29th July 2024
Markets last week
Summary
Volatility rose as the rotation from mega-cap tech stocks to the broader market continued
Developed market equities outside the US benefited from this rotation
Defensive sectors (healthcare, utilities) performed well; cyclicals (communication services, technology, consumer discretionary) declined
Earnings challenges and slowing European economic growth negatively impacted cyclical stocks
June’s US Personal Income and Outlays report showed slowing consumer spending and lagging income growth
Consumers are increasingly dipping into savings to maintain spending
The US economy grew at an annual rate of 2.6% in Q2, exceeding expectations
Inflation shows signs of easing, with the core Personal Consumption Expenditures (PCE) indicator nearing the US Federal Reserve's (Fed) target
The yen strengthened by 2.4% against the dollar ahead of central bank meetings this week. Hedge funds reduced bets against the yen as global carry trades unwound
The yen’s rise negatively impacted Japanese equities, which fell by 5.6% last week
A weaker yen previously benefited Japanese companies by boosting international earnings and attracting foreign investors
Chinese equities fell sharply as unexpected rate cuts by the central bank failed to boost economic confidence
This Wednesday: Federal Open Market Committee (FOMC) rate decision. No rate cut expected, but Powell may signal future cuts. Fed funds futures suggest a rate cut in September
Wednesday: Bank of Japan (BoJ) rate decision. BoJ may hike rates as well as reducing their bond purchases. This could impact yen short positions and support the currency’s recent strength
Thursday: Bank of England (BoE) rate decision. A 50% probability of a rate cut this week, or if not a likely cut in September. UK services inflation remains sticky suggesting any rate cut may be a one and done for now.
Markets last week
Equity rotation continues amid rising volatility
Volatility has continued to rise, driven by an accelerated rotation in investor positioning. In recent weeks, there has been a notable exodus from the small cohort of mega-cap technology-related stocks that have dominated index performance. Investor capital has flowed into the broader market and smaller companies, benefiting developed market equities outside of the US.
From a sector standpoint, defensives stood out during a week of wavering risk sentiment. Healthcare and utilities ended in positive territory; consumer staples held up well while cyclicals were the worst-performing sectors. Communication services (particularly interactive media), technology (large-cap tech and semiconductors), and consumer discretionary (broadline media and automobile manufacturers) all experienced significant declines.
A challenging earnings week for cyclical stocks exacerbated their underperformance compared to more defensive peers. Signs of decelerating economic growth in Europe led to negative share price reactions to earnings reports.
The rotation into smaller companies comes hand in hand with the rising likelihood for interest rate cuts. Smaller companies tend to have higher levels of debt and therefore will benefit from a fall in borrowing costs. So long as the soft-landing scenario remains intact - where the economy cools enough for inflation to fall back in-line with the 2% target while simultaneously avoiding a recession – such a rotation is likely to find momentum.
New insights into the US economy
The latest Personal Income and Outlays report for June shows that US consumers are increasingly feeling the pinch. While spending is still growing, it’s slowing down, and income growth is lagging. This suggests that consumers are dipping into their savings to maintain their spending habits. With the labour market cooling, consumer spending could continue to slow as the year progresses.
The US economy is bifurcated with high interest rates taking their toll on lower income households while those with more savings continue to spend and benefit from higher interest rates. With this bifurcated nature, surface economic growth has remained buoyant, continuing apace in the second quarter at an annual rate of 2.6%, well ahead of consensus.
Inflation continues to show signs of easing, with a few months of the core PCE indicator now close to the Fed’s target. This progress supports the case for interest rate cuts in the coming months. A rate cut could provide significant relief for struggling consumers as well as the broadening of equity market performance.
Japan
The yen strengthened 2.4% against the dollar, continuing the sharp rebound that began on 11 July when the currency hit its lowest level against the dollar since the 1980s. This surge has been driven by Japan’s intervention to support the hitherto weakening currency. Hedge funds last week were reducing their oversized bets against the yen as global carry trades (borrowing in a low interest rate currency to lend in a high interest rate currency) unwound.
