The market is always right

Chief Investment Officer's team

17 July 2023

AT A GLANCE

Last week was spectacularly positive across all asset-classes, celebrating a slide in inflation
This is good news, confirming the “Goldilocks Interlude”, but not a massive game changer
Our TAA is thriving, and our slightly defensive positioning is unchanged in July

After the best first half of a year since 2000 for US stocks, last week could also be remembered for its celebration of a slide in core inflation. Stocks gained almost 5% in emerging markets and 3% in developed ones, bonds added 2% on average across segments with yields tumbling in a bull flattening pattern, and alternatives were also all positive. A spectacular week.

There are, indeed, very good news: the slide in inflation is broad based, from headline to core, from goods to services, and across regions. US numbers released on Wednesday were the catalyst, with headline CPI now less painful at 3% year-on-year, and core at 4.8%, better than the median forecast of 5%. Is it a game changer? Not necessarily. Inflation in the West remains way too high for central banks, and the positive trend of June will encourage them to keep the pressure until mission is accomplished. The “Goldilocks Interlude” that we have identified is still on, but the next concern will be growth, especially in the West. We therefore keep our overweight on quality bonds, as well as a preference for emerging markets within our slightly underweight allocation to equities. Looking East, China’s Q2 GDP growth as well as June retail sales were below expectations, confirming that the recovery is fading, even if June industrial production was a good surprise. Patience is required there, as it looks like the authorities are favoring gradual and targeted policy steps rather than the massive, coordinated stimulus plans that many market participants are expecting.

The week ahead will be all about Q2 corporate earnings, but will also provide big-picture insights: US retail sales and industrial production, inflation and consumer confidence in Europe, and a G20 Finance Ministers and Central Banks meeting in India. Have a great week.

The market is always right

Cross-asset Update

The very benign CPI report followed by a disinflationary PPI print in the United States has reinforced the outlook for a continuation of the Goldilocks scenario, whereby growth remains resilient, and inflation is falling. And the Fed’s Beige Book, a nationwide survey of the state of the US economy painting the picture of cooling activity, was yet again a confirmation of easing price pressures combined with still decent growth. Overall, there is reason to believe that markets can grind higher, while yields should eventually fall alongside inflation.

Indeed, short term macro signals are not that underwhelming. The new-orders-to-inventory ratio of the US manufacturing index, the most leading component of business confidence, has been rebounding for a few months now, suggesting a temporary pick-up in economic activity. Also, the Chinese credit impulse, that tends to lead the global business cycle by 3-4 quarters (it stated to rise in late 2021) and measures how fast credit grows versus the economy, has been rebounding as well, however feebly. In short, the impression is that animal spirits could be further heightened by positive macroeconomic surprises, hence the growth slump most were expecting, including ourselves, is being pushed further out, though not outright denied for reasons explained below. If this is indeed the case, the most cyclical pockets of the equity market should catch up with the technology sector that has had an impressive run, while credit spreads are likely to remain tight. The weakening of the dollar is also helping on two fronts. Financial conditions outside of the United States are being loosened, in particular in the emerging countries, while US exports are going to be more competitive.

Yet, we hold the view this improvement should not be extrapolated way too far in the future, as two main pillars of the recovery, loose financial conditions, and excess consumer savings, will not be able to help for much longer. According to most projections excess savings accumulated post-pandemic and in 2021 should be fully depleted at latest by 4Q24, negatively impacting demand. And the real Fed funds rate, the policy rate deflated by real PCE inflation, is now well in restrictive territory at levels last seen in late 2018, when markets cracked under the weight of excessively tight financial conditions. Considering that the Fed is going to hike once more in July, we hold the view that it is only a matter of time before the cumulative effects of the tightening weigh on the economy and markets.

Overall, investors can enjoy the Goldilocks interlude for longer, mindful that enthusiasm should be termed by year-end.

The market is always right

Fixed Income Update

The June CPI release surprised with lower-than-expected numbers. Headline CPI rose 0.2% MoM and 3.0% YoY, slightly below consensus expectations for a 3.1% increase. Core CPI decelerated to 0.2% MoM and 4.8% YoY versus expectations for a 0.3% MoM increase and 5.0% YoY increase. Following the CPI numbers, both the 2-year and the 10-year yield shed more than 15bps and 20bps, respectively during the week. The downward surprise in CPI, along with other positive macro indicators such as lower-than-expected nonfarm payrolls, job openings, and higher initial jobless claims, contributed to the decline in yields. However, despite these factors, the hawkish comments from Federal Reserve members continue. With a high probability of another rate hike in the July meeting, investors are closely monitoring key macro indicators leading up to the September meeting. While investment-grade (IG) spreads remained steady at 122 bps, the global high yield and emerging market spreads compressed by 21 bps and 8 bps respectively during the week.

