19 Jul 2024
The US economy has continued to drive the path of stock markets in the developed world with US interest rate policy remaining at the forefront of investor attention. The mid-June Federal Reserve meeting saw the US central bank publish its latest Summary of Economic Projections (SEP) and Chair Powell outlined the Fed’s thinking on the economy. The overall message portrayed an economy with continued strong fundamentals which had continued to make progress towards the Fed’s dual mandate of maximum employment and stable prices over the past two years.
Economic indicators such as GDP growth moderated from 3.4% in the fourth quarter to 1.3% in the first quarter but for the Fed private domestic final purchases, which excludes inventory investment, government spending and net exports grew at 2.8% in the first quarter, only a small moderation from that recorded in the second half of 2023. While consumer spending has slowed, corporate capex has picked up from last year, driven no doubt by investment in AI. Many of the leading tech companies investing in this space have positive cash on their balance sheets, so higher interest rates are not affecting their investment spending. The Fed expect a moderate slowdown in economic growth to around the 2% level over the next few years.
Unemployment & wage growth
Recent jobs data indicate a modest weakening in the jobs market. The unemployment rate has ticked up, but it remains historically low at circa 4% driven slightly higher by an increased supply of workers, particularly among the 25-54 age group, something US economic policy has targeted in recent years. Nominal wage growth has eased, though remains higher when looked at in terms of wage increases and productivity growth than is compatible with a 2% inflation rate but continues to improve and the jobs to workers gap has narrowed, although there are still more vacancies than available workers. After a couple of unexpectedly high inflation readings in the first two months of the year, the FOMC seemed encouraged by the more recent run of better-than-expected inflation numbers. Powell emphasised that the Fed is not waiting for the US economy to weaken to cut interest rates, but rather for the Committee to gain greater confidence that inflation was moving sustainably towards its 2% target.
Economic data & voting intentions
The US economic outlook as outlined by the Fed is not reflected in US voter expectations for the domestic economy. In the US, a recent Guardian-Harris survey showed that 56% thought the country was in recession, 49% that the stock market had fallen this year, and a similar number thought that unemployment was at record high levels. This is reflected in the low number of voters who trust Biden to run the economy compared to Donald Trump.
To date, the Biden administration has not been able to turn hard US economic data into voting intentions. A sharp rise in inflation was seen across the Western world through the pandemic and then Ukraine supply side shocks, and inflation has already fallen dramatically from its 7% highs. Positives for the economy have been ignored such as unemployment being at its lowest level for 50 years, strong wage growth, particularly amongst lower paid and black workers and the surge in manufacturing investment which is at record high rates due to the Biden introduced Inflation Reduction Act (IRA).
The US Election
The importance of the US election will increasingly come to the forefront as November gets ever closer, and to date, conventional thinking is that Trump would be positive for the US stock market, with investors looking back at the performance of the S&P 500 under Trump when it benefitted from lower tax rates and de-regulation which boosted corporate profitability and confidence. To date, Trump’s proposals on across the board tariffs seem to be ignored by most investors, despite Moody’s Analytics suggesting that his policies could trigger a recession by mid-2025 with both unemployment and inflation jumping. His policies on immigration have the potential to increase labour costs.
Trump & policies
Trump has continued to reiterate his long-standing plan to impose a 10% tariff on all imports and 60% tariffs on goods from China which the Peterson Institute for International Economics suggest would see average families pay $1,700 more a year in higher prices. Republicans continue to dismiss this as fake news. Both sides of the political debate in the US seem to believe nowadays that globalisation is toxic, and America is in zero sum competition with China. Trump has even outlined plans for an all-tariffs policy in which import duties would replace income tax. Ironically, blue collar workers who seem to be increasingly shifting to Trump, would pay a far higher share of this cost than the rich who spend a lower share of their income on goods.
In a recent book, Robert Lighthizer argued for full decoupling with China and has been touted as the next Treasury Secretary. Trump’s policies, if fully enacted, would lead to greater debt levels, higher borrowing costs and soaring inflation, but the Biden administration has been unable to effectively bring this message across to voters. Both presidential candidates are espousing an American First policy, but Trump would likely look to do this in an erratic manner and unlike in his first Presidency, seems to have appointed or selected personnel to rapidly enact these policies. On tariffs, Trump has already employed staffers to cost out his intended measures. As the November election date approaches, and with the upcoming Party conventions, investor focus on the economic consequences of presidential policy will increasingly come to the fore.
