Wednesday 10 April 2024

FTSE comes within a whisker of all-time high

Last week was tougher on equities, with most major equity markets seeing some retrenchment. The FTSE 100 was one of the better performing markets, although the difference is minimal.

The previous leaders, the NASDAQ and the TOPIX were the short-term laggards. All of which would seem fairly standard procedure for an equity bull market.

The FTSE 100 came within a whisker of an all-time high earlier in the week, rising through 8,000 on an intraday basis before easing back slightly.

What is it that has been helping it recently?

The broadening of the global equity rally away from seven big technology-enabled companies is clearly a factor. The critical sector to have picked up the market leadership baton has been energy.

The FTSE 100 is often seen as a key play on energy and mining as the sectors form a larger proportion of the UK equity market than they do of other regions. Energy was the reason the FTSE 100 performed really well during 2022.

Often, however, it is lost in the noise of the FTSE 100’s varied composition. The UK market has substantial weightings to cyclical sectors like energy and materials but also some very defensive sectors like tobacco, consumer staples, and pharmaceuticals.

It, therefore, ends up being easier to define in terms of what it doesn’t have, which is much of a technology sector. Investing in energy felt frustrating during 2023. The oil price was weighed down by recession fears and company valuations did not seem to reflect fundamentals, because the sector has a huge amount to commend it.

A favourable capital cycle for oil

We have liked energy throughout this period, recognising that the way in which energy companies are being managed has fundamentally changed. Historically, energy companies sought to grow.

When the oil price was high, they would use it to justify embarking upon new energy projects, any of which would obviously be less profitable if the oil price was to sink back. However, this did not matter in the early 2000s when investors and industry experts would talk about the world reaching peak oil supply where the risks to oil prices were only to the upside.

Since then, the term ‘peak oil’ has become more associated with peak oil demand than supply. This shift of asymmetry of risk has left investors and company management much more cautious in their approach to capital investment. It will feel unintuitive to consider a sector to be attractive because of its downbeat long-term assessment of the addressable market, but there are good reasons to feel it will work well.

The solution to high oil prices is high oil prices, so the sage investors and industry experts are prone to joke. That’s because, as was the case in the early 2000s, high oil prices cause companies to bring on new capacity (as discussed above), which then saturates the market and brings the price back down. Now imagine a world in which the dominant sentiment in the industry is about avoiding stranded assets and managing the transition.

Energy’s place in a portfolio

The reluctance to invest, which that new environment creates, means that only the most profitable projects get actioned, while also supporting oil prices because less new supply comes online. That’s obviously not a fictional scenario, it’s what’s happening now.

It’s not all good news.

It means there is some upside risk to the oil price, coming not from lofty demand expectations but from more tangible undersupply, which means the world needs to transition away from fossil fuels fast for demand and supply to balance. In the meantime, the likelihood is a period of unusually profitable oil and gas supply.

That could end up being unhelpful from an inflationary perspective, in which case deciding to have shunned those sectors from an investment perspective would feel particularly frustrating (as it would have been in 2022). It means that energy companies lend themselves to inclusion in portfolios and are naturally complementary to secular growth stocks.

These are often considered long duration, meaning a lot of their value is perceived to be generated a long way into the future. The most obvious problem with this is that it leaves a long period in which a peer can emerge to fight for market share and undermine the valuation. But a secondary risk factor is that long duration stocks, like long duration bonds, are sensitive to interest rate risks.

This is much less the case for low duration sectors like energy, where the expectation is that companies make big profits and distribute them to shareholders rather than ploughing them into new investment.

Of course there are risks. Companies could abandon their newfound capital discipline and revert to their bad old ways. They are also inclined towards investment in renewables, which will be lower returning in the future. Some balance between reinvestment and distribution of profits seems appropriate and seems to be achieved.

We monitor a basket of major energy producers and found a less than 1% increase in capital expenditure and a slightly larger increase in production. At the same time, most players have increased share buybacks, dividends, or both, reflecting the shift of emphasis away from investment and towards distribution.

One last risk may occur to you reading these comments. Will companies be allowed to make substantial profits by underinvesting in their core business? The risk of windfall taxes always raises its head at such times. What is unusual is that in this instance, the windfall results from an international push by governments to slow and eventually stop investment in fossil fuel assets to slow the pace of climate change.

This is perceived as being easier to achieve than slowing demand for fossil fuels, which would be done through ever higher fuel duties. Fuel duties are highly political, such that the freezing of the motor fuel duty is now as much of a budget tradition as the red ministerial box that contains the chancellor’s speech in the UK.

UK taxes on fuel have been declining in recent years. While hypocritical, could a future government impose a windfall tax on an industry that is making excess profits as a result of following a government-sanctioned initiative? Stranger things have happened. The risk is lower in the U.S., which makes a global basket of energy producers attractive relative to UK companies.

That said, the impact of previous windfall taxes on UK producers’ businesses have tended to be minor where those companies are global oil producers, because the tax only relates to the UK part of the business.

Is it unethical to invest in energy stocks? That is very much a personal choice. It seems clear that if transition is to be achieved, it will be through underinvestment in energy. That does not come without cost and high energy prices seem likely to be a necessary feature. Another owner might be tempted to see companies increase their investment

Diversification: beloved by many, employed by few

Holding the stock of companies benefitting from secular long-term growth trends, such as cloud computing or artificial intelligence, alongside the stock of energy producers benefitting from engineered undercapacity in an industry we are trying to ween ourselves off, has obvious portfolio benefits.

They provide returns at different times, meaning they perform differently and are subject to different risks. However, few fund managers follow this approach because energy is widely seen as a value sector, whereas technology is a growth sector. In some investors’ minds, these are the investment equivalents of oil and water.

It seems odd to miss out on the diversification benefits of mixing them. Why doesn’t it happen?

An optimist would say this is because fund managers feel they will do their best work if focusing on a specific sector of the market and learning about that area in greater depth. It is certainly difficult for the generalist to achieve excess returns by spreading their net widely (knowing a little about a lot of things).

A sceptic would say fund managers tend to align to a specific risk factor, achieving high returns while that factor is in vogue, which investors misattribute to ‘alpha’. One of the central challenges of fund analysis is distinguishing between true alpha and that which comes from following a specific style.

We believe getting sufficient depth of analysis across a sufficiently wide spectrum of industries can only be achieved through a level of teamwork and analyst enfranchisement that is unusual in the industry, where fund managers like to feel personally responsible for the investments in their portfolios.

Economic resilience continues

The recent outperformance of energy at a time when technology has been losing momentum presented the opportunity for this sojourn into the merits of energy within a balanced portfolio. We normally spend more time discussing the week’s economic data.

Last week, the data was pretty good. Purchasing managers indices suggest the manufacturing recovery is gathering pace. This is true for services as well, although in the U.S. and UK there was some loss of momentum.

It is too soon to determine whether this would form a new trend, and in the UK, where we have had two successive rounds of National Insurance cuts in quick succession, there are factors to support ongoing services consumption.

On this note, a succession of Federal Reserve speakers discussed last week the outlook for interest rates. They didn’t do much to change the market’s expectation for two or three cuts beginning in June. But they did suggest the inflation and economic data would need to confirm this course of action. At the moment, they don’t seem to be doing so.

Inflation data have been a bit sticky (not coming down fast enough) while Friday’s jobs report is a good example of the resilience of the U.S. economy. It provided another positive surprise, with an estimated 300,000 new jobs created during March (expectations were for 200,000) and upwards revisions to previous month’s reports as well.

This is not an ideal situation for long duration equities, although over the last year they have managed to outperform despite higher expected interest rates. It does suggest resilient demand for energy.

Final week before Easter break a positive one for investors - 3 April 2024

We take a look at how Easter affects the markets and recall the events of Silver Thursday.

The S&P 500 continued to reach new all-time highs and from a technical perspective there were encouraging signs. For those concerned about the narrowness of the market earlier in the year, evidence of leadership shifting from technology and growth companies to a broader range of companies is good news.

