Markets pick themselves back up!
Author: Tom McGrath CIO, 8AM Global
Market Overview
Despite no obvious catalyst, financial markets staged an impressive comeback last week as attention turned to the latest inflation numbers from the US and European monetary policy. These didn’t bring any pleasant surprises; they were a tiny bit on the high side, but I guess investors were content that they wouldn’t stand in the way of the Fed cutting rates. We also got another rate cut from the ECB, which had been well telegraphed. So, I guess the strong bounce in equities and, to a modest degree, the bond markets can probably just be put down to a positive shift in sentiment. The US led the charge, and it was interesting to see the sharp bounce in small cap on Friday, as the Russell 2000 took the top spot in equity indices last week. Oil recovered a touch, and Gold continued to hit new highs, finishing over 2,600 for the first time. Rather than try to understand the reasons for the continued strength of this precious metal, I will simply offer the most basic of explanations: more buyers than sellers!
ECB Cuts Rates
There were no surprises as the ECB cut rates by 0.25% last week. It also reiterated its commitment to a meeting-by-meeting, data-dependent approach. Given that we got a slight upward revision to its core inflation forecast, this probably means that we won’t see back-to-back rate cuts at the next meeting in October. The hesitancy is typical of the Europeans, who are inherently reluctant to sound the all-clear on inflation, which at 2.2% in August is within clear sight of the 2% target.
The decision was accompanied by slight downgrades to projections for GDP output over the next three years, underscoring a worsening backdrop that may yet see the pace of rate cuts pick up, especially if we see the Fed more aggressive. On the face of it, markets were unphased by bad news on inflation and growth, and the MSCI Europe put in a solid 2% gain for the week.
US Inflation
Core Price Inflation came in a bit hotter than expected, with a 0.3% rise in prices; the market had expected a smaller 0.2% increase. As in prior months, the most significant upward surprises came from shelter and transport services, while most other components aligned with forecasts. Core goods prices fell by 0.2%, with used vehicle prices down 1%. The numbers increase the likelihood of a cautious approach by the Fed, likely starting with a 25bp cut next week. Curiously, after an initial sell-off on the release, equities and bonds were unphased and finished higher on the day!
The surprise came from a re-acceleration in owners’ equivalent rent, which is most likely just ‘data noise’ as the real-time measure produced by Zillow suggests this should be heading down, not up. The problem is the Bureau of Labor Statistics methodology looks at the average rents in force over the previous 12 months. It, therefore, moves much more slowly than the private sector indexes based on newly signed leases each month. This chart from Pantheon Macroeconomics shows that the index of rents kept by Zillow tends to predict the official figures quite closely but with a 17-month lag. If that pattern continues, it’s indeed only a matter of time before shelter inflation falls.
Despite the August increase, core inflation has averaged around 2% annualised over the last three months. As a result, the Fed will likely focus more on labour market conditions at the upcoming FOMC meeting, and given that we are only seeing a gentle softening and no reason to panic, I think the Fed will adopt a gradual pace of rate cuts, starting with 25bp in September. We could then get a couple more cuts before the end of the year, more likely in October and December, but the current market pricing suggests more. If I am right and the market is wrong (and that’s far from certain), the main question for market direction (ignoring politics) is whether investors can live with that gentle pace. I think the equity markets could, but we might see a backup in yields with the 10-year heading back to 4%.
We continue to believe that economic growth will prove stronger than currently expected, and our take on the last employment report was that it wasn’t as bad as widely believed. If anything, much of the weakness could be attributed to productivity growth, and that’s no bad thing, especially for corporate profitability. It would seem that the Fed now think the inflation genie is back in the bottle and that the next task is to avert a recession that we (and most others) cannot see signs of. So, for the time being, we are going to get rate cuts, which is arguably a much ‘easier-than-necessary’ monetary policy; that’s a pretty good backdrop for risk assets.
UK Economy
After a solid start to 2024, GDP remained unchanged for the second consecutive month in July. At the sector level, notable shifts balanced each other out. The drop in retail sales and the effects of industrial strikes on the health sector in June reversed in July. However, this improvement was offset by manufacturing, construction, and professional services declines.
These drops in July are a reaction to the unusually strong performance in June. Business surveys still suggest solid growth, and the economy’s momentum should still result in healthy GDP growth in the third quarter (0.4% best guess). While this is slower than in the year’s first half, those earlier gains were well above the usual trend. Consumer spending has played a minor role in the recovery so far, but with rising confidence and steady income growth, there is reason to expect it to pick up. We are still expecting another rate cut from the BOE in November, so the combination of falling inflation, falling rates and modest growth argues for a ‘UK goldilocks scenario’. If it plays out that way, the potential for UK equity markets to offer great value on the world stage is exciting, and I hope that global investors begin to wake up to that fact.
China (argh!)
I have almost got to the point where I write Chinese equities off once and for all (surely the point at which they will undoubtedly rebound as the fickle hand of fate dictates), and today, I am struggling to find something positive to say. I decided to borrow from the latest message I received from the Artemis SmartGarp Emerging Markets fund manager. I always prefer to get a view of China from an Emerging Markets manager rather than a China portfolio specialist, as the EM manager isn’t obliged to like China. So, here is a direct lift from Raheel Altaf, who is still finding value…
“We’re still optimistic about the opportunities in China. China continues to disappoint with respect to domestic growth, consumers are not unleashing their significant savings and the government policy response has been inadequate so far. To counter this, pessimism is extreme, valuations offer support and earnings appear to have hit a trough. In the last few years, we have taken reasonable exposure to China, but with a preference for deeply valued, strong balance sheet, high dividend paying companies. These have held up extremely well against more volatile markets.
Our China positioning today still has these characteristics, the table highlights the margin of safety in valuations and superior quality characteristics. More recently, we have been using market weakness to buy into China consumer plays. We have increased our exposure to Alibaba, Tencent and Geely, as examples and recently added JD.com. These are higher beta names and likely to do well against a more favourable sentiment towards China. Many of these names are cheaper than they have ever been. JD.com for instance trades on 6x earnings, Alibaba 9x. We can’t forecast what will happen in the future, but think the risk reward is extremely favourable at present.”
That is a sensible conclusion. When you compare the valuation of some of the large, growing Chinese tech companies to those in the US, they have outstanding value. Remember, the Chinese economy is still growing at a pace that dwarfs the rest of the world, but when investors return and the value is realised, it remains anyone’s guess. We continue to maintain indirect exposure to the market via some of our Asian positions and Emerging Markets and hope they surprise us soon in a good way.
Next Week – It’s a biggy, Fed, BOE and BOJ updates…
U.S. Federal Reserve (FOMC) Meeting: On Wednesday, September 18th, the Fed is expected to announce its latest interest rate decision, with markets anticipating a 25-basis-point cut. The meeting will also provide updates on the Fed’s outlook for inflation and employment.
Bank of England (BoE) Decision: The BoE will make its interest rate decision on Thursday, September 19th. While the BoE cut rates in August, I don’t think we will get one here, but we might get some noises that one is coming; November remains my best guess.
Bank of Japan (BoJ) Meeting: On Friday, September 20th, the BoJ will announce its interest rate decision. The central bank is widely expected to maintain its current policy, with rate hikes anticipated later in 2024.
Chinese Economic Data: China’s retail sales, industrial production, and fixed investment data for August will be watched closely to assess the country’s economic slowdown.
Eurozone Inflation: The Eurozone will release its flash estimates for CPI on Wednesday, September 18th.
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