Monday Digest

Posted 15 July 2024

Lower inflation, less profits?

Global stocks fell into the latter part of the week – thanks to a sell-off for US mega-caps. Smaller caps and other regions outperformed, in a reversal of the year’s trend so far. UK stocks did well, with markets seemingly believing Kier Starmer’s promise of quietly competent government. The clearest signs of markets’ endorsement (or at the very least its lack of opposition) of the Labour government’s plans are sterling’s appreciation versus the euro and gains for the FTSE 250. It seems that, after upheaval in Europe, investors now see the UK as relatively stable – a far cry from the ‘Liz Truss moment’ less than two years ago.

US events were more impactful for global stocks. Remarkably, a surprisingly low US inflation print led to a sell-off for the ‘Magnificent Seven’ stocks on Thursday, dragging down national and world indices. This makes a Federal Reserve rate cut much more likely, which was previously considered only good news. Instead, the reaction suggests disinflation will mean lower medium-term profits.

Aggregate figures hide so much dispersion, though. US small cap stocks rallied hard, which is a little counterintuitive. Small-caps are generally seen as more sensitive to growth, while long-duration assets (like tech stocks) are supposed to benefit more from low rates.

Instead, investors clearly think an easing of the rate burden for small-caps is more important than immediate growth. Tech giants might have been punished because investors doubt how cycle-proof their earnings really are (Nvidia has to have companies to sell to, of course) or just simply diversified some of their allocations towards small and midcap.

In any case, the rebalance could be positive. It dissipates the market concentration we were worried about, and the dollar has weakened, which should benefit global growth. US specific growth implications depend on whether you think lower borrowing costs for most – or the investment spending of the mighty few – are more impactful.

Inflation targets: can central banks adjust?

The idea of central banks changing their 2% inflation targets is a hot topic this year. The question they face is: what long-term target is the optimal balance between growth and stability? 2% is orthodox but ultimately arbitrary, and there have been suggestions that the Federal Reserve or ECB have implicitly moved to a 3% target, to accommodate structural changes in the post-pandemic world economy. Resilient US growth with inflation persistently around 3% (as measured by CPI) shows that this is not necessarily a threat to price stability.

To clarify, higher background inflation doesn’t necessarily mean lower real growth or profits – as some have worried. Higher prices mean higher revenues for someone, which is why equity earnings are considered a natural inflation hedge. In the US case, 3% long-term inflation might actually mean higher real growth, as consumers have kept spending (until very recently) and corporate profits are keeping up with higher inflation. We might think this applies less to the weaker economies of Europe and the UK, but on the other hand, you could argue that less dynamic economies need higher targets to avoid stagnation (Japan maintained a 2% target despite no realistic chance of hitting it for well over a decade).

It might surprise to learn that most central banks have discretion over their inflation targets. Indeed, the Fed and ECB already showed a willingness to reinterpret their “price stability” mandate by changing to “symmetric” targets in 2020 and 2021 respectively. The Bank of England is different; its 2% target is set by law and it has to report to the treasury when it is not met. This might be why the BoE has looked more hawkish than peers in recent years. Unless the treasury tells it to change, we should expect UK policy to be more restrictive than elsewhere.

Trump trumps Truss?

Opinion polls and betting markets suggest a second Donald Trump presidency is now likely. How that will affect markets depends on whether the Republicans can also win a ‘clean sweep’ – the White House and both houses of congress. Current odds suggest the party will win control of the Senate, but lose their majority in the House of Representatives. That would limit what Trump can do, but the House race is very tight.

If Republicans did get a clean sweep, Trump’s agenda of tax cuts and tariffs will become reality once more. Markets reacted very well to his 2017 tax cuts, but they may not be so happy about an expansion of the fiscal deficit this time around. Trump has no qualms borrowing to fund tax cuts, but current debt metrics are worse than in 2017 (debt-to-GDP at 122% and a 6.3% deficit last year), in part because of his policies.

Potential trade wars – particularly with the EU – will make any debt problems worse. The US historically has escaped bond market punishment due to its status as world’s largest economy and owner of the global reserve currency. But fragmented global trade and deteriorating fiscal policy make it less likely capital will flow to the US. The dollar is already expensive on historical and purchasing power parity bases.

Without international flows, the treasury will need to borrow from domestic investors – which takes capital out of the stock market. If yields (particularly longer-term) go up, the extreme result would be a ‘Liz Truss moment’ and a reckoning for US policymakers that thought their bonds immune to global pressures. That isn’t our base case, but the risk is growing. That growing risk itself might lead to short-term sell-offs, but the bigger problem for the US is a long-term deterioration of its global market status.

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