Monday Digest
Posted 29 July 2024
Don’t fear the rebalance
The rough patch for global stocks continues – yet again concentrated in the frothy US mega-caps. Smaller caps continue to be a bright spot, but in aggregate these gains are being outweighed by large-cap losses. The “Magnificent 7” (Mag7 – Apple, Amazon, Alphabet, Meta, Microsoft, Nivida, Tesla) looks far from magnificent, falling more than 11% since early July. Ultimately, though, we think the market-wide rebalance is positive.
Tesla was the worst offender last week, losing 12% share price after extremely disappointing Q2 profits. The electric carmaker is being hit by both sour tech stock sentiment and a global downturn in the autos market. Chinese overproduction means carmakers have no pricing power – and there is a similar story in microchips. Manufacturers are under real pressure.
Fortunately, that weakness is not yet spreading into services – as it historically has. The problem is firmly on the supply side, and demand has held up reasonably. For now, it looks like manufacturing weakness is a good thing for consumers – lowering their prices and giving them more money to spend on services. That could change (particularly if manufacturers cut jobs) which we will have to keep an eye on.
We welcome the large-to-small cap rotation, but Mag7 losses could still be painful for markets overall. Those companies are big enough that their troubles weigh down the entire stock market – in which US consumers are heavily invested. Still, capital readjustment helps growth prospects for smaller caps, as will the Federal Reserve’s upcoming rate cut. The case for global, not just US, growth is still strong. The UK has been a notable bright spot, for example, thanks in large part to the new government’s closer European relations.
Last week’s market wobble might not be over, for the US mega-caps at least. But the rotation will hopefully move capital from where it was too concentrated to where could have the biggest growth benefits. Investors should not fear the rebalance.
Sahm-thing to worry about?
The “Sahm rule”, a US recession indicator based on how quickly unemployment is rising, is close to being triggered. The rule says that a recession starts when the three-month average unemployment rate is 0.5 percentage points above its lowest level in the previous 12 months – because when unemployment rises, it usually rises quickly. After US unemployment climbed to 4.1% in June, the gap has now narrowed to just 0.43pp.
We are unlikely to trigger the 0.5 threshold soon for technical reasons (the previous low drops out of the monitoring period next month) but a similar regularity noted by former New York Fed president Bill Dudley (three-month average unemployment 0.3pp above the cycle low) has already been breached. Of course, recession indicators are all rules of thumb that come with exceptions, and American economist Claudia Sahm, the rule’s namesake, noted last year that her rule would not be the first to break down during this post-pandemic cycle.
The key question is whether unemployment will stabilise at the current rate, or job losses will spiral. Fed officials seem to expect stabilisation, largely because current unemployment is close to their estimate of the ‘neutral’ rate. This is backed up by the ‘Beveridge curve’ – data showing that there is a balancing point between unemployment and job vacancies (increases in the latter are usually thought to be inflationary). June’s unemployment was at that point, which we can interpret as neutral (as the Fed seems to) or, more worryingly, as a tipping point.
Past resilience of the US economy should perhaps suggest a positive view, but this might be counteracted by the drying up of pandemic-era savings. Upcoming rate cuts will help in any case, but businesses might not be far from cutting jobs. The US economy certainly looks more fragile than it did a few months ago.
China won’t ship out inflation
The cost of shipping freight out of Shanghai has soared recently. This has historically been an indicator of downstream inflation – thanks to its effect on Chinese goods producers, and eventually US consumers. Spiking Shanghai freight are therefore worrying many about a return to global inflation. But we think this time is different, and we won’t see inflation shipping out of China.
What seems to be pushing up costs this time is a massive pickup in US demand for Chinese goods. This is almost certainly due to Donald Trump: the former president and Republican candidate unleashed a wave of tariffs on Chinese trade during his first term, and has promised to do so again if re-elected. His administration will reportedly target 60% or higher tariffs on Chinese goods. With Trump currently the favourite for November’s election, Chinese exporters and US importers think this might be the last realistic chance to trade. So, they are rushing to exchange goods, even if freight costs seem prohibitive.
This is unlikely to result in price pressures down the line, simply because Chinese firms are in no position to put up prices. Its domestic economy is weak and the government has been exacerbating a severe overproduction problem. That has resulted in ‘dumping’ goods (particularly electric vehicles) on international markets, pushing down prices. This is one of the key reasons global manufacturing is so weak. At the moment, China is exporting disinflation.
Chinese producers will likely bear the freight shipping costs, because they have little choice. Whether Trump wins or loses in November, we should expect the rush of China-US shipping to end in 2025. Freight costs are not as inflationary as in the past.