Macro
Year-over-year (YoY) Consumer Price Index (CPI) has not reached a new low in the past year, bottoming out at 3% a year ago. Persistent inflation results from robust growth and a tightening cycle without even a soft recession. While CPI remains far from the FED’s target, Core Personal Consumption Expenditures (PCE) is more likely to approach 2%, though this might not happen this year. The FED argues that the inflation data is insufficiently positive to warrant a rate cut at the next meeting.
Some market participants are concerned that the FED’s focus on historical data does not fully appreciate recent indicators, such as the slowdown in consumer spending evident in the retail sales data. These participants look forward to the first rate cut, which would signal that the FED is confident in controlling inflation. However, apart from the signalling effect, the impact of the first cut itself is expected to be minimal, given the deeply inverted yield curve. The 10-year yields are around 4.3%, while the FED funds rate remains between 5.25% and 5.50% since July 2023. The 2-year to 10-year curve is now more inverted than at the start of the year.
Many analysts argue that the FED is overly data-dependent. Although inflation has not yet hit the target, it is moving in the right direction, and the numbers cited by the FED are backward-looking. An important component to watch is the wealth effect. So far, real estate has held up well in this high-interest-rate environment. Still, if this sector weakens, confidence in the economy may diminish, potentially leading to a pullback in consumer spending.
Suppose former President Trump wins the upcoming election and implements his policies. In that case, we might see an extension of tax cuts, a continuation of the deficit, and significantly higher tariffs, potentially leading to a steepening yield curve. The biggest policy difference between the two leading candidates is their stance on deregulation.
Rates
The primary motivation for a potential rate cut by the Federal Reserve remains to be determined, as more data is needed to gauge economic outcomes accurately. Regardless of which scenario unfolds, expectations are leaning towards at least one rate cut towards the end of this year. The question is whether this will be a systematic or one-off ‘cut and see’ move. This depends on the primary motivation behind the move:
- Moderating inflation. If the economy remains strong but inflation moderates satisfactorily, a one-off cut or a few cuts followed by a pause will be most likely.
- Economic weakness. If the main issue is weaker economic data (expected to coincide with moderating inflation) and a downward trajectory in economic activity, we can expect a shift in monetary policy. In this instance, rather than a ‘cut and see’ approach, we could expect an extended rate cut cycle that can be executed over a longer period.
Before the September meeting, when the market expects the first rate cut, we will have two payrolls and three CPI reports, which will provide crucial data for the FED’s decision-making process. Many rate observers argue that the economy still needs to feel the impact of the FED’s rate hikes fully. This suggests that more time is required to understand the full effects of the current monetary policy lag. Market expectations have already shifted to pricing in two rate cuts, reflecting growing concerns about economic growth over inflation. This shift has led to increased volatility in the rates and currency markets.
Last week’s Treasury auction saw a bid-to-cover ratio of 2.74x, slightly higher than the 2.67x average in the previous six auctions, indicating steady demand for government securities. The best value currently lies in high-quality floating rate instruments. The front end of the curve allows investors to be more opportunistic, enabling them to act on opportunities when spreads widen.
The timing for rate cuts will likely coincide with the U.S. presidential election, which might influence the FED’s decisions. Those within the FED who advocate for rate cuts believe they must bring rates down to 2.75%, implying 10 cuts of 25 basis points each from the current levels. However, the market prices at a terminal rate of 4%, suggesting only 4 to 5 cuts to reach a neutral stance.
The market is currently pricing in 1.75 rate cuts. The FED is inclined to cut rates and likely has the space to do so by the end of the year. Investors are closely watching how shifting concerns from inflation to growth will influence the FED’s actions and market volatility in the coming months. The yield curve has been inverted for so long that predicting a rapid reversion is risky, especially with the FED still holding $7 trillion in bonds on its balance sheet. in bonds on its balance sheet.
