Investment Viewpoint: Markets adjust to stronger data and evolving rate expectations

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Markets and macro insights with Sebastian Orsi, Senior Research Analyst

Key Takeaways:

• Global markets ended lower last week. Stronger than anticipated US economic data raised the spectre of the US Federal Reserve (Fed) moving to tighter policy and there was a reversal of some of the recent IT investment theme gains.
• In Europe, economic data remains soft, but energy price-induced inflation is still pushing bond yields slightly higher. The European Central Bank (ECB) is likely to increase rates this week.
• A lack of tangible progress in the US-Iran negotiations saw oil prices rise initially, but this tailed off through the week. An outcome that allows energy flows through the Straits of Hormuz to resume imminently is becoming increasingly important. This seems to be desired by the main parties, but confirmation is needed.
• Much will be made of the greater than 10% decline of the Philadelphia Semiconductor Index late last week. It bears watching but should be put in context of recent parabolic gains; it was down 4% for the week and is still up about 70% year-to-date.
• With global economic growth still on track and strong corporate earnings growth, our investment strategy remains slightly pro-risk, with a bias to quality and structural growth over more cyclical segments. While markets may need to digest a change in rate expectations, historically rising policy rates have not necessarily been a negative indicator for equity market returns.

Global markets ended lower last week – why was that?

• Global equities gave up modest mid-week gains on Friday to close 1.2% lower in euro terms (-1.8% in local currency terms). Euro area bonds fell by 0.7% as bond yields rose.
• The US-Iran ceasefire deal deadline passed, there were no official talks, and there were some military attacks but there were also clear efforts at negotiating a ceasefire extension. Oil prices rose slightly before settling back closer to flat on the week. Falling oil and product inventories are increasing the urgency to reopen the Straits of Hormuz.
• Within equities, market internals changed to close the week. The US was the weakest region and Europe fell the least, but much of the US decline happened after European markets closed Friday. So, there may be follow-through to other regions to start this week. Sector mix drove much of the regional performance differences.
• In general, we might describe last week’s equity sector moves as a reversal of recent trends and an unwind of some of the very strong IT investment theme gains. This contributed to declines in IT, Consumer Discretionary and Communication Services. Defensive sectors such as Health Care and Staples rose last week, as did Financials. Energy was the strongest sector, having been the weakest for the last two months.
• Euro area bonds reacted negatively to euro area inflation statistics and US economic data. The euro yield curve shifted higher and flattened as two-year yields rose 0.12% to 2.68%, and 10-year yields rose 0.08% to 3.04%. The ECB is likely to raise rates this week.
• US bond yields rose (and bond prices fell) mainly on the stronger-than-anticipated economic data releases which mean the US Fed is almost certainly going to end its easing bias commentary. The more Fed rate sensitive US two-year yield rose 0.16% to 4.16% and the 10-year yield rose 0.10% to 4.54%.
• The first of a few mega-cap IPOs was launched last week for SpaceX. Fast entry into several indices is widely anticipated. Market participants are eagerly watching developments to gauge the impact of the IPO on market sentiment.

What does this mean for investors?

• As we have noted previously, markets are moving on daily news reports about the US-Iran war and its related impact on global energy supplies. Despite the daily volatility, beneath the headlines global equities have been driven by the IT investment cycle. A small number of related sectors and stocks have driven the indices to all-time highs. The rest of the market has been relatively pedestrian
• Some of the IT investment theme enthusiasm unwound late last week after bellwether results that were very strong didn’t lead to outsized forecast upgrades. We wouldn’t expect this to be the harbinger of the end of the IT investment cycle, perhaps more of a pause that refreshes.
• With oil and product inventories at very low levels, a negotiated outcome in the US-Iran war that allows energy flows to resume is becoming increasingly important. It does seem that the two major participants are working toward this outcome. But markets will need confirmation. Otherwise, the growth and inflation implications will likely escalate.
• For now, the US economy appears to be performing reasonably well, with better than anticipated data suggesting stable or even broadening growth. It might take equities a while to digest the impact this is having on US interest rate expectations, but better growth should continue to support corporate earnings. Rising policy rates have not historically been a negative for continued equity market progress.

Was there any major macro-economic or geopolitical news last week?

• The very strong US Employment report released on Friday was the main economic news. The US added 172,000 jobs, well above the 105,000 forecast with upward revisions of 93,000 jobs to the prior two months. The unemployment rate remained stable at 4.3% while average hourly earnings growth was 3.4% year-on-year. A significant proportion of the higher-than-anticipated increase came from local government jobs rather than the private sector, and football World Cup-related hospitality jobs may have had an impact. So some analysts are questioning the underlying strength of the data. Still, the overall report was better than anticipated.
• European inflation figures reported last week have likely fixed the ECB’s decision to raise rates at its meeting this week. Eurozone flash CPI for May came in at 0.1% month-over-month, down from 1.0% month-over-month last month. CPI ticked up to 3.2% year-over-year from 3.0% last month. Core CPI was up 0.3% from last month and 0.1% above forecasts, and up 2.5% year-over-year. Eurozone Producer Price Inflation (PPI) was +0.6% month-over-month, down from +3.4% last month; the annual rate was 4.9% year-over-year.
• Euro area unemployment was 6.3% in April, just slightly higher than the 6.2% forecast but stable against last month.

The week ahead: what to watch out for

The ECB is expected to increase rates at its policy meeting on Thursday. Meanwhile, US inflation figures are the main data points of interest in a quiet calendar this week. The feed-through of higher energy prices is expected to moderate but inflation is forecast to remain high. US CPI, due Wednesday, is expected to be up 0.54% month-over-month, down slightly from +0.6% last month. The year-on-year rate is forecast at 4.3%, up from 3.8% last month. Core CPI is forecast to have increased 0.26% month-over-month, down from +0.4% last month. US Producer Price Inflation (PPI) is due Thursday. PPI is expected to decline to 0.50% month-over-month from 1.4% last month. Core PPI is forecast to have fallen to 0.30% month-over-month from 1.0% last month.