The future of this yen rally depends on upcoming decisions by the BoJ, the Fed, and other major western central banks. Carry traders are uneasy about potential tightening of Japanese monetary policy, which contrasts with expected rate cuts by the Fed, the European Central Bank (ECB) and the BoE. These likely moves would close the interest rate gap and reduce the attractiveness of the carry trade against the yen. The BoJ, the Fed and the BoE have their policy meetings this week. The volatility is unwelcome for carry traders who prefer stability. The yen’s recent rally has been bolstered by its status as a defensive currency amid heightened risk aversion from a tech selloff in equity markets.
The rebound in the yen has had negative consequences for Japanese equities as they slipped -5.6% in local currency terms last week. A weaker yen benefits Japanese companies’ as they often have significant international earnings and therefore high profitability when converting those overseas earnings back to the local currency. The weak yen also attracts foreign investors who can buy more yen-denominated assets with their own currency when the yen is weak.
China
Chinese equities dropped sharply as unexpected rate cuts by the central bank failed to boost confidence in the economic outlook. The People’s Bank of China cut its medium-term lending facility rate by 20 basis points to 2.3%, its first reduction since August 2023, and lowered the seven-day reverse repo rate. These moves are aimed to support growth after disappointing GDP figures and general weak economic conditions in China. The lack of significant policy measures from the recent Third Plenum meeting added to the bearish sentiment.e US tech sector, cautious monetary policy from the ECB, rising UK inflation, and geopolitical risks all impacted the landscape. On Friday, a global IT outage due to a defective update by cybersecurity company CrowdStrike, significantly impacted business and daily life. This disruption affected organisations worldwide and contributed to existing turbulence in the tech sector. These factors resulted in poor performance from the narrow cohort of US mega-cap tech-related stocks that have been so prominent year-to-date. Outside of the tech the market performance was more positive.
US political developments: Biden bows out
The political landscape in the US took a dramatic turn last week following the failed assassination attempt on Donald Trump. Trump, emerging resilient and undeterred, has seen a surge in his popularity. This contrasted starkly with incumbent president, Joe Biden's prospects as he struggled to demonstrate his fitness for office. With a Trump presidency and a Republican clean sweep looking increasingly likely, the Democrat machine has now finished with Joe Biden as calls for him to step down grew increasingly louder, with Biden ultimately dropping out of the race on Sunday. The Democratic National Convention, scheduled for August, will determine the new candidate with current vice president, Kamala Harris the most likely replacement candidate.
Trump's campaign has gained further momentum with the selection of JD Vance as his vice-presidential running mate. The appointment of Vance — who was at one point opposed to Trump but now has thrown his full support behind him — signifies a clear indication of Trump’s intention to pursue an assertive agenda if re-elected. This includes expansive fiscal policies, tax cuts, a clampdown on immigration, and increased tariffs on imports — echoing protectionist measures from the past.
These policies are anticipated to elevate US inflation — implying that interest rates and bond yields may remain higher than they would under a Democratic administration. The US yield curve has steepened to reflect this interpretation as Trump’s odds have improved. Treasury yields rose last week with the 10-year yield closing at 4.24%.
Turbulent tech
The tech sector faced turbulence last week with ‘big tech’ experiencing a notable downturn. Despite mega-cap tech-related shares falling, earnings released over the week indicated continued profitability in the sector, although at a slower pace. Many analysts have concluded that the fall presents a ‘buy-the-dip’ opportunity as the sector's outlook remains optimistic. Upcoming earnings will be crucial as they could influence the recent shift from tech-heavy investments to broader market exposure as analysts decide whether the positive outlook justifies the elevated valuation of the sector. At the end of the week, turbulence in tech escalated further due to a global computer systems outage impacting organisations worldwide.
