The Tumultuous August Stock Market Leaves Investors Unscathed, but Disagreements Remain on the Path of Interest Rates

August began with an unsettling start for the stock market, but what initially seemed like a nightmare quickly turned into an impressive recovery. The S&P 500 suffered a sharp 6.4% drop during the first three trading days of the month, marking its worst start to August—or any month—since 2002. This steep decline left the U.S. large-cap benchmark 8.5% below its mid-July record close, as investors braced themselves for more volatility.

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However, the market managed to stabilize, and stocks began to recover. The Nasdaq Composite, which had entered correction territory after falling more than 10% from its recent high, rebounded in just 11 trading days. The Dow Jones Industrial Average climbed back into record territory, and by Friday, the S&P 500 was only 0.3% away from its July 16 record close.

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Louis Navellier, founder of Navellier & Associates, noted the market's resilience, saying, "We’ve made it through a challenging month unscathed and are about to enter the rate-cutting phase of the Fed. For now, the skies remain clear with smooth sailing expected."

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The initial market downturn was partly due to a weaker-than-expected July jobs report, which fueled fears that the Federal Reserve had delayed interest rate cuts for too long. Additionally, the unwinding of the popular Japanese-yen carry trade contributed to the selloff, exacerbating market concerns.

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Fortunately, subsequent economic data helped ease the "growth scare," and the yen carry trade unwind appeared to have run its course without causing significant damage to the financial system. This provided some relief to investors and allowed the market to regain its footing.

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Federal Reserve Chair Jerome Powell further reassured investors in his speech at Jackson Hole, Wyoming, stating that policymakers were prepared to implement a rate cut as early as the following month. Powell cited confidence that inflation was receding and expressed a desire to prevent further deterioration in the labor market.

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On the economic front, personal spending rose by 0.5% in July, up from 0.3% in June, which helped to reassure investors about the economy's health. Additionally, the core personal consumption expenditures (PCE) index, the Fed's preferred inflation gauge, showed a 2.6% year-over-year increase, reinforcing expectations that rate cuts were imminent.

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Jamie Cox, managing partner at Harris Financial Group in Richmond, Virginia, described the situation as a "Goldilocks" scenario for PCE, where consumer strength and clear signs of disinflation are present in the data.

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However, a disconnect remains between the stock market and the fed-funds futures market. The latter continues to price in 100 basis points, or one percentage point, of rate cuts over the Fed's remaining three 2024 policy meetings. This pricing suggests that the Fed might deliver a supersize 50 basis point cut at some point before the end of the year.

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The prospect of aggressive rate cuts is at odds with the more optimistic outlook portrayed by the stock market. Such cuts would imply that the Fed needs to take drastic measures to counteract a rapidly weakening economy or financial instability, neither of which is typically favorable for equities.

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Cox pointed out that this disconnect is not new. Investors entered 2024 expecting the Fed to deliver as many as seven rate cuts, starting in August. However, the Fed did not cut rates earlier in the year, and the resilience of the economy allowed stocks to continue their upward march.

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Cox also noted that the Fed recognizes that current interest rates are considered restrictive, and they will become even more so if inflation continues on its current trajectory. Therefore, the Fed's rate cuts are more about normalizing monetary policy than responding to an economic slump. Cox predicted that the Fed would likely cut rates by a quarter point at each of its remaining 2024 meetings, rather than making more aggressive cuts.

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Steve Blitz, chief U.S. economist at TS Lombard, highlighted the dilemma facing the Fed in this "Goldilocks" environment. While the PCE core rate at 2.6% suggests that the fed-funds rate should be lower than its current 5.25% to 5.5%, Blitz noted that continued increases in real discretionary consumption, particularly in services, could push core inflation higher in the coming months. This situation leaves the Fed in a difficult position.

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Blitz argued that real financing rates are currently too high, which is evident in some areas of the economy. If left unchanged, these rates could eventually trigger a downturn. On the other hand, with high employment, expanding real incomes, and recovering real spending, the Fed must be cautious about easing too quickly, as it could risk reversing the progress made on inflation.

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Blitz predicted that the Fed would stick to cutting rates by 25 basis points per meeting unless there is a sudden deterioration in the data. He also noted that the market appears to be "a step or two ahead of the Fed," as it continues to anticipate more aggressive rate cuts than the Fed is likely to deliver.

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