Summary
1.Disinflation gathers steam: major economies are entering a disinflation phase with inflation rates fast approaching 2%. More central banks will cut rates this year, with additional cuts expected in 2025. Fed rate cuts in the absence of economic recession benefit short-dated bonds, stocks, gold.
2.Political focus switches to US elections: focus on policy not politics. Immediate, dramatic trade tariff increases are unlikely given risks of surging US inflation and diminished household purchasing power. In the long term, global interest rate and economic cycles generally impact financial markets far more than politics.
3.European, US debt sustainability is not a short-term concern: government debt/GDP ratios and budget deficits have undoubtedly increased post 2020, but the average cost of outstanding debt is still low. Political uncertainty has been largely priced in. Prefer shorter-maturity bonds on falling inflation and central bank rates.
4.Can the current rotation to smaller cap stocks continue? July witnessed the largest 1-week rotation from US large-caps into the Russell 2000 index in history. Fed rate cuts should disproportionately aid small-caps, given their higher exposure to floating rate debt. We prefer US stock exposure in the form of equal-weighted S&P 500 or small-/mid-cap indices.
5.When to “buy the dip”? In July, global stocks (-4%) and commodity markets (-8%) have both retreated from recent highs. We see this as merely a late-cycle correction, given reasonable underlying liquidity, economic fundamentals and Q2 corporate results. Buy stocks and commodities on weakness by September.
Weaker activity opens the door for disinflation and rate cuts
Leading indicators such as business surveys suggest a weakening of economic activity after a period of gradual recovery in industrialised countries. However, consumer demand remains relatively resilient as inflation is falling and central banks are expected to cut rates. Companies lowered job openings but are not laying off on a large scale. This is key because they have realised over the past 2 years that qualified workers are scarce. Surveys suggest that households remain confident about jobs and future income. Household generate up to two-thirds of total demand and should offer a key support going forward. Overall, surveys imply that companies are more cautious, but index levels do not suggest recession fears. China has shown signs of recovery as confirmed by recent data on intra-Asian trade. Structural challenges remain. At the Third Plenum, Chinese authorities raised hopes for further support measures. They will probably use a gradual approach. We may see some upside surprises.
Global inflation has been on a downward trend since late 2022. This disinflation was first driven by falling goods prices as the strong post-Covid demand reversed and demand shifted towards services. Service prices and items related to housing have been much stickier and this largely explains why the normalisation process in core inflation is slower. Now, cooling wage inflation suggests that more normalisation of inflation is ahead. The recent rise in container shipping costs is a concern but the total impact on core CPI inflation is small and should not derail the disinflation trend. The renewed fall in oil and gas prices is positive news. Fixed income offers yields close to 15-year highs
In the US, consumer price inflation is slowing, in line with the cooling of job creation. After three months of sluggish growth, the CPI index fell in June, month-on-month, for the first time in two years. Core CPI inflation rose by 0.1% over the month, also clearly decelerating. Core inflation year-on-year for June was 3.3%. A few volatile categories explain this deceleration, with a -5% month-on-month decline in airfares and a -2.5% decline in hotel prices. Auto insurance rebounded as largely expected, but inflation in non-shelter services cooled, with recreation services and transportation services excluding auto insurance and airfares contracting and inflation in medical care services also printing lower. Rent for primary residence and owners' equivalent rent recorded their weakest monthly gains since July 2021 and April 2021, respectively. July core PCE inflation, the Fed’s favourite measure, confirmed this with 0.2% month-on-month and 2.5% on a yearly basis. The recent rise in producer price inflation needs to be monitored. The Fed is expected to cut rates for the first time in September followed by further cuts next year and in 2026.
In the eurozone, flash headline inflation fell to 2.5% while core inflation was unchanged. Lower energy and food inflation were the key drivers. Headline inflation should reach 2% in the third quarter. Continued stickiness in the more wage-sensitive parts of the inflation basket, such as services, could somewhat delay disinflation in the core measure. The disinflationary trend remains in place and continues to suggest further rate cuts by the ECB. We expect 2 more rate cuts this year and 3 more next year.
