Global Stock Markets
For some time now, the majority of market participants have been preparing for a soft landing scenario. An environment where the US experiences sub-trend growth, while inflation should get too near the FED’s target of 2%. In line with this expectation, the US economy is slowing. GDP growth in the first quarter decelerated to 1.4% from 3.9% in Q4, on an annualised basis.
While the unemployment rate is ticking higher, up from 3.4% to 4.1% compared to last year. Against this backdrop, the US stock market has kept its strong posture from the fourth quarter.
Only in April, when a string of reports had shown higher-than-expected inflation data, stocks experienced a pullback, resulting in the only down month since last October.
Technology stocks continued to lead the market amid ongoing enthusiasm around Artificial Intelligence. The spectacular performance of the mega cap tech stocks has pushed benchmarks to record highs, but market breadth has remained weak.
The largest six stocks have contributed two-thirds of the S&P500’s 15% return this year. Nvidia has been particularly outstanding. It alone has contributed 300bp of the 12% return in the MSCI world, which consists of 1’500 of the world’s largest stocks.
Although many warn about this concentrated leadership, a narrow market per se is not an indication of negative future returns. However, it is clear that large stocks with substantial index weightings can significantly influence the overall performance of an index and lead to potential overvaluation, as their market movements often disproportionately impact the index’s value.
From that perspective, not everything can be reduced to the narrative surrounding the hype around AI. As we have discussed in previous editions, the proliferation of passive investment strategies has led to some distortion in the forward-looking information in equity and credit markets.
The significantly increased options trading volume has further impacted how market dynamics and risk assessments have evolved. The hugely increased use of options and the rise of passive investing have led to a sea change in the investment framework.
Global passive equity funds’ net asses surpassed those of their active counterparts already in 2023. While pessimism sells, but optimism pays, pragmatism should be factored into the equation. It is important to understand the changing market configuration.
As the macroeconomic cycle will pursue its course, political uncertainty has increased. The main central banks have signalled that they are ‘data dependent’, so will have to be all market participants. A soft landing remains our central scenario for the US economy.
Incoming economic data will be watched. Three risks have to be considered. First, the geopolitical situation remains uncertain in the Middle East, Ukraine and Taiwan. The upcoming US Presidential Elections add another layer, while European politics have increased the risk premium in Europe.
Global Fixed Income Markets
Bond markets started the second quarter with the same weak posture. At the end of April, the US 2-year yield traded above 5%, while the US 10-year yield was above 4.7%.
As incoming economic data was pointing at weaker consumption, falling inflation and contradictory labour market figures, yields have been drifting lower since. Since the start of the year, the bond market has been continually converging with the FED’s interest rate expectations.
At the start of the year, the market had a total of 150bps of easing priced in. It had expressed near certainty that the FED would start cutting rates as early as in March. In March, the FED only confirmed its easing bias, reiterating three cuts to be expected.
At the May 1st meeting, the FED cited a lack of further progress toward the 2% goal. FED Chair Powell stated then that gaining confidence to cut would take longer than thought.
At the June meeting, the FED’s median forecast was reduced to just one 25bps cut for 2024. The ECB delivered a 25bps cut it had signalled in March, cutting the Main Refinancing Rate to 4.25%.
The Swiss National Bank, after surprisingly becoming the first developed country to cut rates, followed by another cut in June. It set the policy rate at 1.25%.
Interestingly, June was the first month in four years that no central bank hiked rates. The Bank of Japan ended its Negative Interest Rate Policy in March, which lasted for eight years. Yet, continued not to specify future steps of this long normalisation, despite the Japanese Yen having fallen to the lowest level since 1990.
Slowly declining inflation and the US economy’s ability to grow despite high real interest rates make for a favourable environment for investment-grade bonds. Monetary easing hopes are alive.
Credit markets have been doing well for some time now. However, spreads between junk bond yields and investment-grade counterparts are tight. The compensation for yield on bonds with ‘high’ risk compared to ‘moderate’ risk has not been of concern. It’s a segment that needs to be observed.
For now, things are ok, as incoming economic data seem to confirm the soft landing scenario. In terms of tight spreads, credit markets are in bubbly territory, currently only 200bp between junk and BBB. That compares to 700bp during the pandemic lockdown and more than 1300bp during the GFC.
It’s like with volatility, which can stay low for a very long time. Yet, ultimately, low volatility precedes periods of high volatility. Tight credit spreads precede periods of wider spreads. It’s just not possible to perfectly time the impending shift.
US Dollar
The Dollar remains the name of the game. That may sound trite, but it remains central to the capital markets. With the prospect of rate cuts in the US, many see the Dollar to soften somewhat. Yet, interest rate differentials are not the only driver in FX.
Particular focus in Q2 was on the Japanese Yen’s weakness, which is weighing on other Asian currencies. The Chinese Yuan and the Korean Won, have both weakened near their central banks’ possible red lines, at CNY 7.30 and KRW 1400.
According to Bloomberg, the Dollar’s share of payments via SWIFT increased to 47.5% from 41.8% in 2023. Euro’s dropped to 23.4% from 36.3%, Yuan increased to 4.1% from 2.1%.
