US Inflation behaves

Market Review:

Confounding market pundits that had been expecting a hot inflation print, Wednesdays US CPI number came in lower than expected, triggering a sharp drop in bond yields and a surge in equities. By close on Friday night, the mighty old Dow Jones Industrial index had scaled and closed above 40,000 for the first time in its history. Not bad for an index that was below 2,000 when I started out in the industry in 1988. For anyone that gets investment vertigo , ‘an irrational fear of buying shares at a high point’, please remember that there is no ceiling to how high equity prices can go. This is because equity investment is inexorably linked to economic progress, corporate innovation, rising wealth, population growth and the demand for goods and services. As these increase, so will the overall value of companies, punctuated by fear and greed pricing cycles.

US Market & Macro : Along with the Dow Jones breaching a symbolic, although largely irrelevant number, we also got all-time highs from the broader market, S&P 500 and the tech heavy Nasdaq Composite. US Small caps, as represented by the Russell 2000, are still some way from the their all-time high set nearly 3 years ago in November 2021. Before we can pronounce current US equity conditions as the second roaring 20s bull market, we will probably need to see small caps join the party too. That said, without a shadow of doubt, investors are in upbeat mood with the S&P Global Fund Manager survey reporting that equity investor risk appetite surged to a 2½-year high in May …..and that was before the inflation data.

‘Investors have also become more upbeat about market performance over the coming month, contrasting with the negativity seen over the first four months of the year. Optimism is also spreading to more sectors. Most notable is a rebound in views towards tech stocks. Sentiment has been buoyed by better-than-anticipated earnings performance, which has propelled shareholder returns and equity fundamentals to the fore in terms of perceived market drivers’

Soft Landing Signs …

So just how good was the news on inflation? Not very in truth, it was only a teeny, tiny bit better than analysts had been expecting, which leads me to conclude that the market really is in a ‘glass half full mood’ at the moment. The so-called core CPI, which excludes food and energy costs, climbed 0.3% from March versus a 0.4% expectation. But it did at least snap a streak of three above forecast readings, which had spurred concern that inflation was becoming entrenched and the year-over-year measure cooled to the slowest pace in three years. I think the data obviously shows there is still work to do on inflation, but more importantly it reminded investors that disinflation is still occurring and that the Fed is still likely to cut rates this year.

It therefore made sense for bond yields to drop as they did, providing support for equities, however, it remains reasonable to question whether these figures indicate a significant turning point in the fight against inflation. Digging in, we can see that whilst victory can be declared over food, energy and goods – service sector inflation remains stubbornly high.

Now a large chunk of service sector inflation is centred around people-heavy businesses in which wages are the bigger component. To get this down, we are going to need to see further weakness in the jobs market, ergo jobs data has probably now become the most important thing the Fed are watching. If we can continue to see less strength as the last few reports have suggested, then I think we will see the Fed start to warm the market up to the prospect of rate cuts. Lending further support to the argument for further rate cuts last week, came news that retail sales, new home construction and manufacturing had reported for April, softer than expected.

Goldilocks , or even a hard landing ?

With rate cuts back on the table and an economy still growing, the ‘goldilocks’ scenario has once more become dominant and whilst only a week or so ago, the risk seemed to be that the economy might actually be running a little too hot for those cuts to happen, thoughts have now swung to the risk of a hard landing. The unexpected coolness of retail sales has seen a new wave of thought, what if actually the economy is losing too much steam? There are signs that bond investors might be warming up to this possibility as the yield on treasuries has fallen back down below 4.5%.

Bears have been growling since mid-2022 that the US consumer will soon run out of the excess savings accumulated during the Covid-19 fiscal stimulus spree from 2020 to 2021, forcing them to rein in spending. Certainly, the increase in the use of ‘buy now, pay later’ suggests that some segments of the population cannot carry on consuming indefinitely, particularly those being squeezed by higher mortgage and credit card interest payments.

But, whilst that is undoubtedly true for many households, the economy must be viewed in aggregate and there is one very large (in terms of wealth) segment that has truly, never had it so good and that is the baby boomers and they have only just started on a spending spree that could last for decades. Baby Boom households have a record $75 trillion in net worth and they are the richest cohort of seniors ever. Not only have they seen their assets rise stupendously, but also their income from savings – I even saw an article with Blackrock’s CIO of fixed income Rick Reider arguing that rates should go down to curb their spending , how’s that for counterintuitive ; ‘in fact, I would lay out an argument that actually if you cut interest rates, you bring down inflation. Middle- to higher-income Americans are getting a big benefit from these interest rates’, he said.

