Still mostly sticking to the plan

Posted 14 June 2024

After a cacophony of political noise, central bankers were again the ones to really strike a chord with capital markets this week. Britain’s political parties unveiled their manifestos and French President Macron shocked everyone with a surprise election call – causing fairly significant market consternation – but it was an updated interest rate forecast from the US Federal Reserve (Fed) that turned out to be the key driver of markets. The Fed signalled it would cut interest rates just once this year, disappointing those who were betting on two cuts. This was called “hawkish” by the media, but we think “bullish” is probably more appropriate. It was more about recognising economic strength than a preference for higher rates.

UK underperforms, but don’t blame elections.

First off, we should say something about manifesto releases from Labour and the Conservatives. UK investors are understandably anxious to hear how the election and future government might affect their portfolios, but the answer is, once again, probably very little. Labour is expected to win a majority, but not change much about the UK economy or the fiscal position as far as asset prices over the short-to-medium term are concerned –  particularly when compared to the market upheaval the ill-fated Liz Truss government managed to cause. The policy-lite manifesto Keir Starmer’s party unveiled this week did nothing to change those expectations.

Interestingly, the few weeks since Rishi Sunak announced the election have coincided with a pretty dour period for UK stocks, and  right after a period of outperformance for UK assets, too. But this is probably a coincidence. Britain’s biggest stocks did well in previous months because the group is dominated by banks, multinational energy and commodities companies – stocks that usually do well when the wheels of the global economy turn to expansion. Global growth positivity has slowed in recent weeks, with a distinct shift back to the US megacap stocks, with their seeming immunity to economic downturns.

On the plus side, UK stocks still have cheap valuations compared to international peers, and the longer-term growth case is not damaged (in fact many economists suspect it might be marginally improved) by the widely expected imminent switch in government. What the Bank of England does will be much more important for UK assets and, on that front, it looks like the bank has more room to cut rates than international counterparts. Recent inflation data was barely above the 2% target, and markets are evenly split on whether the BoE will cut this month.

Fed signals economic positivity – not hawkishness.

After multiple signals that US inflation had come down significantly, markets thought the Fed would validate their implied expectations of two quarter-point rate cuts this year. But the Fed’s ‘dots plot’ – which shows committee members’ expected rate paths over the next few years – revealed that officials expect to cut rates just once in 2024.

This was called a “hawkish” move by financial media, but US stocks still ended the week up. This is because the Fed’s update was more about acknowledging the US economy’s strength and resilience than turning hawkish. Indeed, in the press conference, Jerome Powell acknowledged that recent economic data had been soft – perhaps a signal that he personally would be inclined to cut rates sooner rather than later.

Some recent US inflation data has indeed been soft – including May’s CPI print of 3.3%, released only a few hours before the Fed’s dots plot announcement. But other sources are still pointing toward US strength, such as the outsized jobs increase reported last week: 272,000 jobs were added in the US last month, smashing expectations of 185,000.

It is an open question whether this job market strength will lead to renewed inflationary pressure. What is not up for debate, however, is that the US economy is stronger than other regions and still stronger than most expected it to be at this stage of the cycle. This strength is giving the Fed pause. As the dots plot shows, officials still plan to cut rates this year, but they need to see more evidence that the current gentle slowdown in US growth is sufficient to keep inflation from flaring up again.

That makes perfect sense, and markets are unlikely to interpret this as a negative signal about the US economy or financial conditions. Central bankers are sticking to the rate cut plan, just getting more realistic about how, when and to what magnitude it can be implemented.

Investors flock back to tech megacaps, a possible warning sign for global growth.

At the time of writing, the Bloomberg World Equity Index is showing a tiny overall gain since the end of last week in Sterling terms, but the distribution of returns across sectors and regions is skewed. Across the board, stocks are more down than up,  with just the top 5 positive contributors – Apple, Broadcom, Nvidia, Microsoft and Taiwan Semiconductor – skewing the markets overall back into positive territory. The most negative contributor has been JP Morgan but most of the bottom quintile come from Europe.

LVMH was Europe’s worst performer. The luxury goods company is caught between a rock and a hard place, with its home base being disrupted by Macron’s remarkable decision to call for a parliamentary election and yet more signals of poor demand in its biggest market, China.

Europe has done badly this week, France leading the way down with a 5% loss. Often, as Europe is more cyclical than the US, underperformance can be related to slower global growth expectations (see red line in the chart below). One might expect slower growth in Europe, given the political upheaval, but there are also other signals of slower growth expectations. In the US itself, the Russell 2000 (the 2000 stocks with market cap below the top 1000 in the Russell 1000 index) has been slipping back relatively since the start of May and absolutely since mid-May (the yellow line shows the Russell 2000’s relative performance). And within the top Russell 1000 index, the value-oriented stocks have been underperforming the growth stocks (shown by the blue line).

Together, these signals seem to add up to weakening investor perceptions of the economic growth outlook globally, and even within the US. This went hand-in-hand with the recent decline in global bond yields – at least until political uncertainty intervened. Next Friday, we have the release of the latest business sentiment readings in the form of the “flash” regional purchasing manager indices. It seems to us that these more forward-looking data could set the scene for the equity markets through much of the Summer, coming just as we head into the Q2 earnings season.

Following the very strong run, markets feel a little fragile. It has been powered by a strong run up in earnings expectations which is starting to seem questionable given the run of softer economic data. However, it is perfectly possible that the data could start to turn better, much as it did this time last year. Should that be the case, we would see the pro-cyclical assets – ie. the laggards of the rally of the past 12 months – do well, with a lot of room to rebound from the recent underperformance.