Credit
Current razor-thin credit spreads need to be judged in the context of anticipated economic activity. With the current strong economic growth, monetary policy seems less restrictive than expected, and 10-year yields are comfortably hovering around 4-4.5%. If this economic strength is maintained, interest rates might stay at their current levels longer than expected. In this scenario, credit investors attracted by high all-in rates rather than thin spreads might not be sufficiently compensated for the level of risk they are taking. Conversely, if the U.S. economy faces sudden weakness, locking in high all-in rates will be attractive, but spreads near all-time tights will be highly vulnerable.
The credit market is entering a precarious phase, with spreads compressing to razor-thin levels. Due to tight spreads, hedging credit risk has also become very cheap. Therefore, if an increase in defaults is expected, investors can inexpensively hedge that risk.
If the economy remains strong, the FED might keep rates high, and as debt gets refinanced, increasing financing costs will put more pressure on companies. On the other hand, rates will only be cut when the economy and labour market weaken, decreasing demand and pressuring credit portfolios.
For more risk-sensitive credit investors, the most attractive part of the market is in high-quality floating rate instruments due to tight spreads and the inverted yield curve. Those who take more risks can take advantage of rate volatility and trade around the curve. Investors in distressed credit will find many opportunities from upcoming refinancing by companies that survived the COVID-19 crisis thanks to ultra-low financing costs.
In the investment-grade (IG) space, $31 billion was sold last week, exceeding projections.
Equities
The S&P 500 closed the week at 5,464 points, almost exactly at the median year-end target of strategists, currently 5,450 points. S&P 500 index earnings forecast for the end of 2024, 2025, and 2026 stands at $270, $300, and $325, respectively. This suggests limited upside for this year but indicates potential targets of 6,000 and 6,500 for the next two years.
The big story of 2024 in the equity market is the significant multiple expansion driven by robust growth in mega-cap technology stocks and sectoral shifts. This expansion is exemplified by Nvidia’s brief stint as the world’s most valuable company, reaching a market cap of $3.35 trillion on Thursday. However, the stock experienced a 7% peak-to-close decline (8% peak-to-trough) on the same day, selling off by $200 billion and dropping to third place. This slide was primarily technical, reflecting some profit-taking, though Nvidia remains up 150% for the year. The semiconductor landscape is evolving as Nvidia’s profit margins attract competition (“Your margins are my opportunities”). Companies like Google, Amazon, Apple, and Microsoft are developing their own chips, which could impact Nvidia’s market dominance in the mid-to-long run.
Positioning in the market depends on beliefs about the market cycle. The consensus points to a mid-cycle phase, where large caps typically outperform small caps and market-cap-weighted (CW) indexes outperform equal-weighted (EW) indexes. However, the current extreme divergence between CW and EW performance could reverse violently at some point. Meanwhile, the Russell 2000 has had flat earnings for over two years, which is unusual since small-cap earnings typically grow with the economy. Structural factors may be at play, with many small companies growing rapidly being acquired by large caps before they can IPO independently, explaining the stagnation in small-cap earnings.
Geopolitical risks are another important component, though their impacts are difficult to predict. These risks often result in spikes in oil prices and energy. Since the pre-pandemic era, energy has been the second-best performing sector after tech, with roughly double the dividend yield of the S&P 500. As we look ahead, the interplay between mega-cap tech, sector rotations, and geopolitical risks will continue to shape the equity market, making strategic positioning crucial for investors aiming to navigate this complex landscape.
In a mid-cycle environment, Financials and Industrials usually perform better than Technology. However, the AI story has been pushing tech stocks, especially mega-cap tech, higher as they are the main beneficiaries of the AI revolution. This has led many managers to consider sector rotation and a shift to value. Those positioned too early have underperformed due to underweighting mega-cap tech, which drove indexes up thanks to the AI-revolution rally. A more prudent approach involves a barbell strategy: on one leg, taking advantage of momentum in mega-cap tech, and on the other, positioning in attractive value names in Financials, Industrials, and Energy. This strategy allows holding what’s working while preparing for market broadening, mid-cycle behaviour, and convergence between value growth and CW-EW performance.
Friday’s triple witching (quarterly expiration of stock options, stock index futures, and stock index options contracts) caused a significant uptick in trading volume, highlighting the market’s sensitivity to such events.