Debt sustainability issues on both sides of the Atlantic
Pressures of growing government debt in Europe
The average European government budget deficit increased to 3.5% of GDP in 2023 from 3.4% in 2022, while the average government debt to GDP ratio fell to 81.7% from 83.4%.
High levels of debt can limit the country’s ability to respond to economic shocks, making it more vulnerable to future crisis. The European Commission launched an Excessive Deficit Procedure (EDP) against 7 countries, including France, Italy and Belgium for failing to comply with the Stability and Growth Pact.
This comes at a time when France could face political paralysis, as no single party or bloc has secured enough votes to form a majority government.
Should we be worried? No.
First, in our view, political uncertainty in France is already priced in. The 10-year OAT-Bund bond spread has widened and stabilised at around 65-70bps.
Second, with an average nominal interest rate of 2.1% on outstanding eurozone debt, and inflation targeted at 2%, the real interest rate is about 0%. This is far less than potential growth, estimated at around 0.8%.
Third, the ECB has developed several tools over the years to deal with crises, whether targeting a specific country or the entire area. These tools include i) forward guidance; ii) active bond buying in the stressed countries either using the pandemic portfolio flexibility or the new Transmission Protection Instrument which counteracts disorderly widening of sovereign spreads not justified by fundamentals; and iii) the Outright Monetary Transactions, which is designed to safeguard policy transmission and preserve the euro.
US government debt burden has also risen sharply
Despite a resilient economy, the US deficit has grown to 5.6% of GDP in 2024. There does not seem to be any willingness on the part of either Democrats or Republicans to deal with this issue.
The Congressional Budget Office (CBO) estimates that this deficit will increase to 6.1% in 2025 before decelerating to 5.2% in 2027 and 2028, which remains uncomfortably high.
The US federal debt-to-GDP ratio is expected to reach 123% in 2024 and rise further to 134% in 2029 according to the IMF.
The debt ceiling (the government cannot issue new debt to finance its current spending once the outstanding debt reaches a specified absolute amount) will be reinstated at the start of January 2025, which will trigger last-minute political negotiations and market volatility.
But, unlike other countries, the US can afford to run large deficits as it controls the world’s reserve currency, and its real potential GDP (2.2%) exceeds the current average real cost of debt (0.9%).
So, these deficits can continue as long as the US Treasury issues new debt and investors remain buyers. A lack of investor appetite would increase the risk premium and could push bond yields higher, which in turn would increase the cost of servicing the debt. In our view, there is no risk of stress in the short or medium term. The risk is that high debt levels and higher servicing costs would eventually reduce potential economic growth as the federal government is forced to cut spending.
Stock markets hit a speed bump after a strong run
US and Japan lead global stocks
Over the first seven months of 2024, global stocks have delivered strong returns for investors. The Euro STOXX 50 returned 10% to date, while the S&P 500 did even better at +15%, benefiting from heavy mega-cap technology exposure.
However, there were even more impressive returns from several other markets: Taiwan at +23% in US dollar terms and Turkey at +43% in euro terms.
Statistically speaking, during the years since 1990 where the S&P 500 index has risen 10% or more over the first half of the year, it has returned an additional 11% on average over the second half of that same year.
With macro liquidity still strong, financial conditions still relatively loose and short- and long-term interest rates declining, we see a relatively positive backdrop for global stocks until the end of this year.
But watch for higher volatility
This does not mean that it will be all plain sailing for stock markets. Seasonally speaking, stock market volatility (as measured by the VIX index in the US and the VSTOXX index in Europe) trends higher from July to year-end. With the US Presidential elections still ahead of us (in November), stock market investors should brace themselves for choppier waters. It is also likely that we will see a shift in market leadership after such concentrated market momentum, away from mega-cap technology towards other sectors and regions. This rotation may already have started.