The market is increasingly focused on potential policy changes at the Bank of Japan's upcoming Monetary Policy Meeting scheduled for July 27-28. The 10-year Japanese Government Bond yield has risen to 0.475% during the week from 0.36% at the end of June, nearing the upper limit of the BOJ's acceptable range of 0.5%. Additionally, the 10-year overnight swap has increased by 16 basis points over the past month, reaching its highest level since March. We suggest avoiding duration exposure in JPY since the Japanese central bank may need to normalize their dovish policy to take account of the strong growth and higher inflation numbers.

In Asia, India experienced a rise in its Consumer Price Index inflation for the first time in five months, reaching 4.81% in June 2023. The increased inflation exceeded market expectations of 4.58%, primarily driven by a less supportive base and a surge in vegetable prices. However, the CPI print remains below the upper tolerance limit of 6% set by the Reserve Bank of India (RBI). Food inflation spiked to 4.49% in June, which contributes around 50% to the whole index. Market expects that inflation increase reduce the probability of rate cuts during the year in region.

Coming to the region, Egypt's sovereign curve experienced a significant decline of 200 basis points to 400 bps following the Egyptian government's privatization program, which involved selling state assets worth $1.9 billion. These developments are crucial for meeting the conditions of the IMF program. Separately, Egypt's headline inflation rose to 35.8% YoY in June, up from 32.7% YoY in May, surpassing market expectations of 34.5%. Though the market believes there are signs that inflationary pressures may have started to abate, and that headline inflation may be peaking. We saw ADIB and ADCB hitting the market last week, while Dar al Arkan has issued the mandate. ADIB witnessed strong demand and was oversubscribed by more than nine times. Dar Al Arkan is expected to hit the market this week.

The market is always right

Equity Update

A rally of everything last week: from regional banks, to technology, and both emerging and developed markets. Global equities gained 3.4%, that’s what would be usual in a quarter or half a year. Better eco data all around except China and falling sovereign yields supported equity gains. Leading market gains regionally is the Dubai Index, +25.5% year to date with real estate developers continuing to sell off plan residential property at higher rates, malls seeing higher footfall and hotels better occupancy. The additional supply in all three has been quickly absorbed with UAE population on the rise. China still has negative year-to-date returns but a stellar week, aiding EM returns. India continues to build on global relationships and has tied up with the UAE for local currency trades. Indian returns have been muted this year, but we see stable returns for the next few years with its mix of younger demographics, digital shift and foreign policy. As at June-end our revised fair values indicated 10% returns across EM and 1 to 2% for DM in H2.

US markets are seeing further gains in July after a spectacular H1, with the S&P 500 up 18.5% year to date and the Nasdaq +35%. The “Super Seven” stocks: Apple, Microsoft, Google, Meta, Nvidia, Amazon and Tesla continue to lead with exponential returns. Treasury yields lower, as last week's US CPI print confirmed the pattern for falling inflation and a soft landing and a possible culmination of rate hikes in July.

Consensus expects a 7% y/y decline in S&P 500 EPS for Q2, driven by flat sales growth and margin compression. Ten of the 12 S&P 500 companies that reported last week beat expectations. 40% of S&P 500 are companies reporting this week. Negative EPS revisions for 2023 and 2024 seem to have bottomed and revision sentiment has improved. Our estimates for 2023 S&P 500 EPS remain flat y/y ($220). Key areas to watch in earning calls are margin maintenance, should be steady as inflation recedes, the impact of bank stress on credit and lending, potential uses of AI and the spending pattern of the US consumer (lower on goods and more on services). For 2024, FactSet’s analyst consensus is for earning growth of 12% for the S&P 500. US banks JP Morgan Chase, Citigroup and Wells Fargo reported on Friday and beat expectations, JPM benefited from solid loan growth, trading, and net-interest income. CEO Jamie Dimon is optimistic on the economy, but highlighted risks around consumers using up their cash and the continuing Ukraine Russia conflict. Higher provisioning all around in US banks.

On July 24, the Nasdaq-100 will undergo its second ever Special Rebalance “to address the high concentration weight of the largest 7 stocks in the index which will be reduced by 12% (56% to 44%). Nvidia and Microsoft will be reduced by 3% As per Goldman Sachs data $261bn in mutual fund and ETF AUM is benchmarked to the NDX, while hedge funds have an estimated $20bn of net short exposure. The 2011 special rebalance experience suggests the stock-level impact will be limited.

The market is always right

Written by:

Maurice Gravier Chief Investment Officer , [email protected]
Anita Gupta Head of Equity Strategy , [email protected]
Satyajit Singh Fixed Income Analyst , [email protected]
Giorgio Borelli Head of Asset Allocation , [email protected]

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