I don’t agree with Reider’s off the cuff assessment, but I do think the economy will tick along just fine and that for the moment we should welcome signs of a slowdown. Investors are still weened on the need for rate cuts and this has become more likely over the last two weeks of April economic data. In a sense, further ‘weaker economic news’ is still likely to move the markets higher providing it doesn’t get really bad. So the unlikely soft landing is still very much on the cards, Goldilocks is out playing and the bulls are basking in the sunshine and J Powell may yet be remembered as the best of Fed Chairmen.

Europe : I hadn’t actually intended this weeks report to end up as a feel good for investors, but hell why not, its not every week you get all time highs across the board of global stock markets, so its on to more good news this time out of Europe. The Euro Stoxx recorded a new high watermark last week and whilst there was no particular reason, the ECB do seem to be on course for the first rate cut from a major central bank as early as June. Perhaps the spur higher came from the release out of Germany that showed investor confidence rose for the tenth consecutive month, reflecting optimism about a return to growth after over a year of near-stagnation.

The ZEW institute’s expectations gauge increased to 47.1 in May from 42.9 in April, surpassing the 46.4 forecasted by analysts in a Bloomberg survey. Additionally, a measure of current conditions also exceeded expectations. Signs of an economic recovery are growing, bolstered by better assessments of the overall eurozone and of China as a key export market with the optimism particularly reflected in the sharp rise in expectations for domestic consumption, followed by the construction and machinery sectors.

China : Which does neatly lead me on to my final bit of good news that came out on Friday as China’s government, under Xi Jinping, announced a new relending program that will provide 500 billion yuan for housing buy-ups. Markets responded positively, with the Shanghai Stock Exchange Property Index surging 6.2%, helping lift the broader MSCI China Index. Would you believe it, this latest surge has now helped the ‘unloved, untouchable’ Chinese market overtake the S&P 500 for year-to-date gains. If ever there was an argument for diversification in portfolios, this is it and I am delighted to report that the AQ portfolios have maintained benchmark weighting in this market, even as others deserted it.

This latest policy shift aims to ease pressure on developers and increase public housing, marking a change from Xi’s 2017 stance that ‘houses are for living in, not for speculating’. The central bank also cut minimum down-payment ratios for first-time buyers to 15%, and for second-home buyers to 25%, representing a 5 percentage-point reduction. A note of caution though, despite these measures, China’s real estate market still remains fragile with halted construction and developer defaults threatening social stability. Previous mortgage rate cuts have not significantly boosted demand, raising doubts about the effectiveness of these measures and there remains a huge unsold housing inventory. But it was, nevertheless, one more step in the right direction for the world’s second largest economy.

Given that this has turned in to just a feel good article for financial assets, I will throw in a few reasons why I think this rally in China could be sustainable as along with the efforts to shore up the Property market, I can list 5 other factors; Government Stock Purchases: China’s government, through Central Huijin Investment, is actively buying stocks and ETFs to stabilize the market, similar to Japan’s approach; Re-engagement of Global Investors: Global investors are returning to Chinese equities, led by local investors encouraged by easing policies and the Southbound Stock Connect; New Policies to Support Shareholders: The State Council has introduced measures like controlling IPOs, encouraging dividends, and improving corporate governance to attract equity investments; Revival of the Consumer Economy: China’s economy is recovering, with GDP exceeding expectations and consumer confidence rising, especially in the services sector ; Valuations and Buybacks: Attractive market valuations are prompting stock buybacks, particularly in the internet sector, supported by improved company fundamentals and positive earnings projections.

Markets have momentum, and should be safe from any big shocks from economic data for a week or two, so in the short term it’s fair to expect the rally to trundle on for longer. We have long argued that the right question to ask is not whether the Fed will cut once or twice this year. The right question is if the data weakens will the Fed be willing to cut and I think that’s an overwhelming yes. As long as the optionality of a cut remains, we would argue that the ‘Fed Put in on the table’ which should continue to support risky assets. Once risk to the downside could come from Nvidia results next week where expectations are running sky high, but so far this AI Leviathan has not disappointed.