Higher Bar for September Rate Cut

Economic data looks backward while equity markets are looking ahead. Our CIO and Chief U.S.  Equity Strategist Mike Wilson explains why this delays the Federal Reserve in both cutting and hiking rates – and why this is a feature of monetary policy, not a bug.

Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief U.S.  Equity Strategist. Today on the podcast I’ll be discussing why economic data can be counterintuitive for how stocks trade.

It's Monday, August 4th at 11:30am in New York. 

So, let’s get after it.

Since the lows in April, the rally in stocks has been relentless with no tradable pullbacks. I have been steadfastly bullish since early May primarily due to the V-shaped recovery in earnings revisions breadth that began in mid-April. The rebound in earnings revisions has been a function of the positive reflexivity from max bearishness on tariffs, the AI capex cycle bottoming, and the weaker U.S. dollar. Now, cash tax savings from the One Big Beautiful Bill are an additional benefit to cash flow which should drive higher capital spending and M&A.

As usual, stocks have traded ahead of the positive sentiment and the lagging economic data – which leads me to the main point for today.

Weak labor data last week may worry some investors in the short term. But ultimately we see that as just another positive catalyst for stocks. Further deterioration would simply get the Fed to start cutting rates sooner and more aggressively.

The bond market seems to agree and is now pricing a 90 percent chance of a Fed cut in September, and the 2-year Treasury yield is 80 basis points below the fed[eral] funds rate. This spread is not nearly as severe as last summer when it reached 200 basis points. However, it will widen further if next month's labor data is disappointing again.

While weaker economic data could lead to further weakness in equities, the labor data is arguably the most backward-looking data series we follow. It’s also why the Fed tends to be late with rate cuts. Meanwhile, inflation metrics are arguably the second most backward looking data, which explains why the Fed also tends to be late in terms of hiking rates. In my view, it's a feature of monetary policy, not a bug.

Finally, in my opinion, the bond market’s influence is more important than President Trump's public calls for Powell to cut rates.

The equity market understands this dynamic, too—which is why it also gets ahead of the Fed at various stages of the cycle. We noted in our Mid-Year Outlook that April was a very durable low for equities that effectively priced a mild recession. To fully appreciate this view, one must acknowledge that equities were correcting for the 12 months leading up to April with the average stock down close to 30 percent at the lows. More importantly, it also coincided with a major trough in earnings revisions breadth.

In short, Liberation Day marked the end of a significant bear market that began a year earlier. 

Remember, equity markets bottom on bad news and Liberation Day was the last piece of a long string of bad news that formed the bottom for earnings revisions breadth that we have been laser focused on. 

To bring it home, economic data is backward looking, earnings revisions and equity markets are forward looking. April was a major low for stocks that discounted the weak economic data we are seeing now. It was also the trough of the rolling recession that we have been in for the past three years and marked the beginning of a rolling recovery and a new bull market. 

For those who remain skeptical, it’s important to recognize that the unemployment typically rises for 12 months after the equity market bottoms in a recession. Once the growth risk is priced, it’s ultimately a tailwind for margins and stocks, as positive operating leverage arrives and the Fed cuts significantly. 

Based on this morning’s rebound in stocks, it looks like the equity markets agree.  

Thanks for tuning in; I hope you found it informative and useful. Let us know what you think by leaving us a review. And if you find Thoughts on the Market worthwhile, tell a friend or colleague to try it out!

Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income Research and Public Policy Strategy.

Michael Gapen: And I'm Michael Gapen, Chief U.S. Economist.

Michael Zezas: Today  ongoing effects of tariffs on the U.S. economy.

It is Friday, August 1st at 8am in New York.

So, Michael, lots of news over the past couple of weeks about the U.S. making trade agreements with other countries. It's certainly dominated client conversations we've had, as I'm assuming it's probably dominated conversations for you as well.

Michael Gapen: Yeah  certainly a topic that never goes away. It keeps on giving at this point in time. And I guess, Michael, what I would ask you is,  what do you make of the recent deals ? Does it reduce uncertainty in your mind? Does it leave uncertainty elevated?

What’s  your short-term outlook  for trade policy?

Michael Zezas: Yeah, I think it's fair to say that we've reduced the range of potential outcomes in the near term around tariff rates. But we haven't done anything to reduce longer term uncertainties in U.S. trade policy.

So, consider, for example, over the last couple of weeks, we have an agreement with Japan and an agreement with Europe – two pretty substantial trading partners – where it appears, the tariff rate that's going to be applied is something like 15 percent. And when you stack up these deals on one another, it looks like we're going to end up in an average effective tariff rate from the U.S. range of kind of 15 to 20 percent. And if you think back a couple of months, that range was much wider and we were potentially talking about levels in the 25 to 30 percent range.

So, in that sense, investors might have a bit of a respite from the idea of kind of massive uncertainty around trade policy outcomes. However, longer term, these agreements really just are kind of principles that are set out for behavior, and there's lots of trip wires that could create future potential escalations.

So, for example, with the Europe deal, part of the deal is that Europe will commit to purchase a substantial amount of U.S. energy. There's obvious questions as to whether or not the U.S. can actually supply that amidst its own energy needs that are rising substantially over the course of the next year. So, could we end up in a situation where six months to a year from now if those purchases haven't been made – the U.S. sort of presses forward and the administration threatens to re-escalate tariffs again. Really hard to know, but the point is these arrangements have lots of contingencies and other factors that could lead to re-escalation. 

