Markets take good news in their stride

Posted 2 June 2023

Last week we noted how the absence of specifically good news meant markets reacted more negatively than expected to the relatively low probability of a US debt default. We pointed out that the more notable event of the week had been bond yields once again surging.

This week, not only did we get a resolution to the US debt ceiling brinkmanship, but also the welcome news that inflation pressures across Europe were declining faster than expected, while the US jobs market remains paradoxically both vibrant and at the same time showing signs of slowing down (with unemployment going back up). Unsurprisingly stock markets staged a brief relief rally on the debt ceiling resolution, but began wobbling again when Chinese, US and European manufacturing sentiment data showed sure signs of contraction.

On the back of this, bond yields stopped their ascent and declined over the course of the week on the expectation that the economic headwinds in goods manufacturing should persuade central bankers to stop hiking rates. The extraordinarily robust US job market figures on Friday did not appear to change this narrative for bonds, while equities took the strong economic news as outright positive for a change. This came despite expectations for the first rate cut being yet again pushed out further into the future – now only expected for January 2024 (Back in January this year it was implied for the middle of the year).

It is heartening to observe how much more, compared to last year, equity markets are taking the return to higher yield levels in their stride. Particularly notable is that the growth companies of the tech sector, whose valuations suffered substantially last year under rising yields, seem to no longer be seen as growth companies this year, but safe haven investments, almost regardless of how sky-high their valuations (versus actual earnings) are – perhaps as a longer term structural play. Market appear to accept that rates and yields are unlikely to come down in the very near future as inflation proves stickier than anticipated (see our separate article on Europe, where inflation is seemingly declining particularly quickly). Yet in combination with a still booming services sector compensating against the activity slowdown wave in manufacturing, the notion that the global economy will avoid a painful inflation-busting recession became once again the narrative of the week.

There is little doubt in our mind (and analysis) that higher rates and higher yields for longer will leave more collateral damage in their wake, with housing one such area we write about in more detail this week. However, the unique post-pandemic set of economic variables has created ample monetary liquidity constantly searching for a better return, paired with plentiful jobs – and a higher-than-usual debt resilience of the proverbial weak links of the economy – pushing out recession expectations ever further. Perhaps to the point where manufacturing’s overstocking in reaction to the post-pandemic demand surge has worked its way through and the service sector catches up to the same demand saturation level that manufacturing has painfully experienced since last year.

Concerns over China’s lacklustre reopening recovery have been weighing heavily on China’s stock market and have been one of the major recent risks in the hope for a global economic soft landing. This week’s news that Beijing is working on a sizeable property sector support package seems to be precisely what investors were looking for, given the jump with which Chinese stock markets reacted to the news.

In all, it was a good week for the optimists, and to justify their equity buying they would point towards the wider market expectation that yields will fall in the medium term, making equities more attractive versus bonds again (and therefore not worrying too much over the profits squeeze hiatus in the interim). As to the already seriously expensive US stock market, those optimists would argue this is mainly driven by those companies that will shape our society’s future, and therefore justify the hefty premium.

Pessimists will point to the higher-for-longer risks emanating from high interest rates and lending costs eventually driving down demand (and profits), causing a recession-triggering debt default cycle. They might also point out that US tech firms will have to generate almighty profits in the future to justify the current valuation hype.

The ‘jury’ of high ranking forecasters remain split but this past week held more for optimists than pessimists. Whether it will stay this way over the coming weeks remains uncertain and will from week to week be driven by the interaction between falling goods and resource prices and the stickiness in core inflation driven by the ongoing labour shortage. Stay tuned.

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