In Short

• Investors witnessed unusual volatility in August, with significant fluctuations in small-cap stocks and a spike in the VIX Volatility Index due to various economic triggers including the weaker-than-expected July jobs report and the unwinding of the Japanese yen carry trade, but markets largely recovered
• Defensive sectors, led by Consumer Staples, Real Estate, Health Care, and Utilities, drove U.S. large cap gains instead of the usual megacaps
• Fed Chair Powell's dovish speech at Jackson Hole indicated a shift in focus from inflation to the labor market with the potential for a September cut which boosted market confidence and led to a rise in equity prices
• September is historically the weakest month for the S&P 500 Index and investors may consider staying fully invested and maintaining long-term strategic allocations while using periods of volatility to deploy excess cash into equities

The Summer Doldrums Strike Back

While old stock adages should not be a main driver when making investment decisions, we believe there are kernels of wisdom in these sayings. “Sell in May and go away” assumes that a decrease in trading volume during the summer months, mostly due to popularity of travel and holidays and often referred to as the “summer doldrums,” will cause markets to either become range bound or to decline. Historical averages show that this insight does not go unfounded as August is generally a relatively flat month for U.S. equities with an average return of 0.7% during the month for the S&P 500 Index since 1928. However, during presidential elections years, August tends to be the strongest month of the year with an average return of 3.1%. These robust returns are typically followed by a more muted, but volatile, September and October, and rounded out by strength to finish the year as election uncertainty dissipates.

This August was marked by a spike in volatility that was uncharacteristic of the rather placid year so far. While every other month was well below long-term averages of realized volatility, August was more volatile compared to both the rest of the year and to long-term monthly averages. A clear example of sharp price action movement was seen in U.S. small caps, which gave back their substantial July gains (+10%) early in the month (down ~9% through August 5th) but later recovered by the end of the month (up ~9% from August 5th to 23rd). Implied volatility was higher too as the VIX Volatility Index hit a level of 65.7 on August 5th – the fourth highest reading of all time. In addition, the twelve most volatile days of the year so far were in August despite April being the only negative month for the S&P 500 Index.

The August 5th spike in volatility was in part due to a weaker-than-expected July jobs report which triggered the “Sahm Rule” – a recession indicator that starts when the three-month moving average of the U.S. employment rate is at least half a percentage point higher than the 12-month low. However, even the rule’s creator is not convinced that we are currently in a recession and believes that there is substantial scope to reduce interest rates. The following business day, a long-standing foreign exchange strategy – the “Japanese yen carry trade” – was rapidly unwound and a global selloff resulted.

In this context, a carry trade occurs when an investor borrows money in a country where interest rates are low and reinvests it in other assets (generally in different geographies) with an expected higher rate of return. The Japanese carry trade had become popular and, in many cases, quite lucrative over recent years because its central bank has kept borrowing rates low. But as the yen’s value rose over the past month and was pushed even higher by the Bank of Japan’s (BoJ) decision to raise interest rates for the second time since March, the biggest carry trade in the world was adversely impacted. In response, the Japanese stock market fell more than -12% in a single session and triggered a global rout. As a result, the BoJ sprang into action, stating it would not hike interest rates during unstable markets, a move which seemed to calm investor nerves.

Following the unwinding of the yen carry trade, markets recovered but not without turbulence. Despite stronger swings, equities moved broadly higher to close the month. Market dynamics that shifted rapidly in July appeared to revert to the year’s broader trends. U.S. large cap stocks, as measured by the S&P 500 Index (+2.4%), outperformed U.S. small-cap stocks as measured by the Russell 2000 Index (-1.5%). However, when looking under the hood, mega cap technology names did not lead the S&P 500 Index higher during the period. Rather it was the more defensive sectors - Consumer Staples, Real Estate, Health Care, and Utilities. Interestingly, the market cap-weighted S&P 500 Index was basically in-line with the equal-weighted S&P 500 Index in August, reflectively newfound broad-based strength across the index.

While domestic equities (S&P 500 Index) are still outperforming developed non-U.S. equities (MSCI ACWI ex-U.S. Index) year-to-date by +8.3%, it is important to note that in July and August, international markets closed the gap by ~1.5%. The only other months of outperformance this year for the sub-asset class were in March and April.

