In our latest publication, we highlighted that the U.S. economy is potentially at a tipping point where financial conditions are set to tighten as inflation continues to fall and the Fed has been too hawkish relative to economic fundamentals. We wrote:
Since July 11th – when U.S. CPI inflation data showed price pressure continues to abate – we have seen spike in volatility and tighter financial conditions alongside the rotation across asset class and within asset class. In fact, at the time of writing, VIX closed the day at 23 after spiking to as high as 29, much higher than the normal range of 12 to 20.
The good news is that the correlation between stock and bond price is back to negative in the past two weeks, with fixed income assets becoming a traditional hedge against downside risk for a balanced portfolio. The relevant question today is whether the current correction is an opportunity to buy the dip, or the start of a larger correction in the case of recession (Figure 1).
To answer that, we have to first understand what drove the massive rotation we saw in equity to bond and from cyclical to defensive. There are several catalysts.
First, both CPI and PCE inflation in the U.S. continue to drift lower. Goods prices continue to deflate in June, energy prices are under control despite the unfavourable news coming out of Middle East, and service inflation has been trending lower – with shelter cost also showing decent progress and expected to trend lower in the coming nine months. These all increase the likelihood that the Federal Reserve will start easing monetary policy in the September meeting and push bond yields significantly lower as investors are increasingly pricing in rate cuts in the subsequent meetings.
Many analysts now expects the Fed to continue easing by 25bp at each meeting next year, on top of 25 bps at every meeting this year, until it reaches 3% by November 2025. The upper end of the Fed funds target range is forecast to end 2024 at 4.75% and 2025 at 3.00%. With the U.S. GDP growth potentially falling below potential, the Fed may find itself needing to go back to a neutral stance much sooner than we currently anticipated, opening the room for 50 bps cuts in the coming meetings. With long-term yields moving lower, rate-sensitive defensive sectors such as utilities and real estate have been outperforming the equity benchmark (Figure 2).
Looking back, our decision to tilt the portfolio towards defensives is paying off. The article we published last week highlights this risk emanating from the labour market:
Historically, rate cutting cycle tends to support the performance of rate-sensitive sectors such as utilities, consumer staples, and healthcare – sectors that have been outperforming the S&P 500 benchmark since the beginning of the rotation on July 11th. Moreover, valuation for cyclical and defensive sectors are more attractive compared to its growth counterparts (Figure 9). The rotation back towards defensives, which have lagged significantly over the past two years, could be catalyzed by further progress on inflation and softer labour market condition. The case for being overweight defensive is even stronger in the case of U.S. economy decelerating faster than currently expected.
Second, the manufacturing and other cyclical parts of the economy are faltering amid elevated borrowing rate, slowing consumer demand and business capex. Consumer spending, which account for over two third of U.S. economy and had been a large contributor to U.S. economic strength, is now seeing signs of weakness. McDonald’s Q2/24 earnings highlights that fewer diners were visiting at its chain in the U.S., with comparable sales declined for the first time since the pandemic. Meanwhile, Hershey – the chocolate bar marker – said that consumers were “pulling back on discretionary spending” as its organic sales fell by a sixth. Similar volume decline is also reported by Kraft Heinz and Starbucks. Spending on luxury goods and travel booking have also been soft, as highlighted by the poor results of Burberry, LVMH, Kering, and Booking Holdings, among others. The disappointing recovery across cyclical sectors and slowing consumer spending is also weighing on these firms’ earnings outlook, triggering the rotation towards defensives from cyclicals, and also from equities to bonds (Figure 3).
Third, the job market is softening at a more rapid pace and the fundamental picture may be weaker than it seemed on the surface. Household surveys indicate job gains in the U.S. economy may have stalled in recent month, contrary to the relatively robust non-farm payroll figures (Figure 4). In July, the unemployment rate rose 0.2% to 4.3%, triggering the Sahm Rule, which links the start of a recession to when the three-month moving average of the jobless rate rises at least half a percentage point above its low over the past 12 months. We have stated that labour market is the key indicator to watch, and July’s non-farm payroll release proved to be the most significant market movers so far. The worry today is that too weak of a job market will translate to further pullback in consumer spending, creating a downward spiral between employment and spending outlook – as is the case for China currently.
Fourth, Bank of Japan unexpectedly hiked its policy rate to 0.25% from close to zero previously, creating pressure for traders to close their open carry-trade position that utilize the Japanese Yen as a cheap funding source. The rotation out of mega-cap tech stocks has coincided with the unwinding of several currency trade position such as against the Brazilian Real and Mexican Peso, whose value have fallen by about a quarter against the yen. It is probably not a surprise that some investors have also utilize the yen to lever up their risky equity position.
However, it is not a time to be complacent. The combination of softer macro data and yield curve steepening have historically been a good predictor of recession. There are reasons why the rotation from growth towards defensive sectors could have legs. First, the outperformance of the U.S. economy is diminishing as growth outlook shifted lower. In addition, following a tremendous rally over the past two years, expectations, valuation, and positioning for the info tech sector are stretched, which argue for a healthy correction in the space (Figure 5).
Copyright © 2024, Putamen Capital. All rights reserved.
The information, recommendations, analysis and research materials presented in this document are provided for information purposes only and should not be considered or used as an offer or solicitation to sell or buy financial securities or other financial instruments or products, nor to constitute any advice or recommendation with respect to such securities, financial instruments or products. The text, images and other materials contained or displayed on any Putamen Capital products, services, reports, emails or website are proprietary to Putamen Capital and should not be circulated without the expressed authorization of Putamen Capital. Any use of graphs, text or other material from this report by the recipient must acknowledge Putamen Capital as the source and requires advance authorization. Putamen Capital relies on a variety of data providers for economic and financial market information. The data used in this publication may have been obtained from a variety of sources including Bloomberg, Macrobond, CEIC, Choice, MSCI, BofA Merrill Lynch and JP Morgan. The data used, or referred to, in this report are judged to be reliable, but Putamen Capital cannot be held responsible for the accuracy of data used herein.
putamencapital.com 