Market leadership
The market’s narrow leadership in the US was reinforced in Q2 with all the gains in the S&P 500 coming from either AI stock or AI-related stocks. NVIDIA, which once again has seen significant upgrades to analyst forecasts, has risen by over 40%, while a group of stocks with a strong AI theme now known by some investment banks as the Fab Five: Microsoft, Alphabet, Amazon, Apple, and Meta are up by 11%. Chip companies related to the AI boom, including Broadcom, Qualcomm and Micron are up 17% but the rest of the market has been flat to negative. Clearly expectations for AI related companies are strong, but analyst expectations for NVIDIA, by way of example, involve a 23% annual growth rate for the next few years, which is considerably slower than that delivered over the past five years. Analyst future expectations for the so-called Fab Five are also below growth rates of recent years. While earnings estimates have crept up modestly (apart from NVIDIA) for Apple, Amazon and Micron, it is perhaps the duration of the growth cycle that has altered. This has resulted in a significant increase in short-term valuations with PE multiples for many names rising by 20% over the quarter. For this to be justified, winners today will have to be the winners of the future, but as has been seen in the tech space, incumbents can keep on delivering strong results for many years and maintain or expand already high margins.
Currencies
The strength in the US economy has proved a challenging backdrop for some emerging market currencies in the first six months of 2024. As a result of stronger than expected US growth, with the economy in the US showing continued resilience, despite higher interest rates, the prospects of rapid easing by the US central bank has dissipated and as a result, expected rate cuts in the developing world have also been put on hold in some cases, and expectations of rapid cuts in 2024 are no longer on the horizon. This has also affected many emerging market currencies which are on track for their worst first half of the year since 2020 with currencies in Latin America and Asia both hit. JP Morgan’s Emerging Markets Foreign Exchange Index has fallen around 4.5% this year vs the US$. Countries like Chile, Hungary and Brazil which have cut rates have seen currency weakness, and Indonesia has been forced to raise interest rates to defend the Rupiah.
The Mexican Peso has been hit by investor uncertainty following the election of a new President and has declined by close to 10% since the country’s ruling Morena Party won a landslide victory that stoked concerns about fiscal policy in Mexico and increased interference in the economy. Some Asian currencies have been adversely affected by weakness in the Chinese economy.
India
The election in India produced a surprise, not that Modi has remained as Prime Minister, but that the BJP Party did not record an overall majority. As a result, Modi has had to rely on coalition partners to form a government. The market had rallied when exit polls were released, predicting a Modi majority, but these proved incorrect and the market initially sold off on the announcement of the official results, with companies linked to corporates believed to be closely aligned with Modi hit hard such as the Adani Group of companies. The broader market has since rallied significantly with investors believing that the package of reforms in India will continue, although more far sweeping reforms of the land and labour markets are likely to be put on hold. The positive for investors was that the election results showed India was still a functioning democracy, as there had been concerns that the country was slipping towards one party rule with restrictions of freedom. During recent years, one comment indicated that in India there was still freedom of speech but there was not always freedom after speech.
Investors are now focused on a country where the nationalistic pro-Hindu policies will be watered down, but the broad thrust of the country’s development in terms of its manufacturing base, which continues to receive attractive incentives and has brought in considerable FDI in the country, will continue. Within Asia, India’s attraction as a functioning democracy with strong demographics and under penetrated consumer sectors continues and the election result should ensure the government focuses on creating jobs for the increasingly better educated workforce which bodes well for future consumption and corporate confidence remains high. After a decade of only sporadic corporate capex, Indian companies across many sectors are now investing for the future. India remains an excellent long-term growth story for investors who are prepared to take a 10-year view.
