Macro
PPI came slightly hotter than expected. However, the Consumer Price Index (CPI) for June 2024 reported an annual inflation rate of 3.0%, indicating continued moderation from the previous months. While food prices increased by 2.2%, energy prices saw mixed trends, with a decline in gasoline prices by 2.5% but an increase in electricity and natural gas prices by 4.4% and 3.7%, respectively.
Consumer spending has been robust, driven by households leveraging new debt and depleting savings accumulated during the pandemic. However, consumer confidence remained shaky, and there was a forecasted slowdown in consumption in the latter half of 2024. Those expectations are driven by factors such as weak new orders, increased initial unemployment claims, and the expectation that a large decline in job openings will lead to a pick-up in unemployment.
We have started to observe the initial benefits of AI, which are now helping to maintain the competitive edge of the US economy on the global stage. Companies across industries are adopting AI to improve efficiency, enhance decision-making, and develop innovative products and services. AI integration is expected to drive significant productivity gains in manufacturing processes by enabling predictive maintenance, optimizing supply chains, and enhancing product quality. AI has the potential to address some of the most pressing economic challenges, such as labour shortages and slow productivity growth. By automating routine tasks and augmenting human capabilities, AI can help businesses achieve higher output with fewer resources.
While the US economy is resilient in specific areas like GDP growth and employment, challenges persist in consumer confidence and trade imbalances.
Rates
July has been very volatile for rates. Initially, rates moved aggressively up, with 10Y hitting 4.49% at the start of the month in response to higher unemployment. Rates declined from there to close the week below 4.20% after the CPI data release reflected progress on the inflation front. Despite this volatility spike, the overall volatility level is lower, with the MOVE index now below 90.
Markets expect that July meetings will be very dovish. However, the first cut will likely take place in September. As the economy is only starting to slow, 25 bps cuts should be sufficient. Also, the FED is trying to be more gradual to avoid the risk of putting too much stimulus into the market and reigniting inflation.
Given that inflation has considerably calmed down this year, real yields look considerably high and restrictive. This explains why the market expects cumulative 150 bps cuts to get to the terminal Fed funds rate. Some investors are pushing back, citing that the post-election outlook is fiscally expensive and that the market still expects too many cumulative cuts. This outlook is consistent with both election outcomes; the Trump administration is viewed as significantly more inflationary on the back of planned tax cuts and tariffs.
Credit
The US credit market experiences minimal default rates of 1% relative to historical averages of 2-3% yearly defaults. Although the number of bankruptcies is low and has started to creep up, the number of monthly bankruptcies in June has reached the highest level in 2 years. The market strongly diverges depending on quality. Most markets trade close to par; however, about 4% trade at 20% discounts. Those companies increasingly seek Liability Management Transactions (LMTs) to address their maturities. This strategy helps companies manage their debt loads and avoid defaults but raises concerns about fairness and transparency among creditors. The market response incorporates more detailed provisions and protective clauses in credit agreements and clarifies permissible actions to protect against unexpected subordination or restructuring.
In the CLO space, credit still has attractive total yield and price, with good coverage ratios. However, spreads are extremely tight and reside in the 10th decile. Analysts forecast that improving performance and declining rates could reduce leverage by over 2x by the end of 2024.
As inflation subsites while the FED holds up the restrictive rates, the real rates are increasing, and the financial conditions continue to tighten, putting pressure on the lower quality part of the credit markets. Return profiles in those segments were more attractive recently, but they remain extremely variable to financial conditions, especially now closer to the end of the cycle. Investments in this segment require stronger scrutiny and careful security selection.
Going forward, credit investors expect that monetary policy this year will turn from a headwind to a tailwind as the FED starts executing cuts and helps to release the burden of high capital costs. However, investors must be mindful of the economic slowdown, which is likely to elevate the number of future defaults.
Equities
The power of innovation and technology made the US markets outperform since GFC. Out of 11 GICS sectors, technology has added 5.5% weights over the last 3 years, Financials added 1.2%, and Energy 0.8%, while other sectors have shrunk. Over the previous 5-year tech has added 11.5% weight while every other industry shrunk in size. Over the last 10 years, tech added 14.2% weight, followed by a 7% weight gain of ‘Communication Services’ primarily thanks to adding Meta (Facebook) and Alphabet (Google) to this group.
Interestingly, this year, Semiconductors overtook Pharma, Hardware, and Software to become the biggest industry group in the S&P 500, thanks to Nvidia, AMD, Broadcom, and Qualcomm. Semiconductors went from 2% to 12% of the S&P 500 in just 10 years. The lead in industry groups usually reverses after a period of strong leadership. Furthermore, Semiconductors are a cyclical industry, which can amplify this move.
As we move towards the election, stocks become more vulnerable to correction. Going back to the 1950s, US stocks always had a correction in the months leading up to presidential elections. This year, elections could add to volatility as most presidents maintain the status quo; however, this time, Trump is in the lead and tends to shake things up. Back in 2016, when Trump was elected, industrial, energy and defence stocks had a fantastic run; now, many investors anticipate similar rallies and are positioning themselves accordingly.
In addition, we have overbought conditions and are off the highs on RSI (14-day Relative Strength Index), which had the highest reading for the S&P 500 index since December 2023. We also have extreme optimism, with the AAII survey showing the highest bullishness since 2021. Tech is marching higher; however, its momentum is hitting extremes, and short-term pullback is due. With such concentrated leadership, the probability of rotation from growth to value and from large to small caps is very high.