No Debate

All eyes will be on the political debate tonight. It promises performative success but is unlikely to produce any tangible outcomes. The polarized American electorate is entrenched, seemingly immune to any rational discourse. The same cannot be said for the stock market debate, which continues to rage.

If there was any lingering doubt over the potential for lower rates, it evaporated with last month's Fed's verbal pivot. If there is still any question about 25 basis points or 50, it's up to the CPI tomorrow but is ultimately irrelevant to the outcome. However, the debate about the U.S. economy is still in full swing. Markets are responding to this uncertainty with a waffling choppiness, lurching from data point to data point.

The consensus view depicts a resilient economy slowing at a comfortable and predictable pace. So far, we seem on track to achieve the vaunted soft landing. Stocks and bonds have rallied on that narrative. Although the data have supported this so far, it is less clear that the Fed can arrest the slowing labour market in time to prevent a self-fulfilling sudden stop. The inter-market signals from outside the U.S. are uninspiring. China, mired in a self-inflicted debt and demographic deflationary spiral, is in full retreat, with its stock market at 5-year lows. Commodities are universally weak, led by a sudden breakdown in crude. Only in the self-absorbed U.S. economy are consumers spending freely.

The Eurozone is decelerating after a solid first half. German manufacturers (VW and BMW, notably) are cutting jobs as demand for manufacturing and discretionary exports has suddenly waned. Rate cuts there are ahead of the U.S., buoying the stock markets, especially in defensive and financial stocks. Europe's return to a lower inflation and lower rate regime is a double-edged sword that, while improving relative valuations, threatens to crimp earnings. Cue the negative estimate revisions.

Since the GFC, investors have become used to a positive correlation between stock and bond prices. However, the 2023 market correction cemented the demise of the 60/40 strategies promoted by the risk-averse crowd. This has generated a Pavlovian relationship between the two former asset adversaries.

The COVID crisis's inflation scare prompted policy extremism in both fiscal and monetary terms. Unwinding that creates a confusing mix of positive and negative signals to risk-takers. Lower rates emanating from lower inflation are unequivocally a good thing. But what good can come from lower rates based on a slowing economy, Mr. Risk? Any bond rally from here based on unexpected economic weakness will eviscerate stock prices. Conversely, any sudden rise in yields will come at the expense of lowered valuation. Heads, I win; Tails, you lose.

The next threat may come from a damaging re-acceleration of inflation. Either way the U.S. election goes, tariffs will hike consumer prices as companies pass on the burden. However, lacking the demand-pull generated by COVID-19 support policies, corporations will find it harder this time to convince consumers to absorb the load. The consequent result of weak demand and higher cost structure is a deadly combo for company profits.

So, as we lap easy comps on the lower price front and head further into the weakness in hiring and job openings, all the good news is likely in the rear-view mirror. It argues for holding fire still. The market is now priced for perfection, which seems more fleeting than ever. Rotation strategies did well temporarily this past summer as the predictable broadening of market participation unfolded. It was a trade I missed, but it was likely only a temporary "B" wave rebound doomed to fail.

Next week, the Fed will exercise its put position on the economy and give the market what it has been asking for since last November. My view is to sell on the news! There is no debate on that.

Risk Model: 3/5 - Risk On

After the August data, market prices quickly priced-in the Fed's rate normalization. But economic signals have since deteriorated. It will take very little to reverse the Model, especially given the persistent elevation of AAII Bullish sentiment and the complete collapse of the Copper/Gold ratio. The Vix fear gauge still flashes caution as Japan-based carry trade unwinding erupts easily.

The yield curve has flattened quickly. One interpretation is that the soft landing has been achieved with minimal pain. However, previous examples, such as 1994, involved a quick response from the Fed to the new data. Threading the needle between here and November 5th will take nerves of steel from Chair Powell. I think the sidelines still seem the best place to observe that process.

AAII BULL/BEAR

COPPER/GOLD