Q3 2024 Market Projection

Sell the house, sell the car, sell the kids
Written on July 1st, 2024

Executive Summary

We believe the path of interest rates, not earnings, will determine equity market direction in the next quarter. The surprise increase of $400 billion in the CBO’s updated 2024 budget deficit forecast is just starting to dawn on the fixed income market. Such a huge widening in the deficit needs to be funded, therefore expect larger auctions of coupon securities announced at the next Quarterly Refunding Announcement at the end of July. This news, once digested by investors, sets up a double-digit equity market selloff analogous to Q3 2023, when the 10-year yield jumped from 4.20% to 5.00% to compensate investors for the additional Treasury bond supply.

If weaker payroll numbers begin to water down the consensus view of the consumer, then we expect a downward revision in the increasingly optimistic earnings forecasts coming from sell side analysts. Many economically sensitive stocks have already begun to underperform as concern mounts over a consumer burdened by inflation, depressed real wages, and recent and rising anxiety over job security.

We recommend not to anticipate this scenario, because Pave’s models are still emphasizing the momentum factor, so it is essential to respect the trend. However, it will be prudent to become defensive either at the first sign of weakness in nonfarm payrolls, or when the fixed income market finally prices in a realistic concern over a budget crisis and term premiums rise for long maturity U.S. bonds. We are focusing intently on the 2s 10s Treasury yield curve spread for that reason. Starting in the last week of June, only a week after the negative CBO budget forecast, the curve reversed half of its inversion. That has caught our eye, and we are confident it will become part of the consensus discussion in Q3.

For a numerical breakdown of expected performance by sector at the beginning of Q2 vs. Q3, please see below.

The Economic Backdrop: Cliff Notes on Q2

Last quarter was one of transition.

We had three months out the gate in 2024 of very high inflation that made everyone, including the Fed, take pause.

Since then, we have started to see inflation cool off, but we have seen something else follow suit: the economy. The way in which inflation has dropped sends a troubling message when you go below the surface. The percentage of the total components comprising the Personal Consumption Expenditures (PCE) Price Index that have seen price increases above 5% and above 10% is staying high at above 30%. The percentage of all components that exhibit deflationary tendencies, meaning below zero inflation, has risen from 20% to 30% so far this year. That means services inflation remains as high as ever, but weaker demand has driven the cost of many goods down below their level one year ago. This stagflationary dynamic is supported by the recent data reflecting a slight cooling in the economy.

Our leading indicators of employment have been pointing to an imminent reversal in labor demand. This is critical because investors and the Fed have unwavering confidence in the staying power of the U.S. consumer. The Household Survey is the more accurate employment data–not the Establishment Survey–to signal whether we are entering into a recession. The Household Survey does not double count people forced to hold multiple jobs to survive, avoiding a major flaw in the more widely followed Establishment Survey. Additionally, the Household Survey incorporates changes in the employment situation of independent contractors.

The Establishment Survey only canvasses existing businesses, so freelancers and independent workers are excluded. To make up for that deficiency, the Establishment Survey has added an additional one million employees based on a conceptual birth/death model that continues to assume the same unsustainable level of new business formation that was occurring just after the pandemic. We question that theoretical view of reality, and it is showing up in a significant gap between a declining Household Survey and new all-time highs in the Establishment Survey.

Another important development that became clear during Q2 was a theme we had been warning about over the last six months: the change in the attitude of management toward its workforce. This has been manifesting across most of our leading employment indicators. The warning signs are not only seen in weakening trends in the Household Survey, but in

• Hiring intentions and compensation plans from the National Federation of Independent
  Business,
• Real Household Income Expectations over the next 1-2 years from the University of
  Michigan consumer survey,
• The recent rise of Initial Claims for unemployment insurance, and
• Real Household Income Expectations in 1-2 years.

This list is far from exhaustive but is consistent with a picture that has transitioned from keeping layoffs low, springing from fear of not finding suitable replacements to managers who are now comfortable hiring from a larger labor supply thanks to immigration. Until recently, employment has been strong thanks to this reluctance to let go of existing workers, so a slight uptick in layoffs will result in a drop in nonfarm payrolls. We have already started to see the initial signs of this problem in a rise in continuing unemployment claims. Workers that have either quit or have lost their jobs are not able to quickly return to the workforce, and are forced to continue to receive unemployment insurance.

This is a significant shift in economic conditions because if the increasing anxiety among workers is sustained, it will manifest in even weaker spending, which means lower top and bottom lines for business. Given the management’s mindset change, any business downturn will result in increased firings, which will cascade into even less spending, and the cycle begins to devolve. While we have been expecting this to occur, the consensus has not bought into this concern of ours. However, the most recent FOMC minutes released July 3 mentioned that several participants noted that unemployment may rise further if demand weakens. Perhaps this expectation of ours will finally gain acceptance. We expect that to be the case as we enter Q3.