Sometimes, technical analysis conflicts with fundamental analysis. It’s encouraging to see broader participation in market gains, but amongst that increased breadth, energy stocks have been shining in recent weeks. Their strength reflects the return of some inflationary pressure from higher energy prices. The oil price has risen into the mid $80s per barrel, close to its 2023 peak.

The Organization of the Petroleum Exporting Countries (OPEC+) has maintained production cuts despite pressure from members to exploit reserves while demand remains high. Energy stocks remain a valuable component of portfolios as companies are careful not to over invest, as was their tendency during previous cycles.

This should enable the sector to maintain an unusual level of profitability. The energy sector also offers some benefits from a portfolio construction perspective because, as discussed above, energy price rises can be a problem for the economy and for growth equities.

So far in the first quarter, energy prices have contributed to a number of drivers of inflation, which the market has maintained a relaxed attitude to.

Last week, Federal Reserve board member Christopher Waller, who is known as a relatively hawkish member of the Federal Open Market Committee (FOMC), which sets interest rates in the U.S., explained that he sees the recent data on the economic outlook and the labour market to be showing continued strength. This, alongside slower progress in reducing inflation, persuades him that there should be no rush to reduce interest rates.

As it stands, the chance of a cut in June (the meeting after next) remains at a little over 50%, which seems surprisingly high based on current data.

How does Easter affect markets?

Last week was a shortened week for the UK due to the Good Friday bank holiday. The U.S. does not treat Good Friday as a federal holiday, but the stock market does remain closed on that day, by convention.

Apart from the UK and U.S., several other markets were open despite strong Christian traditions leading to unusually thin trading. Various trading strategies have determined there is both a Maundy Thursday and an Easter Monday effect, whereby these days exhibit above average gains relative to other markets.

The general prevalence of markets to rise more often than they fall, and the tendency of price moves to be larger during times of lower liquidity, could explain these effects. However, these effects are less pronounced now that algorithmic trading, which doesn’t take holidays into account, has evened out some of the fluctuations in trading activity.

Easter has traditionally been a period of relatively benign markets with the more traumatic market events tending to be associated with September and October. However, it’s almost exactly 16 years ago that Bear Sterns was eventually rescued through its acquisition by JP Morgan, after seeing assets diminished by subprime mortgage exposure, an event eventually overshadowed by the failure of Lehman Brothers later that year.

The bunny and the bubble

In 1980, Easter marked a tough time for the markets, which had suffered from fears of contagion effects as a speculative bubble in silver was unwound.


Source: LSEG Datastream

45 years ago, almost to the day, Silver Thursday occurred when three brothers (the Hunts) failed in their attempt to corner the silver market, believing the metal to be intrinsically under-valued as a hedge against inflation. Their aggressive accumulation of silver futures contracts sent prices up 500%.

However, in response to apparent manipulation, regulators increased margin requirements, forcing the brothers to liquidate positions and resulting in an even sharper decline in prices with possible implications for financial stability.

Today, cocoa is experiencing a sharp appreciation. Whilst it’s tempting to attribute this to Easter egg demand, it’s mainly a function of supply shortages due to low crop yields in West Africa, where weather conditions have been too dry. The rise in fertiliser costs driven by the war in Ukraine is also a factor. And yes, demand for chocolate has remained strong among consumers.


Source: LSEG Datastream

The direct impact on inflation will be modest, but it’s one more factor alongside the rise in energy prices, last week’s collapse of Baltimore’s Francis Scott Key Bridge, and continued harassment of shipping in the Red Sea, which has seen Suez Canal volumes down around 50% compared with the same period last year, according to the International Monetary Fund (IMF).

These factors make it understandable that policymakers would be wary of easing monetary policy too fast and risking a resumption of the upward inflationary trend.

 

Dovish interest rate announcements from central banks - 26 March 2024
We review the reporting from the central bank meetings in the UK, US and Japan together with the Purchasing Managers Indices data from Europe and the US.

Interest rates rise in the East

European investors woke up to the Bank of Japan’s (BoJ) decision to raise interest rates for the first time in 17 years last Tuesday morning.

Money markets considered it touch and go whether it would hike or not, while consensus forecasts were firmly for the BoJ to keep rates in negative territory. However, news at the end of last week on the outcomes of the “Shunto” wage negotiations made the case for tightening much stronger.

The “Shunto” translates to the spring wage offensive and represents a set season for wage negotiations, so if workers ended up striking together, their employers would not lose market share to peers. RENGO, the Japanese equivalent of the Trade Union Congress (TUC), announced last week that settlements achieved so far were above 5%, they were well below 4% last year. So, inflation by this measure remains strong in Japan, other measures seem less conclusive.

Most obviously, Thursday’s (21 March) inflation report would have encouraged the BoJ to tread slowly. Although headline inflation rose over the last year, that was mainly to do with fuel subsidies from last year dropping out of the numbers. The latest monthly inflation prints have been soft. The best measure, seasonally adjusted monthly moves in the core inflation rate, has been too low for the BoJ to hit its inflation target for the last four months.

So, although the BoJ did technically surprise the market with an interest rate increase, its rhetoric was cautious enough to leave the outlook for further rate increases wide open. More people are talking about this being a one and done rate hike from the BoJ, although the money market still expects another two hikes this year.

Economic activity edging higher

The most hawkish news for Japan came from Thursday’s (21 March) Purchasing Managers Indices (PMI). It showed the third consecutive expansion in activity overall, with services growing at the fastest pace in ten months, while the contraction in manufacturing was at its least severe since November.

This data suggests demand is holding up in the economy. They also suggest that inflationary pressures remain, as output prices rose in both the manufacturing and services sectors, with higher raw material, fuel, transport, and staff costs being cited as the factors behind the increase.

Although the survey results suggest the above factors might be driving up Japanese prices, the fact that they are not evident in Consumer Price Indices (CPI) suggests they could also be weighing on margins. By contrast, the U.S. equivalent survey cited increased pricing power alongside “a steepening rise in costs”. This qualitative observation may tell us more about the disposition of the report author than the underlying economy, however, references to pricing power were notably absent from other regions.

U.S. composite PMIs input prices vs output prices


Source: Refinitiv Datastream

U.S. interest rates left unchanged

The Federal Reserve left its interest rate policy unchanged on Wednesday. It acknowledged that the economy is doing better than anticipated, easing its growth and inflation forecasts for the year. But the Fed also left unchanged its expectation of three interest rate cuts. That was a slight surprise as CPI data has run hot and the consumer remains resilient.

This doesn’t seem to have changed the outlook for rates much, but it has stalled the upward march of year-end U.S. interest rate expectations that have been underway since mid-January.

With Japan raising rates and the U.S. expecting to cut rates, you could be forgiven for expecting the yen to strengthen. It rallied a little in response to the Fed’s meeting, but overall ended the week lower. The reason for this is that while Japanese rates rose last week, the increase was marginal.

The more important driver of the exchange rate is where each respective currency’s interest rates will be in the future, and in relative terms, U.S. expected rates have been rising relative to Japanese expected rates (Japanese rates rising less than expected, but U.S. interest rates being cut by less than expected).

The outlook for liquidity

A big focus for the year will be on the timing of the Fed’s exit from quantitative tightening (QT). It sounds from Fed speakers as if this could be announced at its next meeting. This could be a positive story for markets because QT was assumed to be a factor that would weigh on investor demand by reducing liquidity that might otherwise find its way into equity and bond markets.

In fact, equity markets have performed admirably while quantitative tightening has been going on, and liquidity watchers put this down to the reduced use of the Federal Reserve’s repo facility.

Repo means repurchase agreement, and it allows an asset owner to raise short-term liquidity by selling an asset, such as a government bond, to another investor whilst agreeing to buy it back at a future date and price. In this way, it turns assets into liquid cash. Reverse repo, as you might expect, is the opposite; specifically, it involves a central bank such as the Federal Reserve selling securities into the financial system but agreeing to buy them back later.