China
Chinese equities, both in the mainland and those listed on Hong Kong, had enjoyed a significant rally in the second half of Q1, recovering from oversold positions as the economy showed tentative signs of stabilisation. The authorities in China seem to have realised there is a necessity to put a floor under growth and in May this year announced plans to help support the property market which has seen falling prices affect consumer confidence. Savings rates in China have increased, and the authorities now realise that without seeing a stabilisation of property prices, this is unlikely to change. The market is now waiting to see how these policies are put into reality and there is focus on the economic forum in July (third plenum) where significant economic reforms have previously been announced.
Mexico
Mexico has benefitted from its proximity to the US and multi-nationals’ reducing supply chain dependency on China, but the recent Presidential election result has meant a short-term setback to the currency and stock market. Ruling party candidate Claudia Sheinbaum will become Mexico’s first female leader after winning a landslide victory which raised fears of radical constitutional change. Mexico remains well placed if the country doesn’t go down an anti-business route.
Brazil
Brazil’s financial markets have been under pressure this year with concerns having grown about the spending plans of left-wing President Lula. The currency (vs US$) and stock market are both down close to 10% in 2024. Expectations for economic growth have been pared back, and inflation forecasts have edged up. The stock market will need reassurance that economic policy will not emulate Lula’s second presidential term for the market to stage a significant rally. With the right policies, Brazil continues to have strong long-term potential.
Geo-politics
Geo-politics remain problematic and tensions between the US and China show no signs of easing with both presidential candidates finding China a useful scapegoat in the run up to the election. Trump, if elected, will be more extreme in the imposition of further tariffs in China. Many Americans believe that China, if gaining economic superiority, will look to leverage this into military supremacy, challenging the right of the US to be the world’s pre-eminent superpower. China continues to operate in a way its smaller Asian neighbours argue is threatening in the South China Sea and reunification with Taiwan remains a long-term goal of President Xi.
Emerging markets continue to wait for a US economic slowdown, and this has resulted in upward pressure on the US currency which is never an easy backdrop for the asset class and in 2024 to date it’s the currencies that have taken the strain in the main. Any sign of US economic weakness would likely be viewed positively by the market if it did not presage a more significant downturn.
Overall, economic fundamentals remain broadly supportive of equity markets with economic growth resilient, even as inflation proves stickier and the challenge of the last mile decline to the 2% level seems a way off. While this has been a more challenging backdrop for government bonds, equities remain supported by strong earnings growth and the prospect of rate cuts to come at some stage. Equities have also taken comfort from the scope for central banks to enact meaningful interest rate cuts if economic growth did turn out to be difficult.
There is much comment in the rise in valuations in the market, but this has been concentrated on the markets narrow list of winners where bulls argue the AI revolution will extend their period of significantly above average growth so short-term valuation numbers are less relevant. Only time will tell if this is the case, but with the S&P 500 on an equally weighted basis showing a decline over the quarter, the valuations on many US stocks have fallen.
Outside of the US, valuation levels do not look stretched with the UK, Asia and the emerging world trading at significant discounts to peak levels or long-term averages. Within bond markets, longer dated bonds remain vulnerable to curve steepening in the market. Credit spreads look tight, but today’s economic conditions are supportive of very low defaults and justify below average spreads vs government bonds.
Market sentiment surveys remain positive which is always slightly worrying as the best gains often occur when investors are reversing bearish positions. There is still the likelihood that many institutional investors are sitting with cash to deploy in the event of a significant market setback.
Geo-politics remains a wild card with US/China relations, Ukraine and the Middle East potential flash points.
Arguably, the narrowness of market gains in Q2 when Nvidia, Apple and Microsoft drove over 90% of Q2 growth in the US equity market give scope for a broadening out of leadership which would be positive overall for US equities. The prospect of rate cuts, even if delayed in the short-term, is generally favourable for equities (especially when economic growth remains robust). The US election will grow more important towards the end of the quarter and could be a dominant factor over Q4.
For longer-term investors, risk assets such as equities and corporate debt remain the best home for those wishing to grow long-term wealth above the rate of inflation providing there is an acceptance that markets do not move up in a straight line for ever. Investors should not confuse volatility and risk and ensuring those reliant on markets for income have a cash buffer to allow them to sit out difficult times is also an important consideration for ageing but increasingly long-lived populations, as the return prospects for safe assets vs inflation rate remain relatively modest.
Graham O’Neill, Senior Investment Consultant, RSMR
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