Nervous markets ahead of second pivot
Posted 6 September 2024
Capital markets have started September rather despondently. It feels similar to (though not nearly as bad as) the sell-off that started in August, after which stock values quickly recovered. There were risks and headwinds back then, but nothing that significantly dampened the long-term outlook. This is even more true now: there are lots of uncertainties, but little that should materially concern investors. After August’s early sell-off and eerily strong recovery, we said markets should be generally positive in the months ahead – but further bouts of volatility were likely. Nothing this week has disturbed that view.
China continues to weigh on growth – and the world gives it little support.
Markets are clearly nervous about slowing global growth, but this has been a feature for some time. It is most obvious in China, and there were more signs of weakness this week. Several big investment banks have downgraded their outlooks for Chinese equity, after second quarter profits shrunk by their largest amount since the end of 2022. Profits are expected to pick up again, but not by as much as analysts thought at the start of this year.
Weak iron and steel demand is probably the clearest sign of China’s struggles. Sentiment among steel producers was negative in July and worsened in August. The Chinese government has been reluctant to substantially support growth and their main lever for that support – stimulating industrial production – is worsening the global oversupply problem. The overhang of China’s unsold inventories is a major headwind for goods manufacturers across the world, and slowing demand for materials is affecting emerging market (EM) commodity producers.
US consumption has been surprisingly strong in the post-pandemic period and, in the past, that would have benefitted Chinese exporters. But tariffs brought in under successive US administrations have weakened that line of support. Things could get worse if Donald Trump is re-elected, with his promises of a 60% blanket tariff or higher on all Chinese goods. The realignment of US-China trade has been a benefit to many EMs as global companies relocated production from China, but EMs in Asia might feel some indirect pain from further deterioration – and perhaps some direct pain if Trump hikes tariffs on them too.
How long can services strength last?
These trade and disinflation problems are weighing on manufacturers globally. Auto manufacturers are the prime example; this week Volkswagen said it was considering shutting factories in its German heartland. German carmakers shutting domestic production is a visceral sign of the industry’s troubles, given its cultural and political importance. But the problems are global, and even US manufacturers are under pressure.
Still, the service sectors have managed to hold up well through this period of manufacturing weakness – particularly in the US. The resulting earnings resilience has been good news for markets and the US economy – as they form the largest share of both, and are the backbone of employment. But the sell-off this week may be in part driven by a fear that the downturn will spread to services. There are some tentative signals that this might happen – core service inflation has slowed quite quickly, and labour market pressures have eased – but nothing conclusive. Markets seem worried about what will happen if manufacturing stays this weak.
Of course, the reaction could go the other way around – resilient services eventually leading a manufacturing recovery, as markets have predicted for most of 2024. The Fed pivoting to lower interest rates would help that, and bond markets now (as of this Friday afternoon) imply more than a 50% chance of a 0.5 percentage point interest rate cut (rather than just 0.25) at the Fed’s meeting in two weeks. But the risk of services weakening challenges the ‘goldilocks’ narrative that investors have embraced for so long. It was hoped that rates would come down while real growth remained – buoying equities – but now the real growth component is being challenged.
The US may struggle to keep shining.
That risk is why the Fed has so clearly signalled its intention to cut rates and support the economy. Indeed, the pivot towards lower rates looks a little misplaced without that context, considering the world-beating performance of US growth and markets over the last few years. After such prolonged outperformance, it seems strange to think that the US economy needs help (many commentators still doubt it does). But as JP Morgan analysts recently pointed out, US employment and core services inflation is now weakening more rapidly than elsewhere.
That might just be because the US is starting from a much stronger point. But it could also be down to factors like fiscal support wearing off and pandemic-era savings being depleted. In any case, continued US exceptionalism is not guaranteed. You could view the momentum shift against big AI stocks in this light. On Tuesday, Nvidia recorded the biggest ever single-day market cap loss of a stock, shedding $278.9 billion after its share price dropped 9.5% on the day.
A potential end to US outperformance would hurt international investors – since American stocks are such a big component of global portfolios. Investors will know as much from big tech’s troubles in the summer and their 2022 downturn.
But there are positives for global markets or the economy. A weaker dollar usually supports global growth, for example. We could end up in a similar situation to 2014-16, when energy and commodities struggled and several big industries were caught in the fallout – but overall there was a real income boost which stabilised the global economy.
The next fortnight will be about central bank meetings and in particular whether the US Fed delivers on their signposted second pivot by lowering interest rates. The European Central Bank (ECB) kicks off proceedings on Thursday 12th, followed by the US Federal Open Markets Committee meets on Wednesday 18th and the Bank of England (BoE) on Thursday 19th. The ECB is expected to cut by 0.25 percentage points, bringing the deposit rate to 3.5% and overnight bank rates to just above 3.4%. The BoE is not expected to move again after cutting the base rate by 0.25 points to 5% on the 1st August.
The Fed will cut its Fed Funds target band by at least 0.25 percentage points at its meeting. The band is currently 5.25%-5.5%, with the “effective” rate just over 5.3%. This week’s soft employment data culminated in a non-farm payroll (the number of new private and government agency jobs) gain for August of 142,000, below the expected 165,000. This decline in employment gains is not horrible but, together with slowing inflation and no rebound in manufacturing, it suggests that rates need to be lower, ultimately down to about 3.5%. The risk of inflation rebounding has faded quickly, so we think the Fed will probably cut its funds rate by 0.5 points, to an effective 4.8%.
Changes to the previous expectation set like this can scare markets in the short-term – as investors start to worry that the Fed knows something bad us mortals do not. Others think the Fed might already be behind the curve of a slowing economy, but this is a scenario the central bank has analysed and prepared for. Its well-researched playbook says it is better to act decisively and quickly when faced with a downturn, so we should expect policymakers to do so. Rates are therefore set to fall and as already stated more likely by 0.5 percentage points than 0.25, as the Fed is now more attuned to downside risks. A more active Fed is a good protection and investors will surely take comfort in that