Other Side of the Dual Mandate

Despite lower trading volumes in August, markets seemed to perk up as the disinflation trend continued, labor market data held relatively steady, and Q2 growth proved stronger-than-expected. Bolstering these datapoints, Federal Reserve (Fed) Chairman Jerome Powell’s dovish speech out of Jackson Hole gave investors further confidence that interest rate cuts were imminent. He stated: “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” Markets reacted accordingly, as Treasury yields dipped and equities soared (led by cyclical stocks, which are more tied to the strength of the economy). In our view, there was a marked shift in the rhetoric of the Fed’s focus from inflation settling closer to the 2% target to fear of the downside risk of the labor market cooling too significantly. This change in their attention and the recalibration of expectations as a result is evident in the movement of the 10-Year U.S. Treasury Yield, which came down from a peak of 4.7% in April to 3.9% at the end of August; it has since moved even lower, to 3.7%, in the early days of September.

Following Powell’s speech, July’s personal consumption expenditure (PCE), the Fed’s preferred inflation gauge, was generally in-line with expectations, consumer confidence posted a six-month high, and Nvidia – the second-largest company in the S&P 500 Index as of the end of August – posted a Q2 beat and raise. Interestingly, despite the strong results, Nvidia’s stock struggled following the earnings call. We believe this could serve as proof that megacap technology stocks are facing higher hurdles after consistent strong performance. Meanwhile, resilient earnings from some of the “big box” retailers helped boost investor optimism that consumers are faring better in the face of higher interest rates than consensus expectations would indicate.

So where does that leave the Fed? If a September rate cut comes to fruition, it would imply a 14-month gap between the last rate hike in July 2023 to the first rate cut, which is significantly longer than the historical nine-month average. However, there are some risks to consider as the Fed contemplates an interest rate cut during its September 18th meeting. As each day passes under the Fed’s restrictive policy, we believe any perceived recession risks could be weighed heavily by the markets. The “bad news is good news” reaction function we experienced in the first half of the year, which implied that weaker data would bring the U.S. closer to rate cuts, has seemingly shifted to a “bad news is bad news” dynamic, as disappointing data could disrupt the soft-landing consensus view and may even derail a cyclical rally.

We are seeing signs of these new dynamics in recent weeks. The August ISM Manufacturing index missed expectations, contracting for the fifth consecutive month, with the new orders component at its lowest level since May 2023, showing signs of weaker demand amid higher interest rates and election uncertainty. Leading up to August jobs data, the Bureau of Labor Statistics (BLS) performed its preliminary annual revisions to nonfarm payroll numbers, which showed jobs created revised downwards by 818,000, its largest negative adjustment since 2009.

August’s non-farm payrolls indicated that the U.S. economy added +142k jobs in the month – once again below the consensus of +165k. Admittedly, there were indications over recent weeks that the risk was for a lighter print as ADP private payrolls and the ISM Manufacturing PMI survey pointed to a weaker level of hiring. Looking at the full picture, we believe that the slowdown in hiring is not a cause for fear, but rather an indication of the normalization that it is necessary to achieve the soft landing scenario so desperately desired and now widely expected. Cracks in consumer confidence and spending have appeared, but with wages pacing ahead of inflation, the sharp decline in the savings rate could stabilize along with CPI. The availability of full-time employment has historically been the driver of consumer confidence and we do not see enough signs today of the level of contraction necessary to hinder consumer spending to the magnitude that would be required to tip the U.S. economy into recession in the next few quarters.

Looking ahead to the remainder of the year, September is historically the seasonally weakest month for the index with a 10-year average return of -2.3% for the S&P 500 Index. This is in part why “sell in May and go away” suggests to re-invest in the fall. Timing the market is a concept that has proven to be extremely difficult for even the most experienced investors and investors may consider staying fully invested rather than trying to exit and enter opportunistically throughout the year. Historically, realized volatility ramps up in October and November. As a result, investors may also consider remaining at-target to long-term strategic allocations across asset classes while using excess cash to extend duration ahead of expected rate cuts which we believe will likely lead to a further decrease in yields. Periods of volatility may also serve as prudent opportunities to deploy into equities which have had an exceptional run through the first eight months of the year.

