Macro
On Thursday, the Bureau of Economic Analysis confirmed that the U.S. economy grew 2.8% in Q2. This strong growth surpassed expectations of 2% and Q1 growth of 1.4%. At first glance, it confirms sustainably strong demand and consumer resilience. However, after analyzing underlying drivers, this result looks less impressive. Q2 growth mainly came from 3, not very desirable areas:
- Inventories (+82 bps): Inventory growth tends to be volatile and mean-reverting throughout the full business cycle. Sometimes, piling up inventories reflects weakening consumer demand.
- Government spending (+53 bps) is engineered rather than organic growth, coming from unprecedented fiscal stimulus, which faces pressure from a growing public deficit. Stimulatory programs include the Chips and Science Act, Inflation Reduction Act, Infrastructure Investment and Jobs Act, and Build Back Better Framework.
- Healthcare services (45 bps) – not directly related to the health of the economy
Growth looks even less impressive when looking at “Real final sales to private domestic purchasers,” which reflects domestic consumer and business spending excluding volatile components (inventories and government spending), which, as explained, significantly affected Q2 GDP.
Economists are concerned that the strong GDP growth is driven by above-trend consumer spending, which may not be sustainable as economic challenges continue to mount. On the one hand, U.S. airports are packed, with traveller throughput near an all-time high. This suggests that middle and upper-middle-class consumers can sustain significant discretionary spending. On the other hand, retailers are noticing a slowdown in demand and report that consumers are shifting towards value-oriented goods. On Friday, the University of Michigan’s consumer sentiment index fell to its lowest since November 2023. Although consumer confidence is waning, this has yet to be fully reflected in consumption. Meanwhile, we are seeing a slowdown in momentum in PMIs, and the index of manufacturing orders has been contracting since April.
A week ago, J. Powell highlighted that the last three inflation prints reflected “a pretty good pace” of price growth. With the Fed becoming more confident that inflation is nearing its 2% target, market expectations for a rate cut in September have strengthened. The Fed is beginning to recognize some downside risks to employment, and we may soon see a shift in policy focus. While hiring has slowed significantly, we have not yet observed large-scale layoffs directly impacting overall employment.
Unemployment remains historically low, but increasing layoffs are pushing it significantly above 4%. The rapid decline in job openings suggests that the U.S. labour market is turning. However, unless the labour market deteriorates substantially, it is unlikely to prompt aggressive rate cuts. The recent jump in initial claims increases the probability of further layoffs.
The labour market has the potential to move quickly, and if unemployment continues to rise, it may soon trigger the “Sahm rule,” an indicator that the initial phase of a recession has begun. Once unemployment begins to turn, it can create negative psychology and trigger a downward spiral. At this point, the market may require aggressive Fed intervention to break out of this negative loop.
There has been also a considerable turbulence in U.S. politics over the past few months:
- Donald Trump was found guilty.
- A game-changing presidential debate took place.
- An assassination attempt occurred.
- President Joe Biden withdrew from the presidential race.
Despite these events, none of them caused significant market movements at a broad level. The primary reason is that none of the candidates have promised to address the biggest issue facing the U.S.—the fiscal deficit. However, on a more granular level, there were some impacts from the election, such as a slight outperformance of junk bonds due to hopes for corporate tax reductions and the strengthening of companies with domestic revenues (as discussed in last week’s ‘credit market’ update). Investors also expect small-cap financials and industrials to rally as a result of increased chances that Trump will win. More specifically, Tesla shares outperformance might also be politically driven. Tesla shares rose 45% in 11 days following the presidential debate and the alleged announcement by CEO Elon Musk that he would support Trump with a $45 million campaign donation (as reported by WSJ, but later debunked). Trump’s lead has, of course, also led to a rally in Trump Media stock.
Rates
The market is already pricing in two rate cuts this year, effectively doing the initial easing work for the Fed. The key question is whether the Fed will cut rates more than twice this year, which seems unlikely. Some economists argue that the Fed’s neutral rate (also known as R*) is around 2.5%. If that’s the case, the Fed is only 10 to 25 basis points away from the neutral rate. However, based on the valuation of the terminal rate in the forward market, the Fed is only 4 to 5 cuts away from reaching it, which could be done with less urgency.
The 10-year Treasury yields are now bouncing off the 4.10% level, which coincides with the bottom of a wedge pattern. In the short term, yields will likely move higher from this level. However, as the Fed is expected to cut rates as soon as September and as yields approach the apex of the wedge, it is likely that 10-year yields will break down after this short-term increase.
Rates investors will also carefully watch the Bank of Japan (BoJ) meeting next Wednesday. Currently, BoJ keep rates much lower than FED’s and most other central banks. This motivates international investors to create a carry trade of borrowing in Japanese Yen and investing in foreign assets. Especially popular are investments in U.S. Treasuries funded by borrowing in Yen due to relatively low risk compared to other carry trades. The issue is that this investment performed extraordinarily well, while JPY has depreciated significantly and caused inflation in Japan, which might prompt BoJ to hike rates. Furthermore, BoJ has signalled the end of yield curve control and Q.E., which signals less stimulatory policy in the future.
