Don’t fear the rebalance

Posted 26 July 2024

The rough patch for global stocks continues. Equities had a fairly dramatic fall on Wednesday, led yet again by the US large-caps. Wednesday saw both the S&P 500 and the Nasdaq experiencing their worst single-day losses since 2022, and the US volatility caused ripples around the world. Some of those aggregate losses were recovered on Thursday and Friday, after data showed that the US economy grew from March to June at a rate that had been well ahead of economist expectations.

Interestingly, for the third week running, the market positivity that ran counter to the overall trend was focused on smaller stocks. However, overall, it was not enough to counteract the value of mega-cap losses. But, sometimes, scraping off excesses is a healthy thing. Even though index-level returns look poor for the week, we think the underlying market rebalance is positive.

In the US, smaller companies caught a bid as Joe Biden’s problem with age became obvious following the first presidential debate. Comment was that smaller companies would be better supported by a Trump presidency, and that event had become a 70% likelihood in the political betting markets. But this week following Biden’s exit from the race, his chances reckoned to have slipped somewhat, back to 60%, yet the smaller caps are still outperforming.

So, now markets appear not to be driven by a political narrative – instead it seems it’s about….

The not-so-magnificent seven.

Just a few weeks ago, everyone was talking about the incredible performance of US tech giants, and how no other stocks could catch a break. But since July 10th, the Russell 2000 – the index for US small and mid-caps – has gained nearly 10%, while the “Magnificent 7” (Mag7 – Apple, Amazon, Alphabet, Meta, Microsoft, Nivida, Tesla) have fallen more than 11%. After disappointing Q2 earnings reports from Alphabet (Google’s parent company) and Tesla, the Mag7 dropped 6% during Wednesday trading alone.

Tesla was the worst offender, shedding 12% of its value after announcing a 33% slump in 2024 second quarter earnings (2Q24 versus 2Q23, analysts had expected a 26% decline). The electric carmaker is suffering from a double whammy: its sales are being hurt by the global downturn in automotives, while the shifting market sentiment on tech is hurting its share price. It is the only Mag7 member to lose value this year (9.6% at the time of writing), but that has not insulated it from the recent tech downturn.

As both a tech company and an auto-manufacturer, Tesla’s struggles are symptomatic of the Chinese overproduction problem. Long story short, weakness in China’s domestic economy has led the government to stimulate production of export goods, particularly of electric vehicles. This has created an oversupply which has ended up being ‘dumped’ on international markets, pushing down prices. That is why global manufacturers – particularly carmakers – are in trouble, and there is a similar story with regards to microchip demand.

No sign yet that manufacturing weakness will spread.

Manufacturing PMIs (measuring business sentiment) were weak across most of the world in the latest data releases. Historically, weakness in the goods sector tends to feed through into services – as producers cut costs, which usually means weaker demand for services somewhere down the line. But manufacturers have been under pressure for a while and there are not many signs that this is significantly hurting the services sector in the western world.

Manufacturer problems seem largely to be about dealing with competition, since Chinese overproduction has hurt other producers’ pricing power. However, the demand side has held up reasonably well and lower prices are helping. US consumers have slowed the growth in spending but now prices are rising at a slower pace than that. Consumers also have more money available for services as the Service PMI also suggests.

Manufacturing pain does not seem to be a drag on the rest of the economy right now, but we must be wary of that changing. Equity valuations have already taken a hit from less positive company earnings outlooks, of which we saw a few this week. Capital expenditure intentions have recently been scaled back although actual spending has remained robust, perhaps because of the laggy timelines involved. Meanwhile, employment indicators have remained positive but if cap-ex intentions are already reduced, any further cost-cutting could mean higher unemployment – which feeds back round into weaker demand.

A better distribution of wealth creation?

Potential cost-cutting and valuation adjustments are closely related to the tech stock losses. The dispersion from mega-caps to small caps is a healthy sign that the expansion of the economy is seen to broaden but, as we wrote last week, losses for the Mag7 could still be painful. The sheer size of those companies means their losses often outweigh gains for others and, considering how heavily US citizens are invested in their stock market, confidence could be hit by a negative wealth effect.

Ultimately, though, the readjustment of capital from large to small companies will help growth prospects for small firms. When you combine this with an upcoming interest rate cut from the Federal Reserve, companies have a solid base from which to build. The case for long-term growth – not just in the US but globally – is not undermined by a few billion knocked off the Mag7’s market value.

Interestingly, the UK is currently looking like one of the world’s bright spots – and recent business sentiment surveys were much better than elsewhere. Britain’s economy was already improving before the Labour government entered office, but the ‘quiet competence’ Keir Starmer has been trying to implement has certainly been well received by markets. Less fractious relations with the EU are by far the biggest benefit for investors’, and there is a sense that trading conditions are stable – or even likely to improve. Sterling strength is a testament to this, and that in itself gives the Bank of England more leeway to cut rates.

Markets have undoubtedly wobbled this week. As far as the US mega-caps go, unfortunately that wobble might not be over. But this is just the surface-level impact of what looks a genuine market-wide rebalance. Hopefully, that deeper process will move capital from where it was too concentrated to where could have the biggest growth benefits. Investors should not fear the rebalance.

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