Inside Markets — Rebound

US equities are higher in a relatively tentative rebound on reassuring Fed/BOJ comments and better-than-feared overnight earnings. However, yesterday’s spike in realized equity saw the VIX reach an intraday high above 65 and close the day near 39. Once it reaches escape velocity above ~30, the VIX usually remains at elevated levels above ~20 for a few months. Higher volatility leads to a more challenging risk/reward tradeoff and tends to result in multiple compression. An optimistic estimate for volatility to return to subdued levels (sustained levels below 20) is late-September/early October.

Yesterday, the NDX closed ~13.5% below its July 10 peak, while the SPX closed ~8.5% below its 7/16 peak. A ‘correction’ is defined as a decline of 10-20% from the most recent peak, while anything greater than 20% is defined as a bear market. Bear markets are usually driven by economic recession and we see limited risk of a near-term recession. We expect the SPX will eventually reach correction territory and remain under pressure (multiple compression) with the NDX until we get through the current period of elevated volatility. A two-three month correction followed by a few weeks of base-building would result in lower valuations and a more positive risk/reward.

The current ‘neutral rate’ is ~4%, which means the Fed is about 100bp ‘behind the curve.’ Since mid-March it’s been apparent that the path to Fed rate cuts ran through weaker labor markets and last Friday’s Jobs Report should start the process. We look for a 50bp cut in September and a 50bp cut in November with 25bp per meeting until the funds rate falls slightly below a declining neutral rate.

Last Friday’s Jobs Report triggered the Sahm recession rule which states that a 3-month average increase in the Unemployment Rate of at least 50bp means a recession has already started. But in a recent press interview, Claudia Sahm (author of the rule) said this time may be different given growth in incomes, resilient consumer spending/corporate capex and unique structural changes to the labor force (immigration). The housing sector tends to be one of the first to weaken at the beginning of a recession, but construction jobs accounted for +25,000 (1-year average of +19,000) of last month’s total payroll growth of +114,000. Homebuilders have also been among the more resilient equity groups over the past few weeks as the coincident decline in mortgage rates could see improved housing demand.