The latest data paints a picture of slowing economic activity. In forecasting which phase we are entering in the economic cycle, the movement in Gross Domestic Product (GDP) is driven by trends in employment, incomes, industrial production, and sales. In that four-category breakdown of the business cycle, employment is already on a downward slope and real incomes have been falling for a good portion of the population thanks to higher services inflation. Industrial Production has not registered more than a 1% annualized increase over the last 12 months, and the annual growth rate of Retail Sales has been on a 3-year downtrend, although it is still positive. Short-term business cycles are determined by fluctuations in consumer spending and business investment, and capacity utilization has seen negative growth since December 2022 after hitting 18% in April 2021, with capital expenditures echoing that weakness.

What is in store for Q3’s economy

We have not seen business conditions deteriorating dramatically. The delay in the timing of the recession is a function of the excessive stimulus from fiscal policy. The mountain of fiscal spending has made a mockery of economists’ and strategists’ economic calls for the recession of 2022. Investors are no longer concerned about a recession, but make no mistake, the potential for an economic slowdown has been set in motion. The question is whether we see the evidence in Q3, Q4, or if the traditional 17-year recession cycle comes in on time for 2025 (2008, 1991, 1974, etc.).

There is still an enormous amount of money being put into the economy thanks to the more than $1 trillion stimulus injections comprising the $738 billion Inflation Reduction Act, the $65 billion Infrastructure Investment and Jobs Act, and the $280 billion CHIPS and Science Act. That is a tremendous amount of economic support.

That support does not come without a cost. There will be a major lag between those outlays and any revenues coming back to the Federal government in the form of tax receipts. This is a problem. The Congressional Budget Office (CBO) had an already shocking forecast in February for a 2024 year end deficit of $1.5 trillion. Fast forward four months, and the CBO projects a $1.9 trillion budgetary shortfall, an increase of 27% in just a brief span. That gap must be offset by a commensurate increase of $400 billion in additional Treasury securities. We are already pushing the limit in our short-term Treasury Bill issuance, so the bulk of that additional supply of government securities that will be force-fed on investors will be in coupon securities with maturities ranging from two to thirty years.

The last time that the consensus was surprised by heavier issuance of longer-term bonds was August 2023, which caused a rise in 10-year note yields from 4.20% to 5%. That dramatic rise in yields caused a double-digit stock selloff into October 2023. We will find out the degree of the coupon issuance at the end of July. If political considerations become a factor, then we may continue to see a heavy overweighting of Treasury Bill issuance in an effort to keep the stock market high into the elections.

Issuing more Bills may make sense to those assuming rates will be lower by next year, but if rates go up, the country is putting itself in a situation akin to emerging market countries. Those economies are dependent on constant rollovers of short-term dollar denominated debt, leaving themselves vulnerable to economic and financial crises with regularity.

While we will stop short of expecting the largest economy in the world to follow in the footsteps of those emerging economies, we are courting adversity: the longer we delay issuing long-term debt, the more severe the negative reactions will be across our risk markets.

The Market Implications of AI

Of course, the prospect of an AI-generated productivity boost holds great promise, but, similar to tax outlays and receipts, this payoff will be delayed. Actual rollout and implication is problematic. To fulfill its promise, AI’s accessibility cannot be limited to startups alone, or from the top down by Apple, Google, Microsoft and the OpenAI’s of the world. The technology needs to be put in place at major industrial companies and by small businesses nationwide to translate into major productivity gains.

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In that sense, our current environment parallels the Internet Age. Whether or not tech valuations are hitting the“off the chart” tech bubble levels does not negate the fact that equity investors have already discounted massive productivity increases that will take years to realize. Normally, when there is a gaping hole between expectations and reality, stock prices mean revert. We are not forecasting a similar market crunch to that which ensued from 2000-2002, but valuations of those stocks benefiting from the AI theme are stretched.

Geopolitics: Look to the West, not just the East

Geopolitical scares kicked off 2024 during the January Taiwanese Presidential elections that sparked China’s displays of force, underlining their strongly held belief in the One China policy. As valid as U.S. investor concerns are in the case of a Chinese military takeover of the island, market-moving political problems in Q3 are less likely to come from China than from Europe. French credit markets were roiled after June’s EU Parliamentary elections took a decided far-right turn. Those surprising results caused France’s President Macron to call for a snap election that resulted in his centrist party shrinking between an upswing in popularity for the socialist alliance of the New Popular Front (NFP) party and the far-right National Rally (RN) party.

The economic consequences are enormous: France is already beyond the EU’s deficit threshold, and the RN may relish a budget fight with Europe as they are trying to carve out France’s independence within the European Project. The NFP meanwhile wants more tax cuts, a younger retirement age, and additional social programs, all resulting in budgetary largesse. The chances of risk premia spikes in credit markets that could cascade beyond France’s borders into Europe and the U.S. make France the center of the geopolitical universe for Q3 and beyond.

Stock internals and homegrown political implications

As far as Q3 positioning for the Q4 election and the Q1 incoming administration, we are seeing capital initially move for a replay of the 2016 market when Trump took over. That expectation helps large value cyclicals that have been underperforming of late: the energy, financials, industrials and materials sectors.