Over the course of the week, US equities declined -1.4%. The ‘magnificent seven’ (a collection of leading mega-cap technology-related stocks, Microsoft, NVIDIA, Apple, Alphabet, Amazon, Meta and Tesla) contributed the entire index decline. If these seven companies are excluded the index was effectively flat for the week. Most sectors ended in positive territory with energy, real estate, consumer staples and financials amongst the best performing sectors. Tech was the worst performing sector by a considerable margin — falling 4.6%.
The dramatic unwinding in tech stock exposure, particularly within the US, has been marked by a spike in volatility. The VIX index, a measure of uncertainty in the US equity market, spiked to its highest level since April, rising from 12.5 to 16.5.
European equities suffered more broadly than the US with nine of eleven sectors falling. Tech was the worst performing sector declining over 10%, driven predominately by the semiconductor industry, as geopolitical concerns arose around the prospect of the US introducing export restrictions on companies selling advanced chips to China.
A cautious ECB
The ECB left monetary policy unchanged last week, as anticipated, and is becoming increasingly cautious about its next moves. Policymakers are debating whether to cut interest rates just once more this year, with a decision in September still uncertain. ECB President Christine Lagarde left the question of further rate cuts wide open emphasising that future decisions will depend on the data, with wage growth and services inflation being particularly key as these areas remain uncomfortably high.
The ECB’s hesitation is also influenced by the Federal Reserve’s (Fed) adjustment of its rate-cut projections, from three cuts to just one this year. This international policy context is crucial, as the ECB must consider the nominal rate differentials between the US and the eurozone. The lack of commitment to further rate cuts has affected sentiment toward European sovereign bonds, particularly German bunds, which have struggled to garner much of a bid following the ECB’s initial cut last month.
UK inflation
UK inflation data released last week came in above market expectations. Service inflation remains at 5.7%, with core prices at 3.5%, while headline inflation stands at 2.0%. This gives the BoE a potential window to cut rates in August. However, inflation is expected to trend higher in the coming months, suggesting that any rate cut might be a one-off for now.
UK GDP prospects appear relatively firm, and there is no urgent need for the BoE to cut rates immediately. Additionally, some fiscal expansion is anticipated, although the new Labour government is proceeding cautiously to reassure markets of their financial prudence.
UK equities continue to perform well relative to other regions. Particularly the more domestic- focussed mid-cap space as the FTSE 250 fell -0.6% holding up well relative to other markets.
The week ahead
Wednesday: FOMC rate decision
Our thoughts: The forces are aligning for the Fed to cut interest rates with progress on disinflation picking up again in recent months. The clear softening of the labour market and the slowdown in consumer spending all tip the scales in favour of policy easing. Promisingly, the US economy has maintained a solid rate of growth, with just the right amount of cooling to see inflation fall back towards target. Although the Fed is unlikely to cut rates this week, Powell is expected to imply incoming rate cuts.
There is no FOMC meeting in August as the Fed heads to Jackson Hole, Wyoming, for the annual Economic Policy Symposium. The next opportunity for a rate cut is in September. Fed funds futures put only a 4.5% probability of a rate cut this week, with a full rate cut priced in for September.
Wednesday: BoJ rate decision
Our thoughts: The BoJ is expected to take further steps towards policy normalisation by hiking rates and fading out bond purchase programmes. This comes as inflation and wage growth have finally picked up, aligning with the BoJ’s long-term objectives. In June, Governor Ueda signalled a ‘sizable’ reduction in bond purchases. Combined with a rate hike, these measures could significantly impact yen short positions, increasing the momentum behind the recent reversal in the currency’s weakness. Japanese inflation in June rose to 2.2% and could offer an opportunity for the BoJ to increase interest rates for the second time in 17 years, having done so already this year.
Thursday: BoE rate decision
Our thoughts: Swaps put a 50% probability on the BoE cutting rates this week, if they don’t they are likely to cut in the September meeting. UK inflation has been stickier than hoped, particularly services inflation which remains at 5.7%. Headline inflation is inline with the target on an annual basis, but it is expected to tick up again in the coming months. This suggests that any rate cut might be a one-off for now, particularly as the UK economy appears relatively firm, and there is no need for the BoE to cut rates immediately.
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