For the duration of the agreement, the Fed will have taken the proceeds out of circulation. So, increasing use of reverse repo is a way of tightening monetary policy and vice versa. The reverse repo facility has been declining as banks have used it less, bolstering their own reserves and offsetting the impact from quantitative tightening.

But that decline will need to slow, stop, or even reverse at some stage, which will have an impact on liquidity. The Fed is looking at how this can be coordinated with the more stimulative impact of reduced quantitative tightening.

Markets were strong last week as the Fed reiterated its three-cut guidance, but they have been strong in previous weeks even when that has seemed in doubt. This loose liquidity environment has been one of the explanations, and as the Fed experiments with the winding down of QT and less liquidity is released from the reverse repurchase facility, there will likely be some wobbles in the market.

A particular sector to watch will be the U.S. regional banking sector because any shortfall in liquidity is likely to be reflected in declining bank reserves and a return of solvency worries due to the bond assets these banks hold, which currently stand at a loss.

The UK hawks take flight

The final (major) central bank reporting last week was the Bank of England (BoE). Again, there was no surprise about its decision to leave interest rates unchanged, but what did stand out was the change in voting, where two hawks had previously voted to raise interest rates, but this time aligned with the majority to keep them on hold.

Unlike in other regions, inflation has been declining slightly faster than expected in the UK. Much of this relates to the delayed impact of the utility bills cap, which meant that inflation seemed slower to take off, before being sharper, and lingering longer, after which it is now declining faster once more.

Indeed, inflation is expected to drop to, or even below, the BoE’s target in the next couple of months as high monthly increases from a year ago drop out of the latest figures. But it is not expected to last, and despite the downside surprise to UK inflation last week, when looking beneath the surface, those indicators of persistent inflationary pressure remain. The median price increase, having been stable but still marginally too high for the last few months, lurched upward this month.

Some of this lingering inflationary pressure is good news. It reflects the resilience of the UK economy and the fact that the UK seems to be emerging from a cyclical downtrend, as reflected in the PMIs. In addition, as we discussed last week, the housing sector is improving both in terms of demand and construction activity.

Of course, there has also been a two, soon to be four, percentage point reduction in tax on a substantial portion of the income for people with a high propensity to spend. But some of the persistent inflationary pressure is down to a lack of productive capacity, partly explained by a high rate of economic inactivity, which itself is driven by an increase in long-term sickness. No doubt this will be one of the key dividing lines for policy going into the next election.

Improvement seen in the UK housing market - 19 March 2024
Hopes for seemingly enormous interest rate cuts during 2024 have been dissipating since the year began. Two months ago, investors thought U.S. interest rates would finish the year at just over 3.5%. Now that is just over 4.5%, implying there may be three interest rate cuts.

But why the change in mood?

In short, inflation has remained stickier than expected. Last week’s U.S. Consumer Price Index (CPI) print saw core inflation slightly above estimates for the second month in a row. Recent monthly readings have been consistent with a rate of core inflation of 4%, which is clearly too high.

Core CPI excludes the volatile food and energy prices that can make interpreting the data difficult. After this adjustment, shelter inflation makes up 45% of what is left. Some of the shelter data is very lagged in its impact because it relates to when tenancy agreements are renewed.

Therefore, the Federal Reserve has discussed core services excluding shelter (so called super-core inflation) as a preferred measure. That rate also remains well above the Federal Reserve’s target rate.

On Thursday (14 March 2024), Producer Price Indices (PPI), which measure the prices of goods sold by their manufacturers, were also above estimates. This seems to fit the phenomenon that we have been highlighting over the last few months, that more companies are experiencing high services output prices.

A matter of ‘when’ rather than ‘if’?

All this sounds pretty concerning given the narrative for 2024 has been about interest rate cuts, and markets have certainly paused for breath. So far though, investors still believe the question is ‘when’ rather than ‘if’ rates will be cut. Despite a full percentage point of cuts for this year being erased, long-term bond yields have risen by around 0.2%.

Theoretically, if you believe that companies are valued based upon bond yields with an acceptable equity risk premium, the stock exchange would be quite responsive to small changes in bond yields, but the evidence to support this is lacking.

Instead, the interaction between share prices and interest rates seems more likely to reflect the broader concept of liquidity, which so far this year remains reasonably abundant. The notable risk on this front would be if liquidity support for U.S. regional banks was to diminish, as we are now a year past the crisis.

U.S. retail sales accelerate in January 2024

U.S. retail sales expanded at the fastest pace in five months during January, which could have given policy makers more inflationary fears to fret over. But this rebound reflected an improvement in the weather rather than a resurgence in animal spirits. Inclement weather caused a sharp decline in shopping trips during January and most of the recovery in February was driven by building materials and garden equipment, both of which are weather sensitive. U.S. goods demand therefore remains in the doldrums, with services having been the category of choice for consumers.

Chinese stocks bolstered by new growth target

Chinese stocks had a good week overall but were struggling for momentum by the end of it. The enthusiasm for these stocks has been bolstered by the idea that the newly announced growth target implies powerful stimulus must be coming.

Alas, it remains a trickle rather than a gush.

Despite property prices, which we learnt on Friday (15 March 2024) are continuing to decline, and bank loan growth, which decelerated to its slowest pace on record last month, the authorities have not been forthcoming with stimulus. Instead, China drained liquidity from the banking system during February and held interest rates steady.

The Chinese economy has shown some green shoots of recovery, with prices at last rising again in February after four months of deflation. It seems likely more stimulus through lower reserve requirement ratios and lower interest rates will eventually be unleashed.

UK GDP estimate turns positive in January 2024

Green shoots are also evident in the UK. The January estimate of monthly gross domestic product (GDP) turned positive, which was implied by the already-released retail sales numbers for that month.

The recovery in the housing market continued as well, as last week’s Royal Institution of Chartered Surveyors (RICS) house price index would seem broadly consistent with house price growth of up to 5%. Demand for housing has recovered following a normalisation in borrowing costs. Most encouraging is that new sellers are entering the market as well, suggesting the recent uptick in prices is perceived to last. It’s not just the secondary market for homes that is recovering.

More housing market activity also seems to be drawing a line under the 15-month housebuilding recession that the UK has suffered. More housing transactions are good for economic activity as they are labour intensive to build and even selling already existing homes triggers a chain of connected economic activity from financing to furnishing.

No change in policy from the European Central Bank - 12 March 2024
There was some modest volatility in equity markets last week as Apple and Tesla came under pressure from investors concerned about their chinese growth. Apple has been losing market share to Huawei while Tesla has been engaged in a price war with BYD, something it appears to be losing.

As members of the ‘Magnificent Seven’ large cap tech enabled companies, weakness in Apple and Tesla caused a meaningful sell-off on Tuesday, but it didn’t take long for normal service to resume. The NASDAQ and S&P 500 were back at all-time highs by Thursday.

European Central Bank announces no change

Thursday also saw the European Central Bank (ECB) announce monetary policy to a distinct lack of fanfare. No change in policy was expected and none was delivered. However, the ECB’s language seemed to turn hawkish. Although this was the least momentous feature in terms of market impact, it certainly highlights a critical area where some complacency might be creeping into markets. 

The ECB replaced the statement, “the declining trend in underlying inflation has continued” with “although most measures of underlying inflation have eased further, domestic price pressures remain high, in part owing to strong growth in wages.” 

Therein lies the risk, it is very much assumed that interest rates are restrictive and the next move in them will be to loosen. Headline rates of inflation have declined, and yet one of the causes of inflation, higher wage growth, remains evident. As a consequence, services inflation has been running well above target in recent months. 

