【MACRO Insight】Economic Growth Concerns Intensify — The Federal Reserve Faces Dual Challenges of Val

In the two years since the Federal Reserve began actively combating inflation, stock traders would watch the screens intently whenever the Consumer Price Index (CPI) was announced. However, as inflation heads towards the Federal Reserve's target and the Fed prepares to cut interest rates, the impact of CPI data on the stock market is diminishing. Instead, the market's focus has shifted to the weakness in the job market and whether the Federal Reserve can avoid a hard economic landing.

Eric Diton, President and Managing Director of Wealth Alliance, pointed out that the key issue facing stock market investors now is whether the Federal Reserve has waited too long to cut interest rates, as the risk of recession is higher than it was two months ago. The S&P 500 Index has just concluded its worst week since the collapse of Silicon Valley Bank in March 2023, with large-cap tech stocks like Nvidia plummeting by 14%. Volatility has also picked up, with the CBOE Volatility Index (VIX) rising from 15 on August 30th to nearly 24 on September 6th.

Options traders are betting that volatility will increase further, but it is lower than the market's previous expectations for CPI days. Data shows that if this target is achieved, it will be the smallest fluctuation on a CPI day so far this year. On the other hand, before the release of last Friday's weak non-farm employment report, traders expected the implied volatility of the S&P 500 Index to be 1.1%, one of the highest absolute values so far this year. Federal Reserve Chairman Powell almost declared victory in the fight against inflation at the Federal Reserve Symposium held in Jackson Hole, Wyoming. Since then, more policymakers have indicated the necessity of interest rate cuts, but the magnitude of the cut remains to be determined.

Now, the Federal Reserve is turning to the other side of its dual mandate, namely maintaining maximum employment. According to data from the U.S. Bureau of Labor Statistics, last Friday's employment report showed that non-farm employment increased by 142,000 people last month, bringing the three-month average to the lowest level since mid-2020. Looking ahead to the Federal Reserve's interest rate decision on September 18th, swap contracts fully reflect the expectation of at least a 25 basis point rate cut. Meanwhile, data compiled by UBS Group shows that implied volatility is accelerating before significant macro events related to employment, and stock market volatility indicators (such as skew) remain high.

Investors have ample reason to be more vigilant about employment data than inflation data. The S&P 500 Index recorded the worst employment data day since 2022 last month, falling 1.8% on Friday, August 2nd, and another 3% drop on August 5th due to weak employment reports. Two weeks later, the inflation data was in line with expectations, and the S&P 500 Index rose by only 0.4%, the smallest single-day increase since January. UBS data shows that dealers expect the volatility of the S&P 500 Index to rise, as the demand for out-of-the-money put options is higher than that for out-of-the-money call options. Federal Reserve officials have entered the pre-meeting silent period and will not make any comments before September 18th.

However, the latest Beige Book shows that compared with inflation, business contacts are more worried about the slowdown in economic growth. Although the general expectation is that the U.S. economy will remain strong, the GDPNow model of the Atlanta Fed shows some slowdown, with the third quarter real GDP growth rate expected to be 2.1%, lower than the previous 3% a few weeks ago. This is just another signal that the Federal Reserve needs to cut interest rates before it's too late to prevent an economic recession.

The rebound in the U.S. stock market is shaking, as it faces a host of challenges that undermine the momentum to push it to new historical highs. The sharp drop at the beginning of last month showed how fast the situation could deteriorate, and concerns about a U.S. economic recession triggered a significant sell-off in the stock market. Although the S&P 500 Index rebounded subsequently, the key is that it did not recover all the lost ground. Subsequently, last Friday's U.S. employment data showing weak job growth further reinforced the view that the labor market is cooling, leading to stock market turmoil.

Concerns about the United States are just one crack. There are also concerns about economic growth in countries such as Germany and the impact of this weakness on earnings and prices. This makes the future path look more unstable, even though the vague interest rate path has become clear, and investors are preparing for the first interest rate cut by the Federal Reserve in four years. In addition, there are the U.S. election, European political turmoil, and the concentration of funds in large-cap tech stocks, all of which could damage the bullish sentiment that sometimes seems unshakable. Valuation bubbles have also created new vulnerabilities. Many people had to chase the rise and buy at expensive prices, which means that if the situation begins to reverse, they may sell quickly, and the market may fall more severely and deeper before the usual bottom-fishing buying appears.

In addition, changes in options trading and the power of systemic investors may trigger unstable trends and potential deleveraging avalanches. New goals, even after the twists and turns of August, the S&P 500 Index is still up 13% this year, and the MSCI World Index is up 10%. Due to the strong start of the year, strategists from institutions such as UBS Group and RBC Capital Markets have revised their year-end targets set a few weeks ago. But now the view seems to be that the best days may be over.

If there is one stock that can summarize this year's rise, it is Nvidia. Nvidia is a symbol of the concentration of cash among large U.S. technology companies, and its stock price has more than doubled in 2024. But this high dependence and concentrated position are worrying, as it heavily relies on artificial intelligence as a reformer of the rules of the game in productivity. So far this year, Nvidia has been the biggest driver of the global stock market, contributing nearly one-fifth to the 10% increase in the Bloomberg Global Index. It has become a barometer of overall sentiment.

Other risks to investor positions come from so-called trend followers or volatility control funds, as well as the options market, which is increasingly dominant but has very short-term trading. The trading flow of these investors may exacerbate intraday volatility, as was the case during the stock market crash in early August. Since last August, economic growth has been at the center, and investors are worried that the United States is in trouble, and the Federal Reserve may have waited too long to cut interest rates. Last Friday, traders reacted to the employment data and increased their bets on a 50 basis point rate cut by the Federal Reserve this month. However, interest rate cuts do not guarantee that the stock market will rise again, as any easing move will be a response to a slowdown in economic activity. If accompanied by a more pessimistic economic assessment, this could become a catalyst for further selling.

As the Federal Reserve seeks direction amid the delicate balance between inflation and employment, investors face dual challenges of increasing market volatility and economic recession concerns. Despite the resilience shown by the stock market in 2024, the volatility of tech stocks like Nvidia, global economic growth uncertainties, and concerns about valuation bubbles all indicate that market fragility is on the rise. At this critical moment, investors need to focus on fundamental analysis, interpret economic data in-depth, and be prepared to deal with potential market fluctuations, while also considering a diversified investment portfolio to reduce risks.