As economic growth concerns are broadening, we have noticed that economically sensitive sectors such as material, consumer discretionary, and industrial stocks have underperformed. While they could be poised for a turnaround based on the potential for a Republican presidency, our models and experience lean against it. Small caps outperformed throughout 2016, but they will underperform if anxiety over an economic slowdown dominates, as we expect. We are closely monitoring if Pave’s models will begin ranking large cap value over US large cap growth; the latter has been the biggest outperformer year-to-date in 2024 (and throughout 2023). Large has outstripped small and the equal-weighted S&P relative to the S&P 500 (weighted by market capitalization) has dropped to levels not seen since the Global Financial Crisis in 2008.
The lows hit on July 3 are approaching the absolute lows hit in November of that year.

We have concerns over a knee-jerk assumption that reflation will be a winning theme leading to outperformance. A return to even more expansionary fiscal policy runs into a brick wall of a budget crisis and the potential for an acceleration toward highly unacceptable levels of bond yields.

Despite stocks sitting at their highest decile of overvaluation historically, overvalued stocks need a trigger to stop being overvalued. While it is possible that earnings growth extends its rise in a hoped-for reflation scenario, we are more concerned that multiples contract as yields rise. We believe that the downside trigger comes either in the form of higher yields (driven higher from increased Treasury coupon supply) or from a reversal lower in employment. In the absence of either of those, we cannot rule out higher stock prices, which, paradoxically, is the norm when market breadth is this narrow.

Going through the Numbers: What Pave’s Models are Observing

At the beginning of Q2, our models reflected the overvaluation concerns in tech and only ranked information technology as the 5th most attractive sector, with telecom as number 10 out of 11. After it sold off sharply into May, our tech scores recovered strongly and tech ranks as our second favorite sector, and telecom is 3. Utilities started last quarter as our third most favored sector based on AI-themed electrical grid plays, and after the selloff it experienced, has shot up to our favorite sector.

Economically sensitive stocks continue to rank among the least desirable sectors, with Consumer Discretionary at 8, Energy at 10, and Materials at 11, so we have quantitative support warning
that the fashionable reflation theme is currently without merit.

Financials were the top ranked sector at the beginning of April, coincident with strong insider buying in banks. Later that month, banks hit their highest outperformance level relative to the S&P 500 index in over a year, but since then our models have been cutting back, and the sector currently ranks 4th. We anticipate that the term premium will return to the long end of the fixed income market, and we have noticed a quick steepening of the 2s 10s yield curve, which will benefit banks.

Importantly, while price momentum is still a top risk factor, interest coverage and the current ratio, two measures of the quality of a company’s financial statements, sit at the top of our factor rankings. Interest coverage is the ratio of earnings (before interest and taxes) by its interest expense. The interest coverage ratio indicates whether a company can pay all its debt out of earnings. The current ratio is a measure of a company’s ability to pay its immediate debt obligations with cash and near-cash short-term assets on hand. This means that our quantitative models are picking up that capital is flowing, and will continue to flow, toward firms that can weather an economic downturn.

Once again, in a reflation scenario, quality is not an attractive factor because if the forecast is for improving economic conditions, then we will enter a “rising tide lifts all boats” scenario. In that case, lower quality, higher indebted companies outperform. When our models emphasize quality, it reflects a heightened risk of an economic downturn. It does not look to speculative stocks, rather it is anticipating a situation that Warren Buffett has described as “only when the tide goes out do you discover who’s been swimming naked.”

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For a full breakdown of how each sector scored at the beginning of Q2 and Q3, see the table below. Percentile represents how well a sector is expected to perform relative to other sectors historically. Percentile is calculated by first taking the Pave proprietary return score for each asset in a given sector and averaging them. That average sector return score is then turned into a percentile based on the theoretical range of possible return scores. For example, 99% would indicate a sector with the highest possible theoretical return potential and 50% would indicate an expectation of flat performance. Rank is simply how each sector’s percentile score ranks compared to the percentile score of other sectors in the same time period.

Pave calculates return scores for every publicly traded asset globally on a weekly basis. As new information arises, scores can change relatively quickly. The only way to get access to Pave’s weekly scores is through a subscription to Pave Pro.

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One Final Note

In our view, the financial sector ranking going forward holds the key for overall exposure management. If it continues its fall down the scoring ladder, it suggests that the potential for an economic slowdown will dampen loan demand even further and negate any potential of a more positively sloped yield curve. If we begin to see financials move back up in the ranks, then all the information we are processing is pointing to a pickup in loan demand from businesses, and improved prospects for lower default rates and charge-offs.

Contact Us

If you’re interested in learning more about Pave Pro, please visit pavepro.ai or contact us directly at salessupport@pavefinance.com. We look forward to hearing from you.

About the Author

Peter Corey is the Founder and Chief Market Strategist of Pave Finance, Inc. He spent over a decade on the sell side as head trader of derivative desks in fixed income and foreign exchange. He spent the last three years of this stint at HSBC running a proprietary macro desk before joining Steve Cohen for over nine years as SAC's first macro trader. He then ran a long/short hedge fund using his quantitative models that was ranked number six in the world by Hedge Fund Research, and acted as a strategist to the CIOs of many of the top hedge funds globally before starting Pave. Peter graduated with a B.S. and MBA from Wharton.

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