Not so immaculate disinflation after all
Tuesday, 6 August 2024 16:27
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Stormy times for markets. Global equity markets took a nosedive in the final two days of last week, with the S&P 500 sliding 3% and the Nasdaq and Stoxx Europe 600 declining by 4%. Still, the most striking feature of recent turbulences in markets was probably the sharp drop in bond yields, with the 10-year Treasury yield falling by 40bp last week from 4.2% to 3.8%! Our technical analyst had rightly flagged that falling below the key 4.15% support level could trigger an acceleration of the downturn and he believes the downside potential could reach 3.5%.
First Fed rate cut clearly in sight. The decline in bond yields was initially driven by last week’s FOMC meeting, which confirmed to investors that the monetary cycle had genuinely turned. The Fed made a clear overture to a first rate cut in September, having gained confidence that inflation is now moving in the right direction following an uptick earlier in the year.
Bad news is bad news again. Disinflation is certainly back on track but economic data published last week revealed that it is no longer immaculate, as it is accompanied by a weakening US economy. This has led investors to question whether the Fed might be falling behind the curve and risking a harder economic landing. Notably, the ISM manufacturing survey came in well below expectations with employment falling to 43.3, the lowest level since 2020. Hard data also indicated a more pronounced loosening in the US labour market, with inital jobless claims rising to their highest level in the past year. Friday’s softer-than-expected labor report was the final piece of evidence, showing the US economy added 114k jobs in July, well below expectations, while the unemployment rate climbed to 4.3%.
Stretched consumer. Bottom-up signals from the US earnings season indicate that consumers are feeling the pinch from tighter financial conditions, with lower-income consumers pulling back the most (e.g., Amazon’s CFO mentioned consumers were “cautious” and “looking for deals”). In Europe, the Q2 reporting season is past the halfway mark, and overall earnings are slightly exceeding expectations, with a 56% beat rate. However, cyclical sectors such as Consumer Discretionary, Industrials and Materials are delivering rather lackluster earnings surprises so far (link to our Earnings radar).
Politics and geopolitics in the background. Finally, developments in the US election might have also contributed to the pressure on bond yields as Kamala Harris is closing the gap with Trump, which somewhat reduces the odds that inflation could reaccelerate under a Trump presidency. Meanwhile, geopolitical tensions have also boosted the appeal of bonds with renewed unrest in the Midde East after Hamas’ military chief was killed in Iran. In our cross asset allocation, we remain invested in gold, which is another beneficiary of these geopolitical pressures, in addition to the future Fed rate cuts, and strong demand from EM central banks.
We recommend a cautious stance on equities, which do not offer a compelling entry point yet, especially in the US. The S&P 500 is still trading at a hefty forward P/E of 21x and on demanding earnings growth expectations (+10% in 2024E, +15% in 2025E), leaving little margin for error. The global macroeconomic backdrop is unlikely to provide much support for equities, while Western central banks appear unwilling to ease faster at this stage (Jackson Hole is still a few weeks away), and the reporting season has been mixed, at best. In the meantime, the uncertainty surrounding the US elections should also lead investors to refrain from taking on additional risks.
European defensive and bond proxy sectors. Amid the risk-off mood, the defensive rotation is accelerating in European equities and we are happy to keep an almost “full-defence” positioning in our sector allocation. In this week’s report, we reiterate our positive stance on key sectors that are both defensive and bond proxy sectors benefitting from falling bond yields (notably Real Estate, Utilities). Conversely, we adopted an UW rating on Banks on 29/07, which are likely to bear the brunt of the weakening economic backrop and declining interest rates.
Week ahead: China Caixin PMI, Eurozone PPI, US ISM services (Monday), Eurozone retail sales (Tuesday), China trade data (Wednesday), China PPI and CPI (Friday).
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