Europe, Value, Mid/Small to play catch-up?
We are entering a period of synchronised central bank rate-cutting cycles in Europe, North America and China, as inflation rates trend towards 2% or even below. We look for the Fed to begin cutting rates in September, while the European and Chinese central banks (ECB and PBOC) should continue to cut benchmark interest rates in the coming months.
In previous interest rate-cutting cycles since 1973 when an economic “soft landing” has been achieved (i.e. avoiding recession), stocks have gone up in the 3 months after the first US Federal Reserve rate cut. Sectors that have usually outperformed in this period include Financials, Healthcare and Consumer Cyclicals.
Look also to mid- and small-cap segments of the US and European stock markets for stronger upwards momentum for the remainder of 2024. While US mid- and small-cap stocks have lagged US mega-caps heavily since May, European and UK mid-/small-caps have performed strongly. Since the beginning of this year, the UK FTSE 250 mid-cap index has returned 11% in Sterling or +13% in euros. The MSCI Europe Small-cap index has delivered 8% so year-to-date – not as strong as the 10% return in the Euro STOXX 50 but demonstrating impressive “catch-up” momentum since mid-April, prior to the June ECB rate cut.
Conclusion: keep a positive allocation to global stocks but expect a sector and regional rotation away from US mega-caps into mid- and small-cap segments. We favour Financials and Healthcare sectors, and World ex-US focusing on deep value.
Why small things matter
The Great Rotation
In early July, the Russell 2000 sat at record lows versus the Nasdaq and at 23-year lows versus the S&P 500. US market breadth was the narrowest for over 20 years with less than 20% of stocks outperforming the index. CFTC data showed that asset managers had never been more short the Russell 2000 versus the S&P 500. Apparently, investors saw little reason to own small-cap equities. This view was changed by a surprisingly weak CPI number, which sparked hopes for more rate cuts from the Fed. The rotation has also been fuelled by perceived odds of the US election outcome as the policy advocated by Donald Trump is generally seen as supportive of smaller and medium sized companies.
In the week from 9 July, the Russell 2000 outperformed the Nasdaq by 12% (the biggest 1-week outperformance since the tech stock bubble burst in 2000) and the S&P 500 by 10% (the largest 1-week outperformance since the Black Monday stock market crash in 1987). During this move, market breadth increased as well with 76% of stocks beating the index. This was the best 1-week breadth measured in more than 20 years. The main driver behind the move was retail money. Over this week, investors have poured more than USD 1.3 billion into the largest ETF (IWM) tracking the Russell 2000, another record.
Dealer positioning was a further factor. Dealers and hedge funds were short of between 10 and 20% of the average daily Russell 200 ETF volume as the market headed into this rotation. They were thus forced to buy USD 9 billion worth of Russell 2000 index exposure over just one week as the index rose.
Small caps should enjoy further tailwinds
As expected, US inflation continues to decelerate, which should allow the Fed to start cutting rates in September. Lower rates are particularly positive for small caps as 30% of the outstanding debt of Russell 2000 companies consists of floating-rate debt. Lower interest rates will thus have a direct positive impact on analyst earnings estimates. Historically, stocks tend to do well when earnings per share (EPS) forecasts are revised higher.
The recent outperformance of Cyclical vs. Defensive stocks also suggests that the market expects some tailwinds from growth. June’s upside surprise in core retail sales can be seen as a case in point.
The improved odds of a Republican clean sweep – Republicans winning both Congress and the White House – is also perceived as supportive. In 2016, small caps outperformed on Trump’s “America First” domestically-focused politics. This domestic bias leaves small caps less vulnerable to higher tariffs.
Earnings for small- and mid-cap stocks are expected to rise while markets are pricing a growth slowdown for US mega-cap names. Keep in mind that concerns about the prospect of “overinvestment” in AI, especially among “hyperscalers” (e.g. Amazon Web Services, Microsoft Azure and Google Cloud Platform), have recently come to the fore. A tightening of the earnings growth spread should provide a headwind to future mega-cap (out)performance while supporting small- and mid- caps. We continue to prefer exposure outside the expensive US mega-cap names via equal-weighted S&P 500 or small- / mid-cap indices.
