Macro
Core PCE (Personal Consumption Expenditure, which strips out volatile food and energy items) rose by just 0.08% in May, the least since late 2020. Wages rose by 0.7% and real disposable income by 0.5%, while savings rates rose by 3.9%. The economy is normalizing with a balanced job market, persistent growth and moderating inflation. This result may provide affirmation that inflation is moving in the right direction and that the FED should be persuaded to reduce borrowing costs sooner.
Over the first 5 months of this year, real consumption has grown below 1%, capital goods shipment has been flat, and new home sales have been running at the lowest level since November. Some economists are worrying about this slowdown, highlighting that the FED can be too slow to react and that its data dependence on the lagging data can be pretty dangerous.
The labour market and consumer spending remain key variables for investors. US consumers remain resilient, and delinquencies have been declining since April. Credit card and auto loan delinquency rates are still around 2010, when unemployment was over 9%. With little accumulated savings to draw on and increased credit costs, consumers might need to curtail spending.
It’s crucial to note the recent revision of the US 2024 budget deficit estimate by CBO, from the previous $1.6t to nearly $2t. This expected deficit now equals the size of the Russian economy, or 7% of the US GDP (22.7% expenditures and 17.2% revenues).
Source: Congressional Budget Office
Rates
Surprisingly, despite positive PCE data, this week’s 10Y yields moved higher to the top of their downtrend channel. The expectation is that the post-presidential debate market started to expect more spending and potential inflationary pressure over the long run, pushing 10Y at a higher rate than the short end of the curve. The bond market’s volatility is declining, and we are seeing the MOVE Index now at 95.
The FED preempted their rate cut move at the end of last year, while this year, they were surprised by the strength of economic growth, which indicates that the rate is more relaxed than initially believed. Now, the FED is acquired data dependent and requires several months of data to validate moderation in inflation and economic activity. For this reason, although we see significant progress on the inflation front and some moderation of economic activity, it will take a few more economic reports before convincing the FED to cut. There are also upcoming presidential elections in November, which makes it politically awkward to shift monetary policy before the election.
The chairman’s risk is to cut before the data confirms any economic weakness and then reverse course. Nevertheless, the FED’s next move is expected to protect the labour market rather than fight inflation.
BMO has an interesting perspective on rates and expects no cuts this year. They argue that the FED has two playbooks:
- Growth playbook – seen between 2000 and 2020, with moving rates in response to the economic growth numbers
- Inflation playbook: hike on ease based on inflation, with little regard to the growth numbers. This is the playbook the FED applied back at the end of the 1970s and what the FED is applying now, starting from the end of 2021.
BMO sees an economic slowdown and suggests that the FED is still using the inflation playbook. It would take for the economy to tip over before it will shift its focus back to growth.
Credit
The credit market will remain constructive as long as high rates are accompanied by high nominal economic growth. Spreads contract further as the all-in yield tempts investors. US IG Spreads are now 94 bps, while HY Spreads are 313 bps. There is also compression between different grades, especially BBB and BB tranches. Spreads are also getting very tight in the private credit space, with some of the most recent deals closing below 500 bps. The covenants of those private dealers are also starting to converge with those of the public markets.
June was the slowest month this year for the US corporate issuance, with sales at $17.6b compare to average of $26b – $31b range for the prior months. Demand is still much higher than supply, however credit investors are getting more cautious with their credit selection. High borrowing costs have been putting pressure on margins and earnings, which will lead to dispersion between sectors and companies over time. This combines with economic softening should incentivize credit investors to go higher up in quality, highlighting the need for prudence and careful credit selection in the current market.
Equities
AI is a powerful once-in-a-lifetime trend that, like any other strong market theme, is prone to being elevated to a speculative theory. However, there is still a long way to go. Currently, however, the rally is supporting chipmakers, model developers, and data centres enjoying higher valuations. The expectation is that AI hype will broaden to other areas. The rising productivity tide will eventually lift all boats.
US equity investors have been calling for broadening the market outside of the AI theme, but small and mid-caps have yet to join the rally. S&P 500 market-cap index continues to trend up, while S&P 500 equally weighted is moving sideways since April. Moreover, the Rusell 2000 is moving sideways from the start of the year. The performance gap is explained by mega-cap tech leadership, responsible for the majority of gains. While stocks hit new highs, they are driven by solid fundamentals and record high expectation of forward EPS, which is not close to $260 for the S&P. Consensus YoY earnings growth for Q2 is at 9%, which is the strongest growth since Q4 2021. 6 most extensive stocks (Microsoft, Nvidia, Amazon, Apple, Alphabet, Meta) are expected to grow Q2 EPS by 30% where S&P494 (rest of the S&P 500) is expected to grow at 5%.
Outside of technology, there are numerous value-oriented opportunities in the equities market. Based on the earning potential and current valuation, the Energy sector is expected to see the largest price increase and technology the smallest. However, energy has performed poorly so far; thus, it’s a contrarian play.
US equity investors must ask themselves how much further markets can raise. The market was up 25% YoY, and non-US equities were up 15%, but with the current valuation, it will be difficult to repeat those returns. We are about to start July, and it’s a strong month from the perspective of seasonality. It has been positive for 9 years in a row. July has historically been especially strong in the election year. However, August to mid-October tends to be weaker.