As a background to the story, the Yen has been weakening against the dollar since 2021. Initially, it was a slow adjustment on the back of expected FED rate hikes. Then, at the end of 2021, the Yen started to depreciate more rapidly as the FED started a series of hikes, causing a large nominal interest rate differential between USD and JPY. This dynamic began to rapidly reverse at the end of 2022 on the back of the market expectations for the FED rate cuts but then continued throughout 2023 and 2024 due to the ‘higher-for-longer’ FED policy. The USD/JPY rate remained high in volatility throughout this period, driven by volatility in U.S. treasury yields. Furthermore, BoJ, since 2016, has been purchasing ¥6tn worth of Japanese government bonds per month to keep JPY rates close to 0.
Credit
US credit issuance volume remains hot. US IG sales has exceeded expectations every month this year. Year-to-date sale achieved $964b, highest volume since 2020 (In comparison annual US IG volume was $759b in 2023, $798b in 2022, $856b in 2021 and $1.23t in 2020).
While the economy is slowing, spreads are still pricing in a soft landing. Junk bonds are continuing to rally, and volatility is subsiding. This makes the credit market the least attractive it has been in a while now. Given where we are with economic and political trends, there is a risk of upside volatility.
Gap between yields on most and least risky debt is widening due to growin concerns about impact of prolong high interest on the lowest quality companies. Combination of long-period of high borrowing costs, together with slowing economy and increased recession risks deters investors from riskiest parts of the bond market. The average spread pm triple-C bonds is at 9.3%, slithgly up from 9.2% a year a go. Wile double-B is at 1.8%, significanlty below 2.5% a year a go. Gap widens as investors recognize late-stage cycle and demanding more compensation from companies with constrained cash flows and liquidity.
Equities
After a sell-off in the tech sector over the last two weeks, July has become the worst month for the technology sector since April 2016 and the second worst since January 2008. This pullback was anticipated in previous updates, which highlighted strongly overbought conditions, sensitivity to stretched valuations, upcoming negative seasonality, and a potential slowdown in the momentum of the A.I. rally.
Tech investors are beginning to scrutinize the valuations of A.I. companies, focusing on their capital expenditures relative to the potential monetization of new technologies, especially in light of rapidly improving model efficiencies and the arrival of newer, more effective chips. They are also grappling with the risk of growth deceleration, which is expected to be confirmed in next week’s earnings reports. Of the 500 S&P stocks, 171 are reporting earnings next week, including 4 of the “Magnificent 7” stocks (Microsoft, Apple, Meta, Amazon). These companies, which trade at high multiples, are particularly vulnerable to potential disappointments. Given that they represent 20% of the S&P 500’s market cap, their earnings reports will significantly impact the index and overall market volatility.
All of these mega-cap tech stocks are trading near their historically high multiples. In other words, they are priced for perfection, and any disappointment could have a large effect on their prices and the overall index valuation. This week, Alphabet fell 5% after reporting a 14% growth in revenues and earnings, slightly ahead of analysts’ expectations. All of the “Magnificent 7” stocks are also off their all-time highs from early July, as the A.I. trend has started to lose momentum due to questions about the returns on large capital expenditures. Strong demand for cloud services, AI-related computing, and the overall A.I. arms race drive significant capital expenditures.
While the Equally Weighted (E.W.) The S&P 500 index is close to its all-time high; the Cap Weighted version of the index has declined 3.7% from its peak (with a 4.9% intraday peak-to-trough on July 25th). Over the past month, 70% of S&P 500 members have outperformed the index. This represents an extreme month-to-month turnaround, going from the second-lowest to the highest percentage of outperformance in 30 years. This highlights the rotation argument from last week’s equity update; however, as a standalone measure, it does not confirm a broader trend.
Major indexes were down, with the NASDAQ Composite declining 2.1%, the NASDAQ-100 down 2.5%, and the S&P down 0.9%, while there was a continued rotation to small caps, which began after the CPI print on July 11th, gaining 3.5%. The rotation to small caps, which started right after the CPI release, was the largest on record when comparing the relative weekly performance of the Russell 2000 to the Russell 1000. To gauge how far small caps could grow, we can compare it to the October-December 2023 small-cap rally, which resulted in 30% gains. This time, due to technical factors such as short positioning and historic size divergence, we could experience an even bigger rally.
From a fundamental perspective, small caps are very sensitive to rate cuts. Therefore, weakening labour data has prompted beliefs in much faster rate cuts and significant fiscal relief for highly leveraged small-cap companies. On the other hand, excessive weakening could cause a growth scare and negatively impact cyclical and small caps. There is already negative commentary coming from the cyclical, as they mention on earnings calls a loss of pricing power, with phrases like “slower price increases,” “slower revenue growth,” “consumers are more challenged,” and “value-seeking behaviour.”
Additionally, we should flag the weakness in the Chinese equity market, which is struggling to rekindle internal consumption. Consumers have pulled back their spending following the real estate market’s collapse. Emerging Markets (E.M.) have lagged Developed Markets (D.M.) due to a 2.3% decline in Chinese equities.