Heat in July
Temperatures in many parts of the United States were abnormally hot in July. Many places throughout the southwest broke new daily records for the average number of days above ninety degrees Fahrenheit. Similarly, July was an even busier month than usual in terms of meaningful economic events, and on top of that, there was a spike in stock market volatility. Investors showed their reflexivity and elasticity to market rate changes and events with big economic implications.
Markets received a positive shock when the monthly inflation report surprised investors with better-than-expected news. The monthly indicator showed inflation had declined more than investors had expected, which sent financial prices on interest-rate sensitive assets soaring. Investors pursued risky and other rate-sensitive assets in July, thinking that today’s relatively elevated short-term interest rates have plateaued and will eventually lessen.
Investors seem practically certain the Federal Reserve will cut interest rates at the next FOMC meeting scheduled in September. They conveyed that message as they competed and successfully drove down longer-term yields on fixed-income and other market-based securities. Of course, investor bids to buy long-term yields pushed the yield curve on government debt further into inverted territory, which makes life difficult for investors who need good quality assets matched against long-term liabilities. An inverted yield curve happens when short-term interest rates exceed long-term bond yields. Therefore, investors believe the Federal Reserve has to reduce short-term rates and play catch up to where investors have positioned yields further out on the curve.
Asset returns from small cap stocks benefited from the inflation surprise and elevated expectations that short-term interest rates are about to decline. Small caps have struggled to maintain pace with the broader market this year. However, the asset’s returns surged throughout the prior month since small caps are usually extremely cyclical to economic changes and interest rate sensitive. Small cap companies that need to replace old and relatively cheap debt with new debt in the next few years may get to do so at interest costs below current market rates. Similar logic also applies to consumers who want to purchase a big-ticket item, invest in a home, or refinance a mortgage.
A number of events added to the already tense political environment. Tragically, US democracy came under attack last month when a live assassin tried to take the life of the forty-fifth President. Second and third-order effects from such a horrible event, if it had succeeded, are severe in so many impossible ways, down to the fragility of significant pieces of current legislation, such as the Tax and Jobs Act, which expires in 2025 if Congress and the President don’t renew it in its present form.
Another surprise in politics last month was President Biden’s public announcement that he no longer will pursue his reelection campaign or the Democratic nomination for President. President Biden’s condition has been a topic of discussion lately, putting the Democratic party into crisis mode. However, Democrats have seemed to unite behind Vice President Kamala Harris as the frontrunner headed to the Democrat’s convention in August. No matter which party wins the presidency or assumes control of the government, the economic policies pursued by one or the other will surely be different, making it a significant election as it will likely define the trajectory of America’s next decade.
Moments of uncertainty that turn up the heat in financial markets, metaphorically speaking, seem to occur at random. Investors have assigned a name to describe such uncertainty and randomness called volatility, which can impact financial returns positively or negatively. Fortunately, better-than-expected macroeconomic news in July pushed good volatility into the markets, especially for small cap and bond market returns. Also, and importantly, current interest rates across many different savings periods are higher now than they were a couple of years ago. Therefore, if bad volatility someday reenters the market, today’s higher rates and yields will likely diversify investors from losses that might occur in other areas of investor portfolios.
