Markets Stage a Comeback to Record Best Week of 2024

• Good Afternoon. Markets staged a comeback this week after last week’s slum to record the best week in 2024, aided by macro data mostly in line with expectations. Now, all eyes are on next week's Fed decision, which will start the new rate cut cycle.

• For the week:

  • The S&P 500 is up 4.02%, the Nasdaq is up 5.95%, and the Dow 30 is up 2.60%.

    

    Source - Barchart

• CNN's Fear & Greed Index moved from Fear to Neutral and now stands at 49 out of 100, a gain of 10 points from last week. Details here

• The top five trending stocks on Reddit are SPY, Nvidia, AST Spacemobiel, QQQ, and Boeing. Read More

• Today marks the 16th anniversary of Lehman Brothers' collapse, a pivotal moment in the 2008 financial crisis.

• A summary of this week’s key economic releases is below:

  

  
  

  

  Source - FT

  • The core CPI, i.e., the Consumer Price Index excluding volatile food and energy, was up 0.3% from last month. This is slightly above the 0.2% consensus forecast. I think the slight pick-up in core CPI increases the possibility of a 25bp rate cut next week (instead of 50bp).

    • Most importantly, the airline fares index rose 3.9 % in August after declining in the previous five months.

  • Month-over-month CPI was flat (0.2%) and in line with the expectations.

  • Year over year, CPI dropped to 2.5% from last month’s 2.9% and aligned with the expectations. This is the lowest reading since early 2021.

  • The Producer Price Index (PPI) and Core Producer Price Index came slightly above forecasts.

• It is interesting to note that the target rate probabilities for the September 18th Fed meeting have increased sharply in a day:

  

  Source - CME FedWatch

• Federal Reserve announced significant revisions to proposed bank capital rules, halving the expected impact on large banks and exempting smaller lenders from most changes. Read More

• US households' inflation-adjusted incomes rose by 4% to $80,610 in 2023, marking the first increase since 2019, but they have not fully recovered to pre-pandemic levels. Read More

  

  Source: US Census Bureau, Bloomberg

• Mortgage rates hit the lowest level since February 2023. The average interest rate for 30-year fixed-rate mortgages decreased to 6.29% from 6.43%. Read More

• Boeing workers have gone on strike after overwhelmingly rejecting a tentative deal with a 25% pay rise. 95% voted against the contract, and 96% authorized the strike, marking the company's first strike in 16 years. Read More

• Global ETF inflows are on pace to cross previous records. Net inflows for the first eight months of the year now stand at $969bn, comfortably ahead of the $848bn at this stage in 2021, when the record full-year totaled $1.3tn. Read More

• Oracle reported solid fiscal first-quarter results, surpassing Wall Street expectations. Oracle announced that its database software would be available on Google Cloud. Oracle also revealed a partnership with Amazon Web Services (AWS), allowing Oracle's database services to run on dedicated hardware within AWS. Read More

• Adobe reported strong third-quarter results for 2024, exceeding Wall Street expectations; however, its fourth-quarter outlook fell short of market expectations. Read More

• Basel III endgame:

  In a major win for the banks, regulators slashed the capital requirements from 19% (for G-SIBs) to 9%. Below are the key points from Vice Chair Barr’s speech and conversation at Brookings Institution:

  • CET 1 Impact: The reproposal will increase common equity tier 1 capital requirements for the G-SIBs, the largest and most complex banks, by 9 %. For other large banks, the impact will mainly result from including unrealized gains and losses on their securities in regulatory capital, estimated to be equivalent to 3 to 4%. The remainder of the re-proposal would increase capital requirements for non-GSIB firms still subject to the rule by 0.5%.

  • Banks with assets between $100 and $250 bn would no longer be subject to the Basel III endgame changes, other than the requirement to recognize unrealized gains and losses of their securities in regulatory capital. This requirement will address the issue primarily blamed for Silicon Valley Bank's collapse.

  • Reproposal lowers capital requirements for credit and operational risk, mainly for mortgages and credit card exposures. The overwhelming increase in the capital requirements for the G-SIBs will be for market risk, i.e., trading activity.
    

    In addition to the above changes, below crucial points are noted from his Q&A:

  • Discount Window: In addition to this re-proposal, Michael Barr confirmed that a new regulatory proposal will soon cover discount window preparedness and assumptions about deposit behavior to ensure banks can use the liquidity sources they rely on.

  • FBOs: Barr doesn’t anticipate the re-proposal having a material impact on foreign banking organizations. Special data collection (included in last year’s proposal) proved that FRB overestimated its impact on FBOs.

  • Regulators are closely monitoring the heterogeneous risks in the commercial real estate market.
    
    

    Michael Barr mentioned that when they worked on the initial proposal last year, the banking stress (March 2023) was fresh in their minds, as we had three of the largest banking failures in US history, and hence, they were quite conservative. Check out my detailed blog from last year, which explains the collapse of Silicon Valley Bank in March 2023.
    
    

• S&P’s New Index-Cap Rules:

  XLK is an ETF that tracks the S&P Technology Select Sector. Below is the breakup of the top 3 holdings of XLK vs. the index it’s tracking:

If you notice, XLK holds far less Apple stock than the index. XLK’s tracking error is 11.07%, compared to 0.02% for the leading ETF SPY.

• This is due to the regulatory requirement referred to as 25/5/50. This rule prevents any single stock from making up more than 25% of a portfolio. Furthermore, the combined weight of the largest holdings — those representing 5% or more of the index — cannot exceed 50%. These rules are designed to protect investors from concentration.

• As per the current S&P capping methodology to meet these requirements, the smaller component was first capped at 5% to stay under the 50% limit. So in the above example, when the index was rebalanced last time, Apple was the lowest in proportion in the index, and hence, it was capped at 5%, and the other two stocks, i.e., Microsoft and Nvidia we in line with the index proportion. This led to underperformance for the XLK as the Apple stock rallied since then, but XLK had lesser exposure to it. This issue caused XLK to underperform its index in the first half of this year also as it had lesser exposure to Nvidia:

  

  Source: Bloomberg

• New Changes: The changes going into effect on September 20th will not cap the smallest component to meet the 50% cap requirement, but all the top holdings above 5% will be adjusted in their proportion. Below, I calculated what the XLF allocation would look like for the top 3 holdings after reducing 13.3% overexposure above the 50% reg limit.

  

• In this case, when the XLF rebalances next time, it will have to sell Microsoft and Nvidia and buy Apple. The new allocation will significantly reduce tracking errors. Read More