The disinflation seen in falling headline inflation rates has been mostly driven by goods prices, whereas more wage sensitive services inflation remains high. But despite near-term pressures, the ECB felt able to lower its estimate for core inflation in 2025 from 2.3% to 2.1% (marginally above the 2% target), prompting a rally in bonds.

It soon evaporated during the press conference when President of the ECB, Christine Largarde, seemed to dampen expectations of an April hike on the basis there will be more data available by June. This leaves markets expecting a quarter of a percentage point interest rate cut in the eurozone by June. 

Coincidentally, more or less the same is expected in the US. By December, it seems likely that both major central banks (the ECB and the Federal Reserve) will have cut most of a percentage point (but more likely in the eurozone).

recap graph 1

Source: LSEG Datastream

Friday saw the release of the US labour market data for February, and it showed a labour market that is still strong. However, there were some weaker elements. The headline is that jobs expanded, and wage growth slowed at just 0.1% over the month, this is the so-called ‘Goldilocks’ report, which is not too hot and not too cold. 

The Federal Reserve is watching wages like a hawk to gauge services inflation trends. On the softer side, January’s bumper gain in payrolls was substantially revised lower and the unemployment rate rose to 3.9% from 3.7%, reflecting a curious discrepancy between the main payroll report (which surveys employers) and the unemployment report (which surveys employees). 

There is probably enough here to keep interest rate expectations subdued going forwards, while providing hope that the short-term increase in monthly inflation will subside.

Japan

Japan, of course, bucks the trend with interest rates expected to rise, marginally, over the course of 2024. That assumption has been challenged by recent data, which have suggested that Japan is losing momentum, so it is particularly interesting that the same factor that is causing anxiety at the ECB (and presumably other central banks) is giving hope to the Bank of Japan (BoJ).

The 2024 spring wage negotiations (known as Shunto) are taking place between unions and employers. Anecdotal news suggests that unions are seeking substantial pay increases, well ahead of current inflation rates and notably ahead of those rates achieved at last year’s Shunto, too.

The Japanese Trade Union Confederation (known as RENGO) suggests member unions will seek pay increases of 5.85%. Recent weak economic data has been positive for Japanese equities by being negative for the yen. Japanese stocks outperform when the yen is weakening.

Last week’s Shunto news, coupled with a jump in Tokyo’s bellwether Consumer Price Index (CPI) rate and better news on capital spending, boosted the yen but weighed on equity performance.

Budget week in the UK

The FTSE 100 underperformed last week as the pound rallied. This reflects a narrowing of anticipated interest rate spreads between the UK and the other major regions, partly aided by a more recent decline in UK inflation and some evidence of more persistent inflation elsewhere.

Most of this seems likely to be explained by timing and the lagged impact of energy price inflation hitting the UK economy and subsequently ebbing due to the utility bills cap. The underlying factors driving inflation in the UK and Europe seem pretty similar.

The main economic event in the UK was the Spring Budget. Like the ECB meeting, this proved to be something of a non-event. Almost everything announced had been preannounced or leaked, ensuring a no-surprises budget, which contrasted with the infamous Liz Truss mini budget that spooked the markets so badly in late 2021.

The event passed off without incident, which is reassuring because with this being a (likely) election year, and with the government lagging in the polls, the incentive for fiscal largesse was high.

Fiscal rules

Recognising that chancellors can feel tempted by non-economic motivations towards the end of electoral cycles, several safeguards have been put in place over the years. Gordon Brown became the UK’s first chancellor to employ fiscal rules.

He was something of a trailblazer with versions of his golden rule being adopted by legislation throughout the core of Europe. George Osborne then added to the fiscal safeguards by instigating the Office for Budget Responsibility (OBR), an independent watchdog that forecasts the likely trajectory of government expenditure and the government against its self-imposed fiscal rules.

Sadly, the framework has not prevented the deterioration in public finances. Understandably, pressures such as the pandemic could not have been foreseen, however, when push comes to shove, the UK’s fiscal rules have been watered down rather than suffering the austerity they might hoist upon the electorate.

Meanwhile, the OBR can only score the government’s fiscal plans, and those plans have invariably led to planned tax increases and spending cuts that are forever pushed back into a subsequent period. To its credit, the OBR has pointed out that it models on the basis of a fuel duty going up, despite the now established precedent of cancelling the fuel duty rise at each successive budget.

So, does spending and taxation carry on unchecked? Far from it. If the government is too profligate, the Bank of England will be forced to raise interest rates and it therefore acts as a stronger fiscal watchdog than the OBR.

And, finally, the bond market and the pound would be the ultimate arbiter of fiscal policy, selling off if the government misbehaves. So, what did happen?

After much speculation, National Insurance was cut. This was in preference to a planned cut in the basic rate of income tax, which would have been more expensive to deliver. National Insurance is also only paid by employees rather than savers or pensioners.

This helps the government justify a fiscal injection during a battle against inflation on the grounds it is encouraging people to enter the labour force.

The UK ISA

Perhaps the most eye-catching announcement was the anticipated British ISA (although the government has chosen to brand it the UK ISA). The permitted investment would be £5,000, in addition to existing ISA entitlements.

Further details were lacking, but according to the consultation document, it sounds as if the permitted investments would be companies incorporated within the UK that are listed on a recognised index (LSE/AIM, Acquis and CBOE Europe), which means Cambridge-based ARM, would fail the listing rule (although a secondary listing in London might qualify).

We don’t know when the UK ISA will be available, but when Nigel Lawson introduced the Personal Equity Plan in the 1986 budget, it was to be available from the following January. Will it be enough to reinvigorate the UK’s flagging listings market? It seems unlikely. 

It would be irrational for anyone to invest in the UK ISA without first filling their normal ISA allowance of £20,000. As this would apply to relatively few people, it seems likely that UK ISAs will form a relatively modest part of the overall savings panoply and will not be enough to convince ARM that it should have listed back in London.

Japanese and US Markets hit the high notes - 5 March 2024

The trend of the market reaching new highs continued at the end of February. The S&P 500 had already broken new ground but was joined by the NASDAQ, which surpassed its previous high seen at the end of 2021.

Japan has seen very strong index performance. Part of that has been aided by rapid yen depreciation. As a result, the Nikkei 225 also reached a new all-time high the week before last. But while the US markets are surpassing levels seen in 2021, the Nikkei is making a first all-time high since an extraordinary bubble in stocks and real estate at the end of the 1980s.

The Nikkei index is one of a few price-weighted indices (another being the Dow Jones in the US) where each company’s weight reflects how big its share price is rather than the relative size of the company. Japan’s more conventional TOPIX index remains well short of its late 80's high.

The FTSE 100 remains 4% off its record high, experienced early last year. Like many regions, the UK has underperformed the US recently, but the performance of indices exaggerates the extent. Overall, The UK market generates a dividend yield of 4% which is significantly driven by the energy sector.

US Personal Consumption Expenditure results give hope to lower interest rates
Over the past couple of weeks, the stock market experienced fluctuations near record highs as traders awaited a barrage of economic data and remarks from Federal Reserve speakers on interest rates. The market absorbed heavy Treasury and corporate sales amidst month-end positioning, with US yields rising after government note auctions. Blue-chip companies sold a record amount of bonds in February to capitalise on investor demand amid lower borrowing costs.

The most obvious banana skin for the market overall was the US Personal Consumption Expenditure (PCE) data.

This ostensibly measures spending and feeds into Gross Domestic Product (GDP). GDP is normally quoted in real terms, meaning it is adjusted for inflation. The Federal Reserve has typically preferred to measure consumer price changes through the PCE over the consumer prices index (CPI).

The PCE covers a broader range of goods and services, as well as a broader definition of consumers and its process for changing the weightings of categories over time is perceived to be better, and its treatment of housing costs is more reflective of actual costs suffered by homeowners.

CPI, on the other hand, is released earlier during the month and certainly sounds more like the measures of inflation used in other regions (although some argue PCE is methodologically closer to other countries’ inflation calculations).