Portfolio Implications

Equities moved higher but domestically oriented small caps were negative. Notably, developed market equities outperformed the U.S. We maintain an at-target overall view across equities with an overweight to small caps, a sector that had priced in a hard-landing scenario as we anticipate further broadening of equity-market performance. Within equities, we still favor lower-beta, higher-quality names with an at-target view on value versus growth. In this more challenging environment, we also favor employing active management to select companies with high earnings visibility.

Fixed Income was broadly higher as short-term yields dropped following all-but-confirmed interest rate cuts commencing in September. We continue to favor credit markets, maintaining an overweight view on investment grade securities, reflecting a general bias towards quality. We maintain an underweight outlook on cash, preferring to lock in yields in anticipation of a decline in cash rates. We maintain an at-target view on high yield debt given the recent tightening of spreads (yield advantage over Treasuries) which has reduced the risk-adjusted return potential of the asset class.

In a challenged fundraising, exit, and financing environment, we believe significant opportunities exist within Private Markets for firms and strategies that can act as liquidity and solutions providers to help close the capital supply/demand gap and support value-added transactions. This backdrop, along with Neuberger Berman’s deep relationships and unique position within the private equity ecosystem, has translated into record levels of deal flow across our platform. We continue to see potentially compelling opportunities across secondaries, co-investments, private credit, and capital solutions. We are cautious on core private real estate but this is offset by what we see as abundant market-dislocation opportunities in the value-add and opportunistic sectors and particularly in real estate secondaries.

Index Returns as of August 2024

Source: Bloomberg, total returns as of August 30, 2024. S&P 500 Index is represented by S&P 500 Total Return Index. Nasdaq Composite NASDAQ-Composite Total Return Index. Dow Jones is represented by Dow Jones Industrial Average TR. Large Cap is represented by Russell 1000 Total Return Index. Mid Cap is represented by Russell Midcap Index Total Return. Small Cap is represented by Russell 2000 Total Return Index. All Cap is represented by Russell 3000 Total Return Index. Large Cap Growth is represented by Russell 1000 Growth Total Return. Large Cap Value is represented by Russell 1000 Value Index Total Return. Small Cap Growth is represented by Russell 2000 Growth Total Return. Small Cap Value is represented by Russell 2000 Value Total Return. ACWI is represented by MSCI ACWI Net Total Return USD Index. ACWI ex US is represented by MSCI ACWI ex USA Net Total Return USD Index. DM Non-U.S. Equities is represented by MSCI Daily TR Gross EAFE USD. EM Equities is represented by MSCI Daily TR Gross EM USD. Cash is represented by ICE BofA US 3-Month Treasury Bill Index. U.S. Aggregate is represented by Bloomberg US Agg Total Return Value Unhedged USD. Munis is represented by Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD. Munis Short Duration is represented by Bloomberg Municipal Bond: Muni Short (1-5) Total Return Unhedged USD. Munis Intermediate Duration is represented by Bloomberg Municipal Bond: Muni Intermediate (5-10) TR Unhedged USD. Investment Grade is represented by Bloomberg US Corporate Total Return Value Unhedged USD. High Yield is represented by Bloomberg US High Yield BB/B 2% Issuer Cap Total Return Index Value Unhedged USD. Short Duration is represented by Bloomberg US Agg 1-3 Year Total Return Value Unhedged USD. Long Duration is represented by Bloomberg US Agg 10+ Year Total Return Value Unhedged USD. Global Aggregate is represented by Bloomberg Global-Aggregate Total Return Index Value Unhedged USD. EMD Corporates is represented by J.P. Morgan Corporate EMBI Diversified Composite Index Level. EMD Sovereigns – USD is represented by J.P. Morgan EMBI Global Diversified Composite. Commodities is represented by Bloomberg Commodity Index Total Return. Commodities ex Energy is represented by Bloomberg Ex-Energy Subindex Total Return. U.S. 10-Year Yield is represented by US Generic Govt 10 Yr.