Equities: All Eyes on the Fed

Political pressure, changing personnel and a complex mix of macroeconomic data in recent weeks have renewed the focus on the Federal Reserve and its policy direction. Compared to the bond markets, equity markets seem to be taking these developments in stride.

The past few weeks have been captivating for Federal Reserve watchers. The resignation of board governor Adriana Kugler and temporary replacement by President Trump appointee Stephen Miran has coincided with the emergence of an expanding list of possible successors to chair Jay Powell and the release of a swath of policy-influencing macroeconomic data.

Taken together, this has renewed the focus on the Fed and future policy direction, which the market still currently expects to head lower even though the path is being made more complex by a mix of positive and negative employment and inflation prints.

The hot Producer Price Index data—showing wholesale inflation rising 0.9% from a month earlier and 3.3% from a year ago—provided a fresh example last week, overshadowing the earlier broadly benign Consumer Price Index data and unsettling the U.S. equity and bond markets.

After equities had rallied to fresh highs earlier in the week on the CPI data (core CPI year-over-year was in line with expectations at 3.1% in July) and expectations the Fed would cut rates in September, the PPI print halted the march higher and in parallel pushed up Treasury yields, especially at the short end.

As a result of last week’s data—including broadly resilient July retail sales reported on Friday—the market is still pricing in a rate cut next month. It’s just no longer fully pricing in a quarter-point cut, as it did at the start of the week.

Such a reaction to the PPI data broadly reflects two views: equity investors see the threat inflation poses to their bet of a soft landing and a more accommodative policy environment, while bond investors see a longer period of above-target inflation, higher economic growth prospects and continued deficit concerns.

Small Cap Signal

A more accurate reading of what the equity and bond markets are signalling is complicated. Combined with multiple exogenous factors influencing the shape of the yield curve, bond investors are clearly preoccupied by the impact of sticky inflation and any weakening in the labor market on monetary easing.

Yet many equity investors are instead more focused on the Fed and continued easing, which would accelerate business and consumer investment, and, through lower financing costs, support smaller companies, especially those in more interest-rate sensitive cyclical industries.

The move higher in the Russell 2000 small cap index in recent weeks—extending a stronger performance overall and especially lower-quality parts of the market over the past few months—gives some support to this, indicating investors are beginning to price in a more accommodative monetary environment as the U.S. economy potentially begins to accelerate out of the current slowdown.

When that may happen is uncertain, but we believe that muted economic growth in the next few quarters is unlikely to approach recessionary levels, and that the economy will continue to demonstrate resilience, particularly to the impact of tariffs and the extent they are being absorbed by companies and consumers.

Further fortifying this resilience and boosting the prospects for growth over the medium term is the administration’s deregulation drive and the passing of the U.S. tax and spending bill. As well as helping to bolster disposable income and sustaining consumer demand, the bill will more significantly benefit small and medium-sized companies by introducing several pro-growth measures aimed at stimulating innovation, investment and domestic production.

Risks to Easing Remain

Looking ahead, the focus now turns to three more major data releases—July Personal Consumption Expenditures, August CPI and August non-farm payrolls—in the coming days as well as the Jackson Hole symposium.

Much of the focus will likely fall on the August jobs report, but the relative strength or weakness of the overall economy will also be a driving factor in the Fed’s messaging coming into and out of Jackson Hole and the September meeting.

In our view, there is likely little to disrupt the near-term path to lower rates, but any evidence showing that services prices are reversing their downward trend could jeopardize rate cuts slated for 2026 and keep the Fed above the 3.5% mark moving into middle of next year.

In addition, evidence of continued political pressure on the Fed could also push yields higher and disrupt efforts to effect more accommodative policy.

History tells us that August and September can bring market volatility, and to some extent we are already seeing this. However, looking through these periods, our medium-term outlook remains constructive.

What’s more, we believe the combination of lower rates to come, deregulation and the pro-growth measures of the tax and spending bill continue to create an attractive case for small and mid-caps, which is why the Asset Allocation Committee is overweight the sector.