Perhaps the most critical difference between CPI and PCE in recent months is that core PCE, which excludes food and energy, has declined faster than core CPI, and thus paints a rosier picture of the consumer environment, which puts less pressure on policymakers to maintain high interest rates.

It was therefore a boon to investors to see the core PCE price index rising by just 2.8% over the 12 months to January (PCE data are released late relative to CPI). This is the slowest pace of price increases since March 2021.

The data were taken positively by the market, seeming to justify hopes of lower interest rates later in the year. Afterall, real spending by consumers declined. But despite the slowdown in the annual rate of inflation, the monthly data were pretty strong, seeming more consistent with the CPI data from earlier in the month.

Gauging trends in inflation is difficult during January when a significant seasonal adjustment needs to be made. There were also a lot of one-off factors distorting consumer activity (such as weather), a strong month for dividend income, and a jump in cost-of-living adjustments for social security payments.

Nvidia’s earnings announcement takes the headlines - 27 February 2024

One topic dominated markets last week, Nvidia’s earnings announcement. It was one of the most anticipated and celebrated events in the market this year. The shares, which were cyclically depressed at the start of 2023, went to triple in value by the end of the year and have risen another 50% since then.

In the week before announcing its profits, Nvidia’s shares slid by nearly 9% as some investors feared that others were expecting too much. Memories of the technology stock market bubble of a quarter of a century ago loom large.

But Nvidia is far from the profitless companies offering jam tomorrow in the late 1990s. Nvidia’s results revealed revenues rising 22% over the preceding quarter, and 200% from the same period last year, with profits up eight-fold.

As with all stocks, the controversy surrounds what will happen in the future. The pipeline for artificial intelligence related sales remains very attractive, but unlike the technology bubble, those expectations are grounded in exceptional growth happening right now.

We believe semiconductors are in a cyclical upswing that forms part of a secular uptrend. Individual companies can be volatile, but the supply chain comprises a number of different types of company serving different parts of the value chain, whose long-term trajectory should be positive, even while different factors move them in the shorter term.

Last week felt like Nvidia was singlehandedly pulling the market around, but what else was going on?

Back in the real world…

The Purchasing Managers Indices (PMIs) offered an early snapshot of economic activity in February, painting a mixed picture. In keeping with other data released so far this year, the US continues to look economically firm.

The manufacturing and services sectors both seemed to expand at an accelerating pace. It makes sense to be a little wary of extrapolating the current trend too far. With unemployment so low there is limited room to expand employment, driving increased household income and spending. However, there still seems to be at least some scope because initial jobless claims for the last week declined. This leaves them very low, at levels consistent with a strong economy, although things can change fast.

Outside the US, PMIs were more mixed. European manufacturing remains in a slump and while France showed signs of early stages of recovery, Germany seemed to regress. Outside of these core economies, the peripheral eurozone members performed better, we just won’t know how much better until the end of the month as they don’t release provisional reports like the core countries.

Inflation benign?

Perhaps worryingly, selling price pressures rose during the month. We can take some comfort from the fact that price data from PMIs do not correlate very well with consumer price indices.

However, they suggest that for the services sector at least, the tight labour market is making it difficult to hold wages down. If other data backed these up, it could be difficult to cut interest rates as fast as the market has been hoping.

Interestingly, the price pressures are quite limited to services while disinflation seems to continue within manufactured goods. This is where we would expect to see the impact of higher freight rates emanating from the Red Sea (or, more accurately, from the Cape of Good Hope, around which Red Sea freight has been diverted).

The Red Sea is an important transit route for Middle Eastern oil and Southeast Asian goods on route to Europe. Freight rates are clearly continuing to rise but in Europe’s biggest economies, impact is outweighed by weak demand. This partly reflects the fact that freight is often transported on long-term contracts, which are less vulnerable to movements in spot freight rates.

China stimulus

China and Europe have a substantial bilateral trade balance, but both are currently labouring some. In China, decades of overinvestment in property, which had become the principal vehicle for the wealthy, has resulted in chronic oversupply.

Bursting that bubble became a priority for Xi Jinping’s Chinese Communist Party, but doing so has resulted in a persistent negative wealth effect (declines in the value of property make Chinese consumers feel poorer).

In an attempt to revive fortunes, China cut the loan prime rate for terms of greater than five years. This is essentially the rate which underpins mortgages and therefore serves as a stimulus for Chinese property. This morning’s data from China’s National Bureau of Statistics showed how important that could be, as property prices have continued to decline over the last month.

The slight green shoot of recovery that might be showing is the breadth of price declines may have narrowed. In December, 62 out of 70 cities saw prices for new properties decline, whereas in January that was just 56. Prices of existing properties fell in all 70 cities in December, whereas two saw an increase in January.

There is clearly a long way to go before this becomes a positive trend, and the risk remains that policy will not be able to turn around a sector so distorted by successive stimulus rounds and captive savings over decades. But at least policy is becoming more forceful in its attempt to support the sector.

Tax cuts

Finally, some good news came from UK public finances. After strong tax receipts, it seems the government will borrow less than had been anticipated by the Office for Budgetary Responsibility. This means we can anticipate the unveiling of tax cuts potentially up to £10 billion in the forthcoming budget.

This is an enormous number that is difficult to put into context. It would be around half the tax cuts that took place at the beginning of this year after the Autumn statement.

Recognising how much £10 billion is might also help to appreciate the scale of the market’s response to Nvidia’s earnings announcement. The company’s market value rose by more than 20 times that much on the day ($277 billion, which is a record daily change in value for a single company)!

The UK saw slowing inflation in January - 20 February 2024

Last week was a strong one for the equity market, but for those focused purely on the macroeconomic factors it contained some reasons for anxiety. Yet again, a crucial data point, US inflation, did not quite fit the narrative contained in most forecasters’ 2024 previews.

The improving outlook for investments hinges upon a fortuitous cocktail of resilient economic activity and receding inflation. Were one of those ingredients to go missing, the outlook could turn sour.

US inflation: threatening to spoil the party

This hypothesis would loom large in the mind of macro investors as the US reported inflation data for the month of January, which was stronger than expected. In immediate response to this data, interest rate cut expectations were pared, bonds sold off (their yields rose), and stocks fell quite markedly.

Of the last six inflation prints, this is the fifth that has been surprisingly strong, and the size of the surprise was the greatest. In late January, an extraordinary six interest rate cuts were expected, starting in March. On Friday, that had been pared back to less than four.

It seemed surprising that such sharp cuts would be expected, as survey data seems to imply that the economy is holding up very well. Jobs growth data has consistently impressed, and with inflation falling and the oil price well behaved, the high wage growth of recent years should be expected to support consumption (the largest component of economic growth).

Should this data worry policymakers?

As ever there were pros and cons. Durable goods prices generally fell, despite increasing spending on the category. Underlying food commodity prices fell, while food inflation reported within the Bureau of Labor Statistics consumer price index (CPI) rose.

The concern will be around the services category. Several different measures that attempt to strip out anomalies, median CPI1, trimmed mean CPI2, and core sticky CPI3, all told the same story. Inflation was stronger at the beginning of 2024 than at the end of 2023.

How concerned should we be about this?

Lower interest rates would be a tailwind for valuations, but they often come as a response to economic weakness, which is a headwind for earnings. What we have seen at the beginning of 2024 is the opposite: the risk of higher interest rates weighing on valuations, but the earnings outlook remaining bright.

Semiconductors: a cyclical play on a secular theme

The theme of artificial intelligence has continued to particularly resonate with investors. The eventual adopters of artificial intelligence (AI) will be drawn from many industries.

For those in highly competitive fragmented industries, any efficiency gains will inevitably have to be passed on to consumers in the form of lower prices. For those companies, AI represents a risk, if not implemented effectively, rather than a boon. For those in fragmented uncompetitive markets, AI could drive profit growth.

