Fear of policy mistakes after mixed earnings and poor economic data

Good Morning. I am on vacation and writing this newsletter from the balcony of my Airbnb with this amazing view of Lauterbrunnen Valley and Staubbach Waterfall :)

Markets continued to drop this week due to mixed earnings from top mega caps and fear of the Fed policy mistake of not cutting rates in this meeting. Especially after poor economic data on unemployment on Friday, which triggered the famous “Sahm rule.” I think the Fed had enough data to confirm that the economy is slowing.

•  McDonald's earnings on Monday, i.e., before the Fed meeting, showed that same-store sales dropped in all divisions. Now, that’s big news as McDonald's serves value-focused consumers, and if that’s scaling back, it’s a big issue as the Fed tries to protect weaker sections of society.

• This blog from former Fed official Claudia Sahm outlines why the Fed should have cut rates this week. I also think the Fed needs to be more proactive. Waiting for the data to confirm everything before you take action will often be too late. A 25bp cut this week would have been more effective. Things might still turn out ok, but delay in rate cuts increases the risk of recession.

• The commentary coming out of the annual Jackson Hole meeting later this month will give hints about the Fed’s thinking.

Market performance for the week: Nasdaq -3.35%, S&P500 -2.06%, Dow30 -2.10%, and Russell2000 -6.82%.

CNN's Fear & Greed Index now stands at 27 (Fear) out of 100, a drop of 18 points from last week.

The top five trending stocks on Reddit are Nvidia, Intel, SPY, AMD, and QQQ.

Here’s what changed in the new Fed statement.

The Fed held short-term interest rates steady but indicated that inflation is approaching its 2% target.

US hiring slowed markedly in July, and the unemployment rate rose to an almost three-year high. The rise in the jobless rate triggered a famous recession indicator known as the “Sahm rule” — which has a perfect track record over the past half-century. Key Stats:

• Total nonfarm payrolls increased by 114,000 versus a downward-revised 179,000 in June.

• The unemployment rate increased to 4.3% from 4.1% in June.

The Nasdaq Composite fell 3.4% this week, bringing its three-week drop to 8.8%, marking the worst stretch of that length since 2022.

Major banks updated their rate cut forecasts. All are calling for earlier, bigger, or more interest-rate cuts.

AI chipmaker Cerebras has confidentially filed for a US IPO. Several high-profile investors, including the Abu Dhabi Growth Fund and Coatue Management, have backed Cerebras.

Intel plunged 25%, the worst day since 1974, as the firm lost out in the AI race.

Billionaire Warren Buffett slashed Berkshire Hathaway’s massive Apple stake. Buffett now has nearly $277 billion in cash, up from a record $189 billion just three months earlier.

McDonald’s earnings and revenue miss estimates as same-store sales declined across every division.

Microsoft reported better-than-expected earnings and revenue for the fiscal fourth quarter. However, Revenue from Azure and other cloud services grew 29% during the quarter. Analysts polled by CNBC and StreetAccount had expected 31% growth. Microsoft’s Azure number hadn’t fallen short of consensus since 2022.

AMD reported second-quarter earnings on Tuesday, beating Wall Street expectations for revenue and showing continued growth in sales of the company’s AI chips.

Apple reported fiscal third-quarter earnings on Thursday that beat Wall Street expectations, with overall revenue rising 5%. Apple’s most important business remains the iPhone, which accounted for about 46% of the company’s total sales during the quarter.

Amazon reported weaker-than-expected revenue for the second quarter on Thursday and issued a disappointing forecast for the current period. In cloud, AWS beat estimates, growing 19% from a year earlier, but the unit is expanding at a slower rate than rivals Microsoft

and Google.

Meta reported second-quarter earnings that beat Wall Street’s expectations and offered better revenue guidance.

MasterCard posted a 14 percent rise in quarterly profit as more people used cards to shop. MasterCard’s worldwide purchase volume increased 10 percent in local currency to $759 billion.

This article from Bloomberg explains how the end of this business cycle is visible from the recent corporate earnings. Key points to note:

• Recent corporate earnings point to a slowdown, not a recession. Consumer spending is slowing down in some places but not all. Rate cuts can prevent this slowdown from turning into a recession.

• Only slowing consumer demand does not lead to recession. Business cycles live and die with capex, so slowing consumer demand just needs to be enough to cause a reaction in capex expenditures. After the Great Financial Crisis, private fixed investments dropped by ~20% as the economy bottomed.

• The big tech companies need to show profit growth emanating from investments in AI. If they can’t, it will trigger the capex pullback.

This article from Trinity Asset Management explains the importance of monitoring credit risk spreads to gauge recession risk. The weakening economic data has led to speculation about a hard landing or, more importantly, recession risk ahead, which could very well happen, but high-yield credit spreads have yet to widen meaningfully, and that’s usually a good indicator of how bad a recession might be looming.

Hard data from Apollo's chart book help us understand that the economy is slowing, but there are no signs of a recession, and a soft landing is still a more probable scenario.

According to estimates from Bloomberg, coupled with quarterly reports, more than 40% of Nvidia’s revenue comes from Microsoft, Meta, Alphabet, and Amazon. The biggest transfer is from Microsoft, with spending accounting for 19% of Nvidia’s revenue. This makes the company its biggest customer by far, nearly doubling Meta’s spend and tripling that of Alphabet and Amazon.

Joachim Klement analyzes why the US landed softly (at least based on the data until now) but not Europe or the UK. The key difference seems to be the type of inflation shock observed by the US vs. others. Klement refers to the SFO FED study, which shows that the financial stress does indeed increase after the Fed fights a one percentage point inflation shock. However, it only increases if supply factors drive the inflation shock. When the inflation shock is driven by excess demand, as it was in 2023, financial stress tends to decline in the aftermath of rate hikes.