To my clients:

My apologies for the short notice, but I will be away from the office next week. My family’s travel plans unexpectedly changed from the end of the month to next week. I will be connected while away and tracking market developments. I will be back in the office on Monday, August 12th.

It was a down week for North American stock markets with the Canadian TSX finishing down 2.6%; the U.S. Dow Jones Index down 2.1%; and the U.S. S&P 500 down 2.1%.

Let’s not sugar coat it – it was an eventful and, ultimately, nasty week. Let’s get to it…

Through mid-week, all was looking reasonably benign, perhaps even rosy. On Wednesday at its policy meeting, the U.S. Federal Reserve acknowledged that inflation continued to trend toward its 2.0% target while, at the same time, the labour market continued to cool also. The Fed acknowledged that the risks of rising inflation vis-à-vis a slowing economy had come into better balance and that a rate cut at this week’s meeting WAS discussed. Ultimately though, the Fed decided not to lower its benchmark rate, instead aggressively signaling that a 0.25% rate cut was likely the baseline case at its next meeting on September 18th. While acknowledging the economy - particularly the labor market - was slowing, the Fed maintained its perspective that recession was unlikely. This guidance was well received by the markets which were up nicely through Wednesday’s close.

Then on Thursday, more overtly disappointing economic data began to emerge – specifically the metrics revealed by the ISM Manufacturing Index (one of the Big 3 indicators I habitually track and report) as well as the weekly jobless claims. The ISM Manufacturing Index came in negative for the 20th time in 21 months. Moreover, at 46.8 it was down notably vs both the previous month (48.5) as well as expectations (48.8). Meanwhile, weekly jobless claims rose to the highest level since August of last year and continued a recognizable upward trend in place since April of this year. The combination of these two readings set the tone for a disappointing day in the markets yesterday which was….

… reinforced by this morning’s monthly Employment Report which, at 114,000 new jobs created, was the lowest reading since February 2021. Moreover, the unemployment rate rose again to 4.3% thereby triggering the so-called “Sahm” rule. The Sahm rule, as Fed Chair Jerome Powell himself noted in his press conference on Wednesday, is a statistical indicator that suggests when the 3-month moving average of the unemployment rate (which in the current case would be the average of the months of July, June and May and stands at 4.13%) rises 0.5% above the 1-year low in the unemployment rate (which occurred July 2023 at 3.6%), then recession follows. So, with the 3-month average sitting 0.53% above the 1-year low, the current case has indeed triggered this statistical rule of thumb. HOWEVER, as Chair Powell also said, though a seemingly reliable indicator, there may be aspects of the current post-covid business cycle that don’t align with historical and statistical norms. He specifically noted that the best known recession indicator, an inverted yield curve, has been signaling recession since it first inverted in July 2022 (so a full TWO years!), yet no recession has so far resulted. In essence, Powell was arguing that the economy was normalizing from post-pandemic induced extremes that saw inflation spike egregiously high because of a bounce-back in demand from consumers as supply chains remained disrupted, while at the same time the unemployment rate sat near all-time lows.

I sympathize with Powell’s perspective and, for the time being, I too believe the current environment is indicative of normalization instead of a prelude to recession, “but” this comes with a couple of BUTS:

BUT #1: the Federal Reserve MUST cut rates at their next meeting, and perhaps sooner. Moreover, a 0.50% rate cut must be on the table vs just a 0.25% cut. I firmly believe that if the Fed had on hand the data from this morning’s Employment Report at its Wednesday meeting, it would have cut rates earlier this week.

BUT #2: the incoming data flow must be monitored, and I will definitely be monitoring to see if deterioration continues.

At this point, I must also point out that markets have had a stellar 18-month run. A meaningful correction was long overdue, and this may well be it. That said, I don’t reposition client portfolios in reaction to corrections. Corrections are impossible to time and attempting to do so will inevitably whipsaw clients out of longer-term gains. However, I am not averse to repositioning client portfolios in anticipation of meaningful recessions. Again, at this point, I don’t believe recession to be the base-case, instead viewing the current economic softening as the aforementioned “normalization.” Further, even if recession odds grow to be the base-case, will it be deep or mild? I can’t envision anything worse than a mild recession. Further still, and perhaps MOST IMPORTANT, is the fact that the Fed has LOTS of room to cut rates materially and quickly if need be. The Fed could cut rates a full 1, 2 or even 3%, and still have the overnight rate sit at levels above where they were just before the pandemic. If/when the Fed begins cutting to stave off recession fears, this kind of ammunition will significantly cushion both the economic and market downside.

That’s it for this week. I’ll be watching, even while away. All the best,

Nick

Nick Scholte, CIM, FCSI

Senior Portfolio Manager

Scholte Wealth Management
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
3200-1055 West Georgia │ Vancouver, BC │ V6E 3P3
Toll Free: 1.844.665.9900 │Email: nick.scholte@rbc.com

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