But it's fair to say, at least in the near term, that we're in a landing place that appears to be somewhat smaller in terms of the range of potential outcomes.  Now, I think a question for investors is going to be – how do we assess what the effects of that have been, right? Because is it fair to say that the economic data that we've received so far maybe isn't fully telling the story of the effects that are being felt quite yet.

Michael Gapen: Yeah, I think that's completely right. We've always had the view that it would take several months or more just for tariffs to show up in inflation. And if tariffs primarily act as a tax on the consumer, you have to apply that tax first before economic activity would  moderate.

So, we've long been forecasting that inflation would begin to pick up in June. We saw a little of that. But it would accelerate through the third quarter, kind of peaking around the August-September period. So, I'd say we've seen the first signs of that, Michael, but we need obviously follow through evidence that it's happening. So,  we do expect that in the July, August and September inflation reports, you'll see a lot more evidence of tariffs pushing goods prices higher.

So,  we'll be dissecting all the details of the CPI looking for evidence of direct effects of tariffs, primarily on goods prices, but also some services prices. So, I'd put that down as tthe first marker, and we've seen some,  early evidence on that.

The second then, obviously, is the economy's 70 percent consumption. Tariffs act as a regressive tax on low- and middle-income consumers because non-discretionary purchases are a larger portion  of their consumption bundle and a lot of goods prices are as well. Upper income households tend to spend relatively more money  on leisure and recreation services. So, we would then expect growth in private consumption, primarily led by lower and middle-income spending softening. We think the consumer would slow down. But into the end of the year.Those are the two main markers that I would point to.

Michael Zezas: Got it. So, I, I think this is really important because there's certainly this narrative amongst clients that we talk to that markets may have already moved on from this.  Or investors may have already priced in the effects – or lack thereof – of some of this tariff escalation. Now we're about to get some real evidence from economic data as to whether or not that view and those assumptions are credible.

Michael Gapen: That's right.  Where we were initially on April 2nd after Liberation Day was largely embargo level tariffs. And if those stayed in place, trade volumes and activity and financial market asset values would've collapsed precipitously. And they were for a few weeks, as you know, but then we dialed it back and got out of thatSo, yeah, , we would say it's wrong to conclude that the economy , has absorbed these tariffs already and that they won't have,, a negative effect on economic activity. We think they will just in the base case where tariffs are high, but not too high, it just takes a while for that to happen.

Michael Zezas:  And of course, all of that's kind of core to our multi-asset outlook right now where a slowing economy, even with higher recession probabilities can still support risk assets. But of course, that piece of it is going to be very complicated if the economic data ends up being worse than you suspect.

Now, any evidence you've seen so far? For example, we had a GDP report earlier this week. Any evidence from that data as to where things might go over the next few months?

Michael Gapen: Yeah, well, another data point on trade policy and trade policy uncertainty really causing a lot of volatility in trade flows.

So, if you recall, there's big front running of tariffs in the first quarter. Imports were up about 37 percent on the quarter; that ended in the second quarter, imports were down 30 percent. So net trade was a big drag on growth in the first quarter. It was a big boost to growth in the second. But we think that's largely noise. So, what I would say is we've probably level set import and export volumes now.

 So, do trade volumes from here begin to slow? That's an unresolved question. But certainly, the large volatility in the trade and inventory data in Q1 and Q2 GDP numbers are reflective of everything that you're saying about the risks around trade policy and elevated trade policy uncertainty.

Second, though, I would say, because we started out the quarter with Liberation Day tariffs, the business sector, clearly – in our mind anyway – clearly responded by delaying activity. Equipment spending was only up 4 to 5 percent on the quarter. IP was up about 6 percent. Structures was down 10 percent. So, for all the narrative around AI-related spending, there wasn't a whole lot of spending on data centers and power generation in the second quarter.

So, what you speak to about the need to reduce some trade policy uncertainty, but also your long run trade policy uncertainty remains elevated? I would say we saw evidence in the second quarter that all of that slowed down capital spending activity. Let's see if the One Big Beautiful Bill act can be a catalyst on that front, whether animal spirits can come back. But that's the other thing I would point to is that,  business spending was weak and even though the headline GDP number was 3 percent, that's mainly a trade volatility number. Final sales to domestic purchasers, which includes consumption and business spending, was only up 1.1 percent in the quarter.

So, the economy's moderating; things are cooling. I think trade policy and trade policy uncertainty is a big part of that story.

Michael Zezas: Got it. So maybe this is something of a handoff here  where my team had been really, really focused and investors have been really, really focused on the decision-making process of the U.S. administration around tariffs. And now your team's going to lead us through understanding the actual impacts. And the headline numbers around economic data are important, but probably even more important is the underlying. Is that fair?

Michael Gapen: I think that's fair. I think as we move into the third quarter, like between now and when the Fed meets in, September, again, they'll have a few more inflation reports, a few more employment reports. We're going to learn a lot more than about what the Fed might do. So, I think the activity data and the Fed will now become much more important over the next several months than where we've been the past several months, which is about, has been about announcements around  trade.

Michael Zezas: All right. Well then, we look forward to hearing more from you and your team in the coming months. Well Michael, thanks for taking the time to talk to me.

Michael Gapen: Thanks for having me on.

Michael Zezas: And to our audience, thanks for listening. If you enjoy Thoughts on the Market, please leave us a review and tell your friends about the podcast. We want everyone to listen.