US Inflation behaves, Bulls get high as Dow crosses 40,000
Author: Tom McGrath – Chief Investment Officer, 8AM Global
Market Review
Confounding market pundits expecting a hot inflation print, Wednesday’s US CPI number came in lower than expected, triggering a sharp drop in bond yields and a surge in equities. By Friday night, the mighty old Dow Jones Industrial Index had scaled and closed above 40,000 for the first time in history. Not bad for an index below 2,000 when I started in the industry in 1988. For anyone that gets investment vertigo, aka: ‘an irrational fear of buying shares at a high point’, please remember there is no ceiling to how high equity prices can go. This phenomenon is because equity investment is inexorably linked to economic progress, corporate innovation, rising wealth, population growth and the demand for goods and services. As these increase, so will the overall value of companies, punctuated by fear and greed pricing cycles.
US Market & Macro
Along with the Dow Jones breaching a symbolic, although largely irrelevant number, we also got all-time highs from the broader market: the S&P 500 and the tech-heavy Nasdaq Composite. US small caps, as represented by the Russell 2000, are still some way from their all-time high set nearly three years ago in November 2021. Before we can pronounce current US equity conditions as the second “roaring 20s” bull market, we will probably need to see small caps join the party, too. That said, without a shadow of a doubt, investors are in an upbeat mood, with the S&P Global Fund Manager Survey reporting that equity investor risk appetite surged to a 2½-year high in May… and that was before the inflation data.
Investors have also become more upbeat about market performance over the coming month, contrasting with the negativity seen over the first four months of the year. Optimism is also spreading to more sectors. Most notable is a rebound in views towards tech stocks. Sentiment has been buoyed by better-than-anticipated earnings performance, which has propelled shareholder returns and equity fundamentals to the fore in terms of perceived market drivers.
Soft Landing Signs…
So, how good was the news on inflation? Not very; in truth, it was only a bit better than analysts had been expecting, which leads me to conclude that the market is in a ‘glass half full mood’ now. The so-called Core CPI, which excludes food and energy costs, climbed 0.3% from March versus a 0.4% expectation. But it did at least snap a streak of three above-forecast readings, which had spurred concern that inflation was becoming entrenched, and the year-over-year measure cooled to the slowest pace in three years. I think the data shows there is still work to do on inflation, but more importantly, it reminded investors that disinflation is still occurring and that the Fed is still likely to cut rates this year.
The drop in bond yields, following the release of the inflation data, was a logical market response. This, in turn, provided support for equities. However, it’s important to note that these figures may not necessarily indicate a significant turning point in the fight against inflation. A deeper analysis reveals that while inflation in food, energy, and goods has been controlled, service sector inflation remains a challenge.
Now, a large chunk of service sector inflation is centred around people-heavy businesses, of which wages are the more prominent component. To get this down, we will need to see further weakness in the jobs market; ergo, jobs data has become the most important thing the Fed is watching. If we continue to see less strength, as the last few reports have suggested, we will see the Fed start warming the market up to the prospect of rate cuts. Lending further support to the argument for further rate cuts last week came news that retail sales, new home construction and manufacturing had reported for April softer than expected.
Goldilocks, or even a hard landing?
With rate cuts back on the table and an economy still growing, the ‘Goldilocks’ scenario has once more become dominant, and whilst only a week or so ago, the risk seemed to be that the economy might be running a little too hot for those cuts to happen, thoughts have now swung to the risk of a hard landing. The unexpected coolness of retail sales has seen a new wave of thought: What if the economy is losing too much steam? There are signs that bond investors might be warming up to this possibility as the treasury yield has fallen below 4.5%.
Bears have been growling since mid-2022 that the US consumer will soon run out of the excess savings accumulated during the COVID-19 fiscal stimulus spree from 2020 to 2021, forcing them to rein in spending. Indeed, the increase in the use of ‘buy now, pay later’ suggests that some segments of the population cannot carry on consuming indefinitely, particularly those being squeezed by higher mortgage and credit card interest payments.
But, whilst that is undoubtedly true for many households, the economy must be viewed in aggregate. There is one substantial (in terms of wealth) segment that has truly never had it so good: the ‘baby boomers’, who have only just started on a spending spree that could last for decades. Baby Boom households have a record $75 trillion in net worth and are the wealthiest cohort of seniors ever. Not only have they seen their assets rise stupendously, but also their income from savings – I even saw an article with Blackrock’s CIO of Fixed Income, Rick Reider, arguing that rates should go down to curb their spending; how’s that counterintuitive?
