MACRO
Financial health of a consumer is back in focus as the cumulative excess savings are in decline. If this excess savings turn negative, consumers will start to draw on credit, which with a current restrictive credit conditions and high interest rates may force them to significantly reduce consumption. Currently US consumer still remains resilient due to strength of the labor market.
This month inflation and interest rates narrative has been reflected in the flows as expected. In August we saw Fixed Income attracting more flows than Equities (based on US listed ETFs +$9.6b FI vs $7.5b EQ) as investors are tempted by the high yields. For equities, investors trimmed their exposure to US large caps (-$7b), most notably to the tech heavy QQQ fund (-$4.6b. Invesco fund replicating NASDAQ-100). They also withdraw heavily from financials (-$1.7b). For Fixed Income, they moves money from the IG corporate bonds (-$3b) to Treasuries ($5.6b).
For the full year however, Equities seen more inflows then Fixed Income (US-ETFs +$128b FI vs $191b EQ). This is mostly cause by investors buying Equities at discount, hoping for mean reversal after the last year’s sell-off. US Equities are nearly 20% up this year and down 20% last year, with big-cap tech nearly 45% up this year vs 28% down last year. Also Commodities have seen outflows (US-ETFs $6b CO) due to disinflationary narrative.
Another important topic is slowing Chinese economy and potential negative impact on the global and US growth. Biggest concerns are related to contraction in the property investment, which for decades supported Chinese economic growth. Second concern is decline in the export, which cannot be offset by also slowing, internal consumer demand. Soaring youth unemployment is another knock to already shaky economic outlook. Furthermore there is pressure on the foreign investors to reduce their investment in China due to to ‘de-risking’ drive.
In addition there are growing tensions between world’s two largest economies. US and China have $700b dollars trade relationship which is important to protect for both parties. Only about 1% of that trade is currently affected by the export controls, US has imposed on technologies that have a direct national security impact. Both nations opened up dialogue on the commercial issues, through the formal working group. They hope to maintain and grow trade between between them, while simultaneously taking into account national security concerns.
CREDIT
Spreads remains tight, but they are diverging between different credit quality tiers. Leveraged loans and CCCs spreads are now significantly higher than BB as the credit conditions continues to tighten. With the growing credit pressures and much higher costs of capital, the High Yield market has now generally, a much lower overall quality.
Global credit analysts are focused on exposures related to Chinese property sector which is going through liquidity crisis and a series of downgrades. Most notably Chinese developer Country Garden Holdings Moody’s rating has been cut this week three notches to Ca. Entire sector is struggling with weakening sales and sizable maturing debt, bringing wider Chinese junk debt market to the lowest level since the post-Covid recovery.
RATES
It has been now 3 years with inflation above the FED’s target. Inflation has come down significantly since the FED has started tightening, but the last mile of going from 3% inflation to 2%, is the hardest.
This week 10Y have moved lower, but just last week 10Y was the highest for the cycle, and 2Y was near the cycle high. In likely scenario (unless we see a recession) that inflation will stay suborn at around 3%, 10Y will remain elevated and can push even higher. This is because after adding a real yield of 100 to 150bps to 3% inflation, the fair value of neutral FED funds rate is expected to be 3.5 to 4%. In addition if the yield curve reverts back to normal, and we will reach the maturity premium of 100 bps (vs FED funds rate), that will put 10Y yield at around 4.5% to 5%.
The FED is probing for a ‘sufficiently restrictive’ level of interest rates, at which it can be confident that inflation is going to come down. Market is convinced we are already there, and currently pricing nearly 90% probability of a pause, and just over 10% probability of 25 bps hike on the next FED meeting.
We can also see that markets is expecting first rate cut only in June 2024′ – striking difference compare to just 4 weeks a go, where market expected 4 rate cuts in 2024.
EQUITIES
US equities where roughly flat for the month of August, mostly thanks to the recovery over last two weeks, which pushed S&P back above 4,500. August drawdown was mostly driven by the sell-off in big caps, and pull back in big-tech rally, partially offset by increased participation by small and mid caps. For the majority of the global markets however, we still see significant losses for the month of August.
Last two weeks rally was mostly driven by buying the dip as market have been oversold after the early August pullback (5% for S&P and 7% for NASDAQ). In mid-August Relative Strength Index (RSI) for S&P 500 showed the most oversold conditions since March, and RSI for NASDAQ Comp & NASDAQ 100, showed the most oversold condition this year. NASDAQ move was also in line with interest rate move. It bottomed (18/08 Friday) just before 10Y has peaked (21/08 Monday 4.33% or intraday 22/08 Tuesday at 4.36%), and since then NASDAQ moved up by 6%, while 10Y decline by 23 bps (-5.5%).
From a sector perspective most interesting dynamics is in financials. As the conditions are tightening, banking sector is back in focus. Analysts are focusing on bank-walk and banks inability to hold on to deposits, which affects banks profitability. Over 9% of all deposits (about $1.4b) has left the commercial banks since the nominal deposit peak in April 2022. This is the highest drawdown on record. Money are leaving banks and are being transferred to the money market funds, which saw over $1b inflow during the same period. Since beginning of the FED hiking, banks have been enjoying high spreads. Now they see deposit withdrawals, which puts their profitability under pressure, which in turn lead to recent underperformance of the banking stocks.