US Elections: Focus on the economic cycle not just politics
Focus on Policy not Politics
With regards to the upcoming US elections, one should focus on policy not politics. Thus far markets are proceeding normally with US equities +15% (as at 22 July) in election years, more than average.
Normally, the market pauses, and can fall moderately from September (data from 1932 to 2020), just before the election in November as investors reduce stock exposure. Post election, the market on average proceeds to go up in the final quarter of the year no matter which candidate or party is victorious.
The composition of Congress will be key for changes to tax and the level of fiscal stimulus.
A sweeping victory for Mr Trump including in Congress could lead to a higher stock market in the near term, a stronger dollar and higher yields due to a rollover of his existing tax cuts, and perhaps additional tax cuts, deregulation, and additional tariffs other things being equal. Looking at history, the dollar rallied 5% and stock market went up 7% after Trump’s “surprise” election in 2016.
Industries that could benefit from deregulation include Oil & Gas and Banking. However, we are in a very different inflation and interest rate cycle today. Furthermore, President Trump is a known candidate now. Hence, if it looks like he is winning, Trump trades could be priced well before the election. History does not repeat but it often rhymes.
If Mr Trump is elected with a divided Congress, expect less market impact. In this case, new tax cuts are unlikely.
There may be some tax cut extensions on selected groups as well as less deregulation. Tariffs do not require Congressional approval and Mr Trump has mentioned a 10% across-the-board tariff increase and as much as 60% on China. An immediate 60% tariff on Chinese goods would be difficult to implement given the higher potential inflation that could ensue, but more trade barriers would be very likely. This could result in a modestly stronger dollar and higher bond yields, but little stock market impact.
For the Democrats, the key will be how long it will take to select a Democratic nominee. Kamala Harris is the clear frontrunner, and given a slew of early endorsements, she is likely to be selected.
Democratic candidate: long-term implications
Currently Vice-President, Kamala Harris has a high probability of becoming the Democrat party candidate for President. She has been boosted by USD 200m in fundraising since her candidacy was announced, plus she has secured key endorsements. The focus will now shift to her pick of Vice-Presidential running mate who could be a candidate from a swing state with appeal to independent voters. From a policy perspective, she can be expected to be a Biden 2.0 (i.e. little change from current government policy). We await key policy pledges, but expect incrementalism given she was second in command in the Biden administration. She benefits from a younger demographic and widens the pool of voters for the Democrats in some key areas. The polls have narrowed from “peak Trump” after the assassination attempt, and there is plenty of time until November.
In the event that Kamala Harris wins the Presidency, the Democratic administration is more likely to face a divided Congress, as the Republicans currently have a higher probability of taking the Senate, than the Democrats of securing the House of Representatives. A split Congress would suggest a relatively neutral market impact on stocks, bonds, and the US dollars.
In the alternate scenario, in which Kamala Harris wins and the Democrats sweep Congress, this could lead to short-term moderate weakness in stocks. This would be due to not extending Trump’s income tax cuts to everyone except perhaps low-income earners, as well as little deregulation.
Furthermore, the Democrats would also be able to implement more fiscal policies, which would possibly boost the economy and as a result, the dollar and bond yields by reducing the number of expected rate hikes. Sector implications are positive for clean energy and companies exposed to the IRA and reshoring in this scenario.
There is still some time before the US elections take place, with many possible scenarios and even possible candidates. Market participants recently priced in as much as a 70% probability of a Trump win. That seems overdone. The US and global interest rate and economic cycles are normally more important than the political cycle for the long term.