This expression harks back to the gold rush, when many were left destitute after investing everything in an often-fruitless search for gold, while those who sold picks and shovels to the prospectors were assured of a much lower risk profit.

Several companies catching the markets attention in recent weeks have included ARM and NVIDIA, which are involved in chip design. Gains in NVIDIA meant the stock eclipsed Amazon and Alphabet in market cap, causing scepticism and fuelling bubble fears, but, unlike previous periods of stock market excess, gains in NVIDIA appear consistent with the improving demand outlook.

ARM, on the other hand, is an unusual situation as only a small amount of the company was listed last year (the rest is owned by Softbank), meaning that good news can be amplified by illiquidity and the unwinding of regrettable short positions held by some investors. Short sellers have sold stock they do not own in anticipation of buying it back at a lower price in the future, however, they will be compelled to buy it back at a higher price if they are wrong in their analysis.

Consequently, that valuation has uncoupled from the company’s fundamentals. The providers of manufacturing equipment, such as ASML or Applied Materials, are seeing an increase in demand. But other parts of the semiconductor value chain, not limited to artificial intelligence, are at an earlier stage in their recovery, particularly amongst integrated device manufacturers. This means that even after what seem to be eyewatering gains in some parts of the value chain, there are others just beginning their journey.

These companies can offer attractive entry points into this generational secular change in an industry emerging from a cyclical downturn. The performance of AI-related stocks was symptomatic of an investment environment which managed to overcome the headwind posed by few rate cuts.

It seems likely that small movements in interest rates would not factor into investors’ valuation models, whereas rising wages and employment implies more money is entering the market through pensions savings.

The US remains the most important economy in the world but despite that, another factor reducing anxiety over the inflation print must be the variation in different countries’ inflationary experience. In January, some economies saw accelerating inflation while some saw decelerating prices, and that lack of consistency is in stark contrast to 2022 when price rises were everywhere.

The UK: emerging from a recession which may never have happened

The UK saw slowing inflation in January. The main impact, like in the US, was lower durable goods prices after January sales, which were sharper than last year. The outlook for UK inflation is a benign one, with headline CPI potentially dropping below 2% as early as March.

Be warned, however, that this drop will be somewhat anomalous, and the median CPI suggests that inflation having come down from its peak will only slowly trend towards the Bank of England’s target on a sustainable basis.

Seemingly aligned with the UK’s weaker inflation data was a downbeat measurement of UK gross domestic product (GDP) for the final quarter of 2023. The headline-writers’ joy was palpable as the UK is adjudged to have slipped into a recession in the second half of last year. The headline is a little misleading though.

While the UK economy laboured during 2023, its contraction has been marginal and recent history suggests it has every chance of being revised away, much as the second recession of the so-called double dip recession of 2011/2012 was erased from history by statistical revisions.

Ignoring the economists, recession would normally be characterised by declining employment (data last week suggested it unexpectedly expanded, again, subject to revision) and consumption.

Retail sales numbers released on Friday suggest that declining inflation is drawing consumers back to the shops, already such that if the recession is not revised away from last quarter, the economy will already have emerged from it this quarter.

CPI1 Taking the median CPI category and therefore not being biased by the more extreme moves in volatile categories.

CPI2 CPI is calculated based upon an average increase in prices by category, weighted by the estimated share of that category within consumer spending. The trimmed mean ignores the strongest and weakest price categories with the aim of being more representative of underlying price trends.

CPI3 Core sticky prices are those which would not normally move much, therefore are “sticky”. Changes in this category will tend to reflect underlying inflationary pressure. But as is often the case with investment themes, the so called “picks and shovels” are the better means of participation. 
The year of the dragon begins - 13 February 2024

Last week was quieter in terms of market movements and general news flow, after the eventful previous week saw corporate earnings reports and central bank meetings. To recap, while central banks are leaning on rate cuts this year, they are willing to wait for more evidence of inflation moving sustainably back to target.

Traders have largely abandoned the idea of a rate cut in March, though they still think there is over a 50% chance of a rate cut in May. Bond yields have moved slightly higher as the timing of rate cuts are pushed back. US ten-year treasury yields have largely traded within 20 basis points in either direction of 4% in the past few weeks. 

The higher yield over the past week did not deter the S&P 500 index from edging higher, passing the historic and psychological 5,000 mark. Indeed, the current corporate earnings season continues to paint a picture of resilience in the economy, and the earnings beat-to-miss ratio remains around 80%.

Overall, we think the direction of travel matters more than trying to speculate on when the cut occurs. Historically speaking, barring a recession, both bonds and equities tend to deliver strong positive returns in the 12 to 24 months after the first Federal Reserve rate cut.

Reassuring economic data

The latest economic releases in major developed economies leant on the positive side the week before last. The final measure of the services purchasing manager indices (PMIs) saw an acceleration in the UK, US, and Japan, for instance, while the struggling manufacturing sector also shows signs of bottoming out.

The latest US Institute of Supply Management services PMI beat estimates and improved across major measures such as employment and new orders. US initial and continuing jobless claims have ticked down in the latest readings, which come just after the blowout jobs data of 2 February. While some of these data results are lagging in nature, the resilient trend does add to the argument of a ‘soft landing’.

For Europe, economic vulnerability is higher, and the Gross Domestic Product (GDP) growth outlook remains uninspiring relative to the US. However, recent economic data has offered some hope. Germany factory orders have been an outsized expansion in December and its services sector business survey turned less negative. The contraction of Eurozone producer prices points to slowing inflation, which would allow the European Central Bank to cut rates later.

In the UK, there are signs of revival in the housing market as mortgage rates have fallen against the backdrop of rate cut expectations. Halifax reported that UK house prices increased at their strongest pace since mid-2022, as its measure rose 1.3% in January and 2.5% from a year ago. Similarly, Nationwide has reported UK home values rose by 0.7% in January.

Overall, the UK housing market has held up much better at the start of 2024 than most analysts were expecting at the start of 2023. On the supply side, the S&P Global UK Construction PMI survey turned less negative in January. While UK economic growth is subdued and quarterly GDP growth has been hovering around the 0% line, the positive developments in the housing market are supportive of consumer sentiment.

China’s deflation worsens in January

Now, contrast that with the latest economic data from China and last week’s wild swing in Chinese markets. As China celebrates the year of the dragon and embarks on a weeklong holiday, there are bound to be frustrations and negative discussions around dinner tables as retail investors and property owners collectively become poorer.

Chinese officials are desperately trying to arrest the stock market rout with several headline catching news pieces last week. Firstly, China has replaced the head of the Chinese Securities Regulatory Commission, as it tries to project an image of a huge makeover. Such personnel change may prompt expectations of sweeping changes at the regulator, and more forceful rescue plans for the crippling stock market.

We then had reports of state fund purchases, the establishment of a market stability fund, and restrictions on short selling by brokerages. While there has been an initial bounce, it was short lived.

These measures are like a band-aid for many fundamental and structural issues facing the Chinese economy. Last week, China reported its deflation had worsened in January, with prices falling by 0.8% year-on-year, the worst result since 2009. 

Some of that price weakness could be due to seasonal factors (different Chinese New Year timings) or pork prices slumping, but ultimately, underlying demand weakness is to blame. The problem with deflation, as the latest data shows, is that once prices fall, it may get more entrenched in consumers and businesses psychologies. If one expects goods or houses will get cheaper, why buy now?

One good thing about Chinese deflation is that it will help export lower goods prices to the rest of the world. Weak Chinese growth will also help to keep energy and industrial commodity prices in check, all else equal. Although further easing measures from China may not drive its domestic stock market higher, they may indirectly benefit western companies with sales exposed to China.

The transition to the year of the dragon is exciting, and for those who are superstitious, it may bring about new energy and fortune. However, practically speaking, the profound issues in the property sector will take years to resolve. The relationship between the state and private companies is also unlikely to change anytime soon, whichever zodiac year we are in.