Commodities
US shale oil production has grown significantly over the last +10 years. US shales met more than 100% of global demand growth. It has been the key source of non-OPEC growth. However, question marks arose on how sustainable US production growth will be.
While oil markets have been broadly balanced over the last year, upcoming reports on US production will need to be looked at closely. The US Energy Information Administration reported in June that it expected US crude oil production to grow by 2% in 2024 and by another 4% in 2025.
At the same time, OPEC+ agreed to extend the cuts of 3.66 million barrels per day (BPD) by a year until the end of 2025. The voluntary cuts of 2.2 million BPD will be prolonged until the end of September 2024 and then gradually phased out over the course of a year.
Crude oil’s narrowing range since September last year needs to be monitored. The Bloomberg Commodity Spot Index is up around 6 per cent in the first half of 2024, with only the agriculture subindex trading down on the year so far.
Copper surged to new all-time highs in May as demand is driven by its pivotal role in the energy transition. Market dynamics and global supply concerns have also propelled prices.
Gold has moved to new all-time highs as well, reaching $2’450 in May. While Silver is up 30% since the start of the year. We wrote in our previous reports that Gold, as primarily a store of value and safe haven for many, could well see an interesting 2024, as it was pushing against the $2,000 level for the fourth time last December.
Central banks have been notable buyers of Gold, which has surpassed the Euro to be the top reserve currency, behind the Dollar. While the data from the largest Gold-ETFs still show, that investors have a significantly lower exposure to Gold than during the previous three times Gold had pushed against $2,000.
We keep the recommended tactical allocation in commodities at neutral, but we are overweight on precious metals.
Macro
Market-based inflation expectations have stayed closer to 2% for the most part since the beginning of 2021. The expected disinflationary forces have been playing out. This trend should continue in Q3.
US headline inflation data and the FED’s favourite measure, PCE, have slowed significantly from their 2022 peaks. Global economic growth slowed in June, while business expectations for the year ahead are reported to have fallen, linked to rising political uncertainty.
The headline JPMorgan Global PMI, covering manufacturing and services in +40 economies, fell from 53.7 in May to 52.9. The soft landing scenario prevails, as the macroeconomic outlook seems clearer. Yet, the risks of an economic slowdown later in 2024 haven’t entirely gone away.
The surveys of new orders from the various Fed districts still show on aggregate a negative reading. It’s important to remain adaptable to changing economic conditions. We wrote before, that fiscal policy is threatening monetary policy. The debate about fiscal dominance, where budget deficits overpower central banks’ efforts to reign inflation, will intensify at one point.
The FED has moved on to the tightening cycle by letting maturing bonds slip off its balance sheet. The Treasury Department, on the other hand, to finance the fiscal deficit of 7.5%, had offset the quantitative tightening by increasing the share of total issuance for Treasury Bills beyond the norm.
However, that has normalised in the second quarter. Recent data suggests data global liquidity has increased in early 2024. Funding liquidity and market liquidity seemed, however, to have turned lower lately. While the MOVE index, a measure of US bond market volatility, has moved to 100 in June, above the traditional norms of around 70.
A higher MOVE influences the efficacy of the collateral pool. The government debt to GDP for the US stands at 120%, for the Eurozone at 112%. In Japan it’s above 200%. These high levels of government debt raise concerns about their long-term sustainability and potential impact on economic growth. It highlights the darkening fiscal outlook and the governance challenges.
There is no political will to deal with the drivers of the deficit, as that would come with economic costs. For the developed markets it is rather unique, they are less used to an environment of fiscal dominance.
The impact from increased government’s share show, that over the last two decades, real GDP per capita has been declining. Today, the net national saving is negative. Something that happened only during GFC and the 1930s.
Tactical Allocation
The inflationary forces are structural and secular, on higher debt-load, demographics and on-shoring of manufacturing. We are currently in an interim period.
In our Q4 report, we correctly anticipated that central banks were at the end of the hiking cycle. Yet, the FED wasn’t forced to act so far, as the economy proved resilient. The picture has now changed. The market expects the FED to cut in September and to deliver a second cut by the end of the Year.
We keep our overweight allocation in fixed income. Judged by the reference US 10yr yield, we see the potential for a tactical rally in bonds. We wouldn’t be surprised to see the 10-year yield back at 4%.
We stay neutral on high yields and keep our preference for investment grade. Selectivity and diversification are key. We are mindful of the developments in the commodities.
S&P500 & Volatility
A soft landing is the desirable outcome. But sometimes one should be careful, when an overwhelming majority expects the same. However, as things stand, we don’t see the macroeconomic situation to be changed a lot in the third quarter.
Expectations for the upcoming US Q2 earnings season call for 8-9% earnings growth year-over-year. Potentially marking the highest rate since Q1 2022. Revenue is seen to have grown to 4.5% YoY.
On the other hand, 60% of S&P500 companies issued negative earnings per share guidance for Q2. These are the key figures that need to be monitored. Volatility measures have started to diverge from the trend in stocks.
What could be an early indication, that the markets could experience a technical pull back. We favour a neutral allocation in equities. We are overweight on US, neutral on Europe and China, and underweight on Japan. While there is no historical analogy to the current environment, we focus on high quality and diversification remains key.
Allocation Recommendations
Disclaimer
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