“…in fact, I would argue that…if you cut interest rates, you bring down inflation. Middle-to-higher-income Americans are getting a big benefit from these interest rates,”
Rick Reider
I don’t agree with Reider’s off-the-cuff assessment, but the economy will tick along just fine, and for the moment, we should welcome signs of a slowdown. Investors are still weaned on the need for rate cuts, which has become more likely over April’s last two weeks of economic data. In a sense, further ‘weaker economic news’ is still expected to move the markets higher, provided it doesn’t get really bad. So, the unlikely soft landing is still on the cards: Goldilocks is out playing, the Bulls are basking in the sunshine, and J Powell may be remembered as the best of Fed Chairmen.
Europe
I hadn’t intended for this week’s report to end up as a feel-good report for investors, but hell, why not? It’s not every week that global stock markets reach all-time highs, so it’s on to more good news this time out of Europe.
Last week, the Euro Stoxx hit a new high watermark, a positive development that seems to be in line with the ECB’s potential rate cut in June. The release from Germany, showing a tenth consecutive month of rising investor confidence, is a testament to the growing optimism about a return to growth after a prolonged period of near-stagnation.
The ZEW Institute’s expectations gauge increased to 47.1 in May from 42.9 in April, surpassing the 46.4 forecast by analysts in a Bloomberg survey. Additionally, a measure of current conditions also exceeded expectations. Signs of an economic recovery are growing, bolstered by better assessments of the overall Eurozone and of China as a critical export market, with the optimism mainly reflected in the sharp rise in expectations for domestic consumption, followed by the construction and machinery sectors.
China
This leads me to my final bit of good news, which came out on Friday, as China’s government, under Xi Jinping, announced a new re-lending program that will provide 500 billion Yuan for housing buy-ups. Markets responded positively, with the Shanghai Stock Exchange Property Index surging 6.2%, helping lift the broader MSCI China Index. Would you believe it? This latest surge has now helped the ‘unloved, untouchable’ Chinese market overtake the S&P 500 for year-to-date gains. I suppose if ever there was an argument for diversification in portfolios. In that case, this is it, and I am delighted to report that the 8AM AQ portfolios have maintained benchmark weighting in this market…even as others deserted it.
This latest policy shift aims to ease pressure on developers and increase public housing, changing Xi’s 2017 stance that ‘houses are for living in, not for speculating’. The central bank also cut minimum down-payment ratios for first-time buyers to 15% and for second-home buyers to 25%, representing a five percentage-point reduction. However, despite these measures, China’s real estate market remains fragile, with halted construction and developer defaults threatening social stability. Previous mortgage rate cuts have not significantly boosted demand, raising doubts about the effectiveness of these measures, and there remains a substantial unsold housing inventory. But it was, nevertheless, one more step in the right direction for the world’s second-largest economy.
Given that this has turned into just a ‘feel good’ article for financial assets, I will throw in a few reasons why I think this rally in China could be sustainable, along with the efforts to shore up the property market.
I can list five other factors;
Government stock purchases: China’s government, through Central Huijin Investment, is actively buying stocks and ETFs to stabilize the market, similar to Japan’s approach.
Re-engagement of global investors: Global investors are returning to Chinese equities, led by local investors encouraged by easing policies and the Southbound Stock Connect.
New policies to support shareholders: The State Council has introduced measures like controlling IPOs, encouraging dividends, and improving corporate governance to attract equity investments.
Revival of the consumer economy: China’s economy is recovering, with GDP exceeding expectations and consumer confidence rising, especially in the services sector.
Valuations and buybacks: Attractive market valuations are prompting stock buybacks, particularly in the internet sector, supported by improved company fundamentals and positive earnings projections.
Markets have momentum and should be safe from any big shocks from economic data for a week or two, so in the short term, it’s fair to expect the rally to trundle on for longer. We have long argued that the right question is not whether the Fed will cut once or twice this year. The right question is, will the Fed be willing to cut if the data weakens? It appears to be an overwhelming yes. As long as the optionality of a cut remains, we would argue that the ‘Fed put it on the table’ which should continue to support risky assets. One risk to the downside could come from Nvidia results next week, where expectations are running sky-high, but so far, this AI Leviathan has not disappointed.
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