Summary: Stocks retreated in August, with the S&P 500 declining by 1.6%, while the Dow and the technology-heavy Nasdaq both lost more than 2%. Despite the generally positive economic data in the US, there have been challenges recently, partly due to the upswing in long-term yields. Also, corporates delivered soft Q2 earnings growth, reflecting a decrease in demand and softening pricing power with persistent margin pressure. We believe the consensus 2024 EPS growth to be too rosy, considering the highly restrictive monetary policy, increasing cost of capital, and diminishing consumer savings. Also, we see headwinds for the tech stocks which may face challenges with the rise in the real US treasury yield and a shift in investment flows away from market capitalization to equally weighted S&P 500 ETFs. Moreover, despite a higher probability of a soft landing in the US, some major economies like China and Germany show further signs of weakening. Given this backdrop, we have maintained a cautious approach to equities. However, we utilized the equity market declines as buying opportunities, increasing our US equity exposure to 52% and our international exposure to 74% during the month.

Valuation

• Valuation metrics for equity remained negative. P/E increased from 22.0 at the end of July to 22.1 at the end of August.
• Forward P/E decreased to 20.7 at the end of August from 21.3 at the end of July.
• Inflation-adjusted valuation metrics continued to be negative.
• Equity valuation metrics relative to bonds remained negative with high bond yields.

Sentiment

• U.S. manufacturing activity contracted for the ninth month, with the ISM manufacturing index edging up 0.4 points to 46.4 in July.
• The University of Michigan Consumer Confidence Index retreated to 69.5 in August, below consensus, with rising gasoline prices and declining equity market weighing on confidence.
• The NAHB index fell from 56 to 50 in August.

Technical

• Technical indicators were positive overall, with positive momentum and fear signals outweighing negative reversal signals.
• The S&P 500 was 8% above its 200-day moving average, 4% above the 100-day average, and 1% above the 50-day average.
• The VIX index spiked above 18 in the middle of the month but settled at 13.6 at the end of the month as the market rebounded.

Macroeconomic

• Nonfarm payrolls rose by 187,000 in July, showing signs of cooling labor market. The four-week moving average of initial jobless claims remained steady at 237,500 as of August 26.
• Retail sales grew 0.7% in July after rising 0.3% in June, supported by a healthy job market and real wages growth.
• U.S. industrial production increased by 1% in July.

Q2 Earnings: The second-quarter earnings results turned out to be better than feared, with the S&P 500's Q2 earnings per share (EPS) experiencing a 4% YOY decline, beating the expected 9% drop at the beginning of the earnings season. Despite this favorable surprise compared with consensus, the Q2 earnings quality remains subpar, as YOY earnings growth remains negative. This situation highlights the risks embedded in the forward consensus EPS estimates, including declining profit margins, persistent inflation, and greater macro uncertainty. Furthermore, we believe that the consensus on profit margins appears too optimistic, given the challenges of companies in passing on higher labor costs to consumers. On one hand, as the goods inflation continued to moderate, the percentage of companies indicating higher prices for their products is currently at its lowest since January 2021, according to NFIB data. On the other hand, despite improved labor supply and moderated demand, companies continue to grapple with elevated labor costs from raising wages to attract and retain employees – at the expense of profit margins.

Growth in China slowing: China's economy displays signs of weakness with declining economic indicators, a struggling real estate sector, and the impact of a weakening global economy. 1) China's July activity data remained lackluster, highlighted by notable negative surprises in key areas such as retail sales (down to 2.5% y/y in July from 3.1% y/y in June), fixed asset investment (decreasing from 4.4% y/y in June to 3.4% y/y in July), and industrial production (falling from 4.4% y/y in June to 3.7% y/y in July). These trends confirm decreasing demand and subdued spending. 2) China's real estate investment has contracted by nearly one-third since its peak in 2021. The sector's decline originated from regulatory mandates imposed on developer debt, liabilities, and liquidity to stabilize the heavily leveraged sector in 2020. A prominent setback recently emerged with real estate developer Country Garden, as its sales deteriorated significantly (down 67% y/y in July), and there are still defaulting risks on their offshore notes. 3) China's export sector is feeling the effects of a decelerating global economy. Outbound trade declined by 14.5% y/y in July, following a 12.4% drop in June. Looking ahead, despite expectations for more easing monetary policy and stimulating measures for the property market, we anticipate long-term growth to fall below consensus given less room for catch-up growth, declining private sector investments, diminishing tailwinds for export, and the persistently challenging demographic and property landscape.

Fed to “proceed carefully”: Federal Reserve Chair Jay Powell addressed the Jackson Hole Economic Symposium, stating that the FOMC will “proceed carefully” in determining whether to hike or hold the policy rate in upcoming meetings. Powell hinted at potential further tightening, considering signs of a strong economy, but also noted uncertainty in the duration of policy lags. He acknowledged progress in curbing inflation from 7% in June 2022 to under 3% a year later and reiterated the Fed’s dedication to lowering inflation to the 2% target. He highlighted that inflation in core services other than housing (a significant portion of core PCE) has remained between 4% and 5% since early 2021, requiring further labor market rebalancing. The market has interpreted Powell’s speech as signaling cautiousness, implying less chance for a September rate hike (14% probability of hike indicated by Fed funds rate futures).