a little bit of money off the table was the AI theme. And that may surprise some of our listeners here, but as we started to look at things and try to decipher where do we want to be positioned in the second half of the year, the AI theme has completely dominated the market year to date.
When you think about performance for the AI theme in 2023, it was driven by earnings gains. All you have to do is pull up a chart of NVIDIA and show NVIDIA's stock price and NVIDIA's forward 12-month earnings figures for the last few years, and you see an explosion in the earnings number from $5 to over $25 over the last 12 to 18 months or so. So clearly, it was driven by earnings last year. But if you look at the performance this year, and not just for Nvidia, but for all these stocks, the performance has not been driven by earnings anymore, it's been driven by multiple expansion. And that's something that sets us up for potential air pockets, to be honest.
If and when people decide to start rotating away from a theme, you can see multiples deflate really quickly. So one of the lessons that we've learned is that you sell when you can and not when you have to. And we feel that that's where we're at with the AI theme at this point in time. So we're deciding to rotate some money out of tech in general and into other areas where we see better risk versus reward, George.
George Mateyo:
No, it makes a ton of sense, Steve. And one thing that we've talked about too is that the market's gotten really concentrated. Right? There's only a couple of stocks that really have been driving the market, and not to pick on any one of them, but I think I read something the other day that looked at the 10 largest stocks now represent close to 40% of the market, which is quite unprecedented. I think it's 37 or something percent, which is pretty unprecedented. Those same 10 stocks actually only represent about 25 or so percent of the overall earnings story. So your point about the fact that earnings lift stock prices has been historically correct, but typically stock prices move ahead of earnings, and that's kind of the market we're in right now. So we have an S&P 500 that's very concentrated, but also maybe a little bit stretched in terms of that disconnect and that gap between earnings growth and valuations.
So I think we've also been thinking about that from the portfolio construction perspective where in the last year or so we've been thinking that a small tilt towards small caps would be rewarded, and that's been wrong frankly, for much of this year. We've also been thinking that the US markets would outperform international markets, and that actually was a pretty decent call. So one out of two ain't bad, I guess. But I think more recently we've started to see some of the rotation we've been anticipating start to take hold, small caps had a pretty strong day yesterday, and we'll have to see how that plays out. But I do think you have to be more selective going forward.
So our view, again, remains being really diversified. Diversification hasn't worked that much this year in the sense that it's been kind of a narrow market, but I think increasingly going forward, investors will be focused on, as you pointed out, active share, being diversified, being more nimble if you will, because the markets might be a little bit more volatile. But really staying really truly to diversified, in my mind, is what's going to matter most. So with that, I'll just kind of say thanks everybody. Have a great week and we'll talk soon.
Brian Pietrangelo:
Well, thank you for the conversation today, George, Steve, and Rajeev. We appreciate your perspectives. And thanks to our listeners for joining us today. Be sure to subscribe to the Key Wealth Matters Podcast through your favorite podcast app. As always, past performance is no guarantee of future results, and we know your financial situation is personal to you. So reach out to your relationship manager, portfolio strategist or financial advisor for more information, and we'll catch up with you next week to see how the world and the markets have changed and provide those keys to help you navigate your financial journey.
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