In that regard, in the longer term, it is important to keep in mind that stock markets go up over time, irrespective of whether the US is under a Republican or a Democratic president. Only 3 times since 1929 has the stock market declined over the full term of a presidency (whether 1 or 2 terms). These declines was largely due to the economic cycle (1. Great Depression, 2. Arab Oil Embargo, and 3. Great Financial Crisis). Hence, at this juncture, we do not recommend making major changes to asset allocation based on purely political scenarios.
Third (Plenum) time the charm?
Key takeaways from the Third Plenum
China’s four-day Third Plenum meeting, which typically takes place twice a decade, concluded on Thursday, 18 July, and it showed a high degree of policy continuity. Historically, the Third Plenum focuses primarily on medium to long-term goals rather than addressing short-term issues. Unsurprisingly, the meeting this time round was a reform-focused meeting of China’s Communist Party Central Committee and yielded a communiqué long on commitments albeit short on specifics.
The key themes related to deepening reform and pursuing Chinese-style modernisation, as China aims to establish a high-level socialist market economic system by 2035. Specific goals include giving a bigger role to market mechanisms, creating a fairer and more dynamic market environment, opening up to the rest of the world, and expandin g international cooperation via reform of foreign trade and investment. The government continues to present a solid long-term vision where unsurprisingly, innovation, green development, and consumption are keys to modernisation and growth drivers.
These policies will be rolled out successively, although President Xi Jinping and his team have promised to complete some reforms by 2029 when the People’s Republic of China marks the 80th anniversary of its founding. Crucially, policy specifics on how these goals can be achieved will be more important to convince markets.
CPC pledged to hit near-term economic targets
The meeting commenced on 15 July, coincidentally (or perhaps deliberately) after the release of figures showing worse-than-expected GDP growth. Real GDP growth decelerated to 4.7% YoY in Q2, missing market expectations by 0.4ppt. The data seriously challenged the official 5% GDP growth target for full year 2024. The industrial sector growth remained strong, partly due to stronger exports, but the growth drag came mainly from the services sector, which slowed to 4.2% in Q2 on the back of softer domestic demand and an underperforming property sector.
The GDP data sparked demand for more stimulus measures specifically for the property sector and consumption. Perhaps due to the increasingly troubled domestic and external landscape, during the meeting, the party did discuss achieving this year's growth target of 5%, keeping growth on track, and implementing macro policies that support domestic demand. This raises hope for more support measures in the near term. Nonetheless, the level of details so far does not point to more than a slow and considered approach to economic stimulus. Given recent weakness in economic data, the market will await more details on these important topics.
PBoC sang the same tune
Following the conclusion of the Third Plenum, the People's Bank of China (PBoC) announced a 10bp cut in the 7-day reverse repo rate (to 1.7% from 1.8%) on Monday, 22 July. In addition, 1-year and 5-year loan prime rates were cut by 10bps (1-year LPR to 3.35% from 3.45%; 5-year LPR to 3.85% from 3.95%). The central bank acknowledged that the economy was facing insufficient demand and weak market expectations, and hence is was committed to adopting countercyclical tools to boost domestic confidence.
Although unexpected, the PBoC’s decision to cut its policy rate was in line with the policymakers’ strong determination to meet the 5% growth target conveyed by the Third Plenum. We think the PBoC is likely to stick to a steady and gradual pace of interest rate cuts. The growing conviction that the Fed is going to embark on an easing cycle in September provides more room for manoeuvre for the PBoC to cut rates earlier.
Looking ahead
Policymakers may need to rethink their near-term policy mix to achieve the 5% annual growth target. In particular, a budget revision is may be necessary to maintain the pace of spending in the context of a continued decline in local government revenues.
The latest end-July Politburo meeting offered little new stimulus, but policy guidance for H2 24 maintained a pro-growth stance. The Politburo emphasized boosting consumption, albeit the pace and timing of measures remain unclear. The target of 5% GDP growth was again reiterated, hence falling below that pace in Q3 could result in new stimulus in Q4 (such as another RMB1trn CGB quota).
Edmund Shing, PhD
Global Chief Investment Officer