Central banks set the tone - 8 February 2024

We had two big central bank meetings last week, with the Federal Reserve announcing policy on Wednesday evening and the Bank of England doing so on Thursday lunchtime.

As expected, neither made any changes, but it was an opportunity to hear the tone being used and to determine the likelihood of an interest rate cut, possibly as soon as late March.

The Federal Reserve chairman, Jay Powell, took the first opportunity to set that tone. Data had been supportive of a continuation of economic growth momentum, alongside weakening inflation. 

Although job openings increased slightly, suggesting the labour market was tight, fewer people had been quitting their jobs, suggesting diminished confidence amongst workers. That matters because wage growth tends to be faster amongst those switching jobs than those staying within the same job.

Blowout jobs growth

On Friday afternoon, more light was shed on the employment position with the monthly non-farm payroll report, which gets pulses racing across the investment world despite a tendency to be heavily revised in the following months.

The Bureau of Labor Statistics estimates that a huge 353,000 new jobs were taken in January, which was almost double the average forecasted figure, and well above even the highest of those forecasts. Not only that, but previous estimates of robust job growth were revised higher.

An important caveat here is that the headline jobs growth number comes from surveying companies and asking how many jobs they have filled. An alternative measure ostensibly, the same thing surveys households and asks how many of them are in work.

This second measure sometimes conflicts with the first and did so again on Friday. But it is accepted that this household survey is not as reliable as the main non-farm payroll report, so this data suggests the labour market is strong.

The second most shocking part of the report was the wage data. In recent weeks, we have seen some more lagged but better-quality data indicating a slowdown in wage growth, but January’s wage gains seem, provisionally, to have also exceeded any forecaster’s expectations.

Wage growth accelerated to 4.5% per annum. Stronger jobs and wage growth is a potent combination which will imply sturdy growth in consumer spending as well as more money flowing into pensions, and, by implication, into the stock market. At the same time, though, stronger wage growth will suggest higher costs for firms and therefore higher prices being charged for their goods and services.

Interest rates

This obviously has serious implications for the Federal Reserve. On Wednesday evening, chairman Powell disappointed some investors, saying he doesn’t expect to have sufficient confidence that he could cut interest rates by March.

There was clear disappointment reflected in the equity and bond markets, with investors at believing there was a 60% chance of a rate cut; this dropped to less than 40% after Powell spoke. And now, following the release of this strong employment report, at the time of writing, the chances of a rate cut seem to have fallen to around 20% (although, chances are still higher than this for subsequent meetings).

Powell’s comments felt like they were designed to calm investors down after he struck a decidedly dovish tone in December. The Bank of England (BoE) was expected to do the opposite.

The BoE has been keen to avoid declaring victory in the battle against inflation. At this meeting, the most obvious relaxation of that stance was evident in the voting. In December, three members had voted for a further increase. In January, there were just two members, while one had even started by voting for an interest rate cut.

Economic forecasts for the UK have been downbeat and inflation has been high. The elevated level of inflation has weighed on growth (which tends to be measured after adjusting for price increases). However, consumer confidence has improved, the housing market has stabilised, and business surveys show growing confidence.

Unlike the US, there is clear evidence of the UK labour market weakening, which ought to be enough to keep the two hawks on the BoE’s Monetary Policy Committee in the minority. It doesn’t currently seem sufficient to trigger the cuts the market is expecting.

Earnings season

Earnings season continues with the oh-so-predictable beats to misses ratio of 80%. So far, around 40% of companies have reported, but that understates the progression through this earnings season as Tesla, Apple, Alphabet, Microsoft, Amazon and Meta have all reported.

So, that just leaves Nvidia to complete the so-called ‘Magnificent Seven’ when it reports on 21 February. Of these big companies, Amazon and Meta dazzled, Microsoft was mixed, Google and Apple underwhelmed, and Tesla was received particularly badly by the market when the numbers landed last week.

Any disgruntled investors may have felt relieved to know that last week, a judge ruled that Musk’s extraordinary record-breaking $56bn compensation should be cancelled. US stocks seemed set to finish the week little changed overall, after mixed performance from the Magnificent Seven stocks.

Despite their size, they contributed an even greater share of the market’s earnings growth. But the rest of the US market, while growing more slowly, did at least seem to surprise analysts more favourably when their earnings were released.

One of the major controversies within the market at the moment is whether, after a strong year of outperformance by the Magnificent Seven, expectations could have become difficult to meet. In the short term some companies showed signs of that, but we still see some of these exceptional stocks as offering tremendous value.

End of month market performance  review - 30 January 2024

We are one fifth of the way through the US Q4 earnings season and the headline statistics are in line with historical norms.

79% of companies posted earnings that exceeded expectations, and so would meet the criteria of an earnings surprise, except that the same thing happens each quarter.

Similarly, sales surprises were a more modest, equally repetitive 52%.

Perhaps more importantly, as you might expect, stocks generally performed better on the back of these earnings announcements. In doing so, they overcame very modest expectations. In fact, on balance, profits of the companies that have reported so far shrank slightly in the Q4.

This was mainly due to the decline in commodity prices, with underwhelming performances from the financial, real estate and telecommunications industries. Consumer discretionary and utilities firms saw the strongest growth. The technology sector has seen modest positive growth so far, with all 14 companies having beaten estimates, but this week will see the behemoths announcing. This will attest to the market’s strong positive momentum.

China in the spotlight

The best performing market last week was Hong Kong, and specifically the 60% of that market that comprise so-called ‘H shares’. These are Chinese companies that have listed their shares in Hong Kong to take advantage of the deeper international capital markets.

Chinese-related shares have been woeful performers in recent years. As we have discussed before, they have typically failed to keep pace with Chinese gross domestic product (GDP). There is no explicit reason why a country’s stocks should exactly reflect its GDP, the companies may earn profits from outside their home economy, they may take a share from the private sector, or the balance of revenues earned by shareholders as profits, relative to those paid to other stakeholders (employees, creditors, government, management) could change.

However, for a colossal, relatively restrictive economy like China, you might expect the link to be close. Chinese companies’ historic failure to keep pace with GDP is likely to reflect a lack of shareholder orientation amongst companies. It is also possible that the official measure of GDP is not accurate.

After a long period of weakness, Chinese markets enjoyed a bounce last week, reflecting the hopes that stimulus would support the economy (and indirectly the market), or just the market more directly. China has been known to encourage various state-influenced entities to support the market in keeping with the government’s agenda.

Recovery in sight?

Last week saw a surprise stimulus announced in the form of a cut to the reserve ration requirement (RRR), which determines how much lending banks can provide against their deposit bases.

This ratio has been gradually declining over the last decade, reflecting an easing of monetary policy, and commensurate with that, the Chinese yuan has depreciated, bracketing occasional rallies when the RRR was held unchanged. The expectation is that China will need to employ RRR cuts and interest rate cuts over the course of this year.

Market recap

Source: LSEG Datastream

The use of RRR is one of the distinctions between Western and Chinese policymaking. Chinese policymakers have also started surprising the market by revealing measures, and even economic statistics, ahead of official announcements.

Perhaps the most marked difference in approaches taken towards the stock market is the Chinese state’s use of it as a vehicle of policy. At the moment, speculation is building that it would like it to rise again.

With that in mind, the formation of a state-backed stabilisation fund has been being discussed. The package has been estimated at two trillion yuan ($278 billion), which should be enough to provide short-term support, but it seems unlikely to prompt a long-term change in market performance, which ought to reflect a stable economic and regulatory background.

After a huge amount of policy and regulatory flip-flopping in recent years, creating that level of business confidence seems challenging. An example of this was the removal of draft video game rules from the regulator’s website last week.

These draft rules were announced in December and caused havoc amongst some large, exposed stocks (such as Tencent). Since then, a key official associated with the rules has been removed, and now the rules themselves have been removed from the website, although so far without explanation.

