With the markets still focused on what the Fed could do over the next 12 months, the real focus should be on volatility. The VIX just touched its highest level since August and the MOVE index, which measures bond market volatility, is at its highest level since January. There’s no shortage of catalysts to feed into why volatility is moving higher. The Iran/Israel conflict is the latest geopolitical risk coming out of the Middle East that threatens to disrupt the energy markets and pull the region into a broader war. China and Europe appear to be engaging in the early stages of a tariff war, which is almost always an economic downer. And that’s not to mention the potential outcome of the November election here in the United States, which could see Trump levying punitive tariffs on China and other exporters that almost certainly derail any soft landing discussion.
I’ve pointed out several times recently that the utilities sector is the one real outlier in this market. While cyclicals took the initial lead at the onset of the Fed’s rate cutting cycle before trading leadership with growthier areas of the market, utilities have been a near-steady outperformer throughout the cycle. It’s still the best-performing sector of 2024, which usually doesn’t happen in an environment where GDP growth is healthy, inflation is lower, the labor market is holding steady and the Fed is cutting interest rates. That’s why I think it’s important not to overlook the strength in this sector and in gold right now. Yes, the U.S. economy looks like it’s in a good place right now, but there are several roadblocks ahead over the next month or so that could quickly flip things upside down.
It’s impossible though to ignore the Fed’s impact on the direction of risk asset prices over the next 12 months and beyond. Judging by the latest Fed Dot Plot (which shouldn’t be taken too seriously), Powell and company clearly have the intention of taking the Fed Funds rate down to around 3%. Last week’s jobs report may have tapped the brakes on those plans a little bit in the short-term (the futures market is now pricing in a roll-of-the-dice chance of no cut at all in November), but it’s unlikely to have derailed any long-term plans. That would probably require a significant slowdown in the labor market or a meaningful uptick in inflation. But I don’t think there’s any question that a big part of the positive sentiment that’s built into the equity markets right now is due to the belief that the Fed is going to keep easing. If that changes due to any of the risks laid out above, this current run for the S&P 500 could quickly end.
The Bank of Japan might have found an ally in new economy minister Akazawa. This week, he said that he trusts the central bank to set monetary policy levels appropriately according to current financial conditions. In effect, he’s backing the BoJ’s preference to raise interest rates from here in order to combat an increasing inflation problem. That stands in contrast, however, to the broader government’s preference for looser monetary policy to support an economic recovery. It’s this kind of internal conflict, in my opinion, that makes the path of Japan so unclear. Governor Ueda came out in favor of tightening just a month or two ago only to quickly take a more neutral position after meeting with the nation’s parliament. Overall, I think we’re still looking at an outcome where the BoJ continues to slowly lift rates and tighten conditions, but does so at a very measured pace. Rate hikes have a very lagged effect, so I don’t believe there’s any imminent negative impact to growth. Getting inflation under control would likely prevent a deeper potential recession down the road and let’s not forget that the yen has strengthened considerably throughout this process. That was a primary goal of the BoJ just a few months ago.
Trade wars are likely to become more prominent in the global narrative over the next few months.
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