Monday Digest

Posted 10 June 2024

ECB’s Lagarde makes rate cut history

Rate cuts at last. The ECB delivered a 25 basis point cut last week, as expected, and markets got excited about easier monetary policy again. ECB president Lagarde spoke about “dialling back” now that inflation is closer to the official 2% target. Nobody expects a full-blown easing cycle (bets on a September cut were dialled back too) but markets are confident that rates will fall globally – especially weaker-than-expected US employment data seemed to confirm an autumn cut from the US Fed.

And yet, no one expects the US or Europe to reach the official 2% inflation target anytime soon. It begs the question of whether central banks have moved to an unofficial 3% target – which would arguably be justified by structural economic changes. Growth and inflation have consistently beaten expectations in the US, for example, but markets expect the Fed to push ahead with cuts this year and next.

That is pushing bond yields sharply down, which is supporting equity valuations. Does this challenge our assessment last week that profits, rather than rates, are driving stock markets? Not exactly. Rates were key this week, but markets are still laser focused on expected profit growth. Nvidia’s incredible performance encapsulates both points: falling rate expectations pushed it to the brink of a $3 trillion market cap last week, but underlying that valuation is an astounding track record for growing profits (up 600% year-on-year last quarter). This is the ‘goldilocks’ environment that markets long for. Rates fall and growth moderates, but not enough to truly hurt profits.

Lastly, a note about elections. Recent stock market swings in Mexico, India and South Africa, following unexpected election results, has some worried about whether the UK election might upset things. This is unlikely, since the near-term impacts of the main parties’ economic policies are unlikely to substantially differ. But even when markets do get spooked by politics, it tends to be short-lived, and in fact most of the time represents a good buying opportunity. It would take a lot to really upset markets at the moment.

May 2024 asset returns review

May was decent for global investors, global stocks gaining 2.3% in sterling terms. This was underlined by strong corporate profits and firmer rate cut expectations. Inflation slowed again but unevenly, sending global bond prices up 0.9%. The US was in line with expectations but Britain and Europe surprised to the upside. This was not enough to deter the ECB from cutting rates at the start of June, however, and US data seemed to confirm an autumn cut from the Fed.

US tech was again the standout, jumping 5.2%, but this was less about rate cut optimism and more about stellar Q1 profits. AI champion Nvidia reported the afore mentioned 600% year-on-year jump for the first three months of this year, and its stock price has been duly rewarded.

US Companies that didn’t live up to the hype were punished – showing that markets are laser focused on fundamentals – a far cry from the ‘valuation vertigo’ fears earlier in the year. Growth is less strong in the UK and Europe, but stock markets still rallied 2.1% and 3.5% respectively, as lower rates are expected.

Emerging markets were down 1.1% through May, despite mildly positive returns (up 0.8%) in China. Currency troubles hurt several EMs – as well as Japan, whose currency is among the worst performing this year. Commodity prices fell too, led by a 7.6% swing down for crude oil. Weaker oil demand is a sign of slowing global growth, but it will undoubtedly be a positive in terms of removing a key price pressure.

May was encouraging overall. Not only did markets recover April losses, but we saw the emergence of a healthy system of market checks and balances: where rates look set to stay higher for longer, profits look strong enough to account for it. And where profits don’t look as good, rate cuts should accommodate.

Will currency volatility return?

Currency markets are having an interesting time. The Japanese yen has lost nearly 10% of its value against the dollar year-to-date, and China’s renminbi is under pressure too – consistently trading at the top of its official exchange rate band. Historically, big currency swings can upset capital markets but, for years now, foreign exchange markets have had little impact on wider markets. That could be about to change.

There are two key reasons why: monetary policy divergence and deglobalisation. Japan is the clearest example of the first (Japanese interest rates are practically zero and US rates are 5.5%) but there is growing divergence between the US and Europe too – with cuts coming sooner in the latter. China is the clearest example of the second – with former president Donald Trump explicitly arguing that the dollar is too expensive relative to the renminbi.

Ironically, trade wars have strengthened the dollar, since threats to the global economy push people toward the world’s reserve currency. Central banks are increasing their dollar allocations too – reversing a long-term trend of higher renminbi allocations.

This impacts how we think about currency moves. A strong dollar is usually seen as a cyclical headwind to growth, but if there is a structural push for a stronger dollar we might have to re-evaluate. For example, the renminbi is historically weak against the dollar, but China’s trade with the US is now smaller than its trade with Asia. The renminbi looks overvalued relative to Asian currencies which would suggest it needs to depreciate.

That would mean financial and geopolitical headwinds – especially if Trump becomes president again. The pattern could play out in the UK and Europe too, considering growth is relatively weaker than in the US. The more economies become misaligned, the more we need to include currency movements as an additional factor in our investment outlook.

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