So, after a decent bounce in Chinese shares, which had been heavily sold previously, the outlook remains clouded. There seems to be limited scope for stimulus to drive a lasting improvement in company prospects without some sense of predictability and stability in the regulatory environment.

Central banks

The relative laggard last week was the Japanese stock market. Earlier in the week, at an uneventful Bank of Japan policy meeting, Governor Kazuo Ueda reiterated his confidence in Japan meeting its inflation target. However, he also stressed the need to keep policy accommodating until that target has been reached.

Japanese inflation has been above target since April 2022, and was expected to spend two and half years above target before dipping below later in 2024. However, in data released on Friday, it seemed price growth may be slowing significantly faster than expected. Stocks fell on the news.

Following Japan’s uneventful policy meeting was the European Central Bank (ECB)’s on Thursday. The bank maintains it is data dependent. This well-worn phrase means that its forecasts are sufficiently vague for it to expect to respond to new economic data, even though monetary policy is assumed to act with long and variable lags. This means that data dependency raises the prospect of inflationary over or under-shoots.

The ECB is widely expected to begin cutting interest rates in April because inflation has been declining fast, inflation expectations have declined significantly, and the region will flirt with recession over the coming quarters.

However, the ECB’s data dependency may encourage it to think about the recent positive inflationary surprises, the elevated level of wage growth, the tight labour market, indicators of rising prices from purchasing managers indices, and an expected increase in loan growth. So, the market’s confidence in forthcoming rate cuts seems a little too over-zealous.

The week ahead

This week will continue the trend of central bank policy meetings. It will also continue the trend of inaction, with the Federal Reserve and the Bank of England both expected to leave policy unchanged. Important for central bankers everywhere will be the early estimates of January’s inflation from Germany, France, and Italy on Wednesday.

At the start of November, these set a disinflationary tone, which seemed to bolster the market rally by triggering a retrenchment for bonds at the beginning of this year. It will also be a big week for company earnings reports with Apple, Microsoft, Amazon, and Meta all due to report.

Tumultuous week for investors but ends on a bright note -  23 January 2024

Markets saw a slight pickup in volatility and a mixed performance over the week. There was plenty of news flow, enough that you might ordinarily have expected a more adverse reaction. Investor sentiment is a complex beast.

There are gauges which suggest bullish sentiment amongst some shorter-term investors, but in general, institutions are gradually overcoming their risk aversion. Often when markets climb, we describe them as climbing the wall of worry, rising as investors anxiety dissipates.

One of the longstanding risks for the market is that of China invading Taiwan. The stakes would be high due to China’s 13% share of world trade, but the chances are low. The challenges faced by Russia when invading Ukraine, with which it shares a land border, would pale in comparison to an amphibious assault across the Taiwan strait, landing on largely mountainous terrain with only a handful of viable landing sites. 

There are more challenges too. Russia’s military was exposed as being underprepared despite having seen action over recent years. China’s military has grown but remains untested and is perceived to be riddled with corruption and vested interests which are symptomatic of the party controlled state.

Recent months have seen evidence of a purge of the Chinese military as President Xi Jinping has found it to be unfit for purpose despite billions having been spent on modernisation. The restructuring is believed to push back the potential date of any viable intervention in Taiwan.

Last week also marked China’s failure to make progress on the diplomatic front, with Taiwan’s incumbent president strolling to re-election, albeit with a plurality that was well down on the majority achieved by his predecessor. The Democratic Progressive Party (DPP) is a Taiwanese nationalist and anti-communist party that is opposed to stronger links with China. 

This year’s election was seen as an opportunity to break the DPP’s rule, but infighting amongst the opposition allowed the DPP a relatively clear path to re-election.

Chinese economy

It was an inauspicious start to last week, which contained little cheer for China. Internationally traded Chinese stocks underperformed. A release of Chinese economic data provided mixed news. An eye-catching headline was the decline in the population growth rate. This was broadly expected and simply a continuation of a trend of slowing, and now reversing, population growth, which has been in place for a decade and was accelerated by COVID. The Chinese population contracted by two million people (or just 0.15%) last year. That contraction will accelerate over the coming years.

recap 23 Jan

Source: LSEG Datastream

The timelier measures of Chinese activity were reasonable, but property prices declined for the seventh straight month, and with most Chinese wealth tied up in property assets, declines in property prices have a big impact on consumer balance sheets.

The likely result is that China will step up economic stimulus after a year in which it took many piecemeal measures that failed to address weak demand. Leaks from policymakers’ deliberations suggest that China is expecting to increase the budget deficit to try and recover growth momentum.

Inflation

For the rest of the world, the very well-ingrained hopes are for monetary stimulus during 2024, but the start of the year has suggested that it might be premature to expect rate cuts.

Inflation has generally been higher than forecast in December (as seen in numbers released in January). There are explanations of course, in the UK, many forecasters failed to account for an increase in tobacco duties. We find it useful to look at a measure of the median price level, looking further than the normal weighted average price level. On this basis, UK inflation has been between 0.2% and 0.3% each month for the last seven months. That’s much more stable than the official core inflation metric, although still slightly higher than the Bank of England (BoE) would want it.

16 Jan Weekly recap FP 2

Source: LSEG Datastream

Inflation is a little too high and the housing market showed signs of life. Rightmove’s house prices improved nationally, and the RICS (Royal Institution of Chartered Surveyors) house price balance also ticked higher.

House prices will reflect the declines in expected interest rates, which have dragged five-year swap rates down and led to lower rates on mortgages. The fly in the ointment for the UK is the labour market, where the latest payrolls numbers suggest a net decline in employment. This data is volatile and subject to revision, so should be treated sceptically, but wouldn’t seem out of place with the longer trend of declining UK employment growth.

It provides a dilemma for the BoE’s Monetary Policy Committee (MPC), which is replicated around the world. If inflation is currently still too high, can it respond to tentative signs of a slowing economy?

The Red Sea

It is particularly hard to do so when inflationary pressures are rising. Shipping costs continue to rise as the Yemeni Houthi rebels attack freights navigating the Red Sea. Conflict has intensified but remains a series of proxy wars rather than a hot Middle Eastern war, which might disrupt oil supply.

There seems a reduced path of free navigation of the Suez Canal now that the US and UK launched airstrikes against the Houthis. Far from discouraging them, the rebels now see US shipping as legitimate targets. Freight rates continue to rise.

Houthis activity is facilitated by Iranian weapons supplies. The Iranians themselves launched attacks on militants in Iran and Pakistan, as well as what they claimed was a Mossad facility in Syria. With the prospect of ongoing Houthi disruption, and a complex web of proxy conflicts taking place within the Middle East, foreign policy is likely to become a topic of the upcoming US election.

Interest rates

Around most of the world, expected interest rate cuts have been pushed back with economic news still seeming to be reasonably upbeat and inflation slightly higher than expected. A couple of weeks ago, we referenced JP Morgan CEO Jamie Dimon’s comments, which he had just made when delivering the company’s Q4 results.

He said, “The US economy continues to be resilient, with consumers still spending, and markets currently expect a soft landing. It is important to note that the economy is being fuelled by large amounts of government spending and past stimulus. There is also an ongoing need for increased spending due to the green economy, the restructuring of global supply chains, higher military spending and rising healthcare costs.”

These factors would suggest that inflation and real interest rates should be higher than they have been previously, as we have discussed in the past.

Earnings season

Finally, we can check in on the US earnings season. Although only 45 companies have reported at the time of writing, the earnings season has already settled into a ratio of 80% positive earnings surprises. Regular readers will know that this is normal and not as bullish as it might seem. With the banks sounding upbeat on economic activity, it will take another view to be able to draw more meaningful conclusions from a good spread of non-bank companies.

Written and prepared for Crowe Financial Planning UK Limited by RBC Brewin Dolphin.
Opinions expressed in this publication are not necessarily the views held throughout RBC Brewin Dolphin. Forecasts are not a reliable indicator of future performance.
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