Gotrade Monthly Recap: July 2023
Introduction
Global stock markets have entered a bull market phase despite signs of a growth slowdown and cautious statements from central banks, which resulted in increased yields and delayed rate cuts. This indicates that risk assets, like stocks and credit, are not only discounting the possibility of a recession but also seem unconcerned about potential policy mistakes by central banks. While a recession led by the US is expected to happen later than previously anticipated, the question of timing remains.
US banks experienced a setback in March, but the broader financial markets appear to have largely overlooked this issue. However, some analysts warn that the situation might not be completely resolved. Corporate bankruptcies have risen significantly this year, even though the economy has shown resilience thus far. There are also emerging concerns in the non-corporate sector, with increasing delinquencies in certain consumer credit areas and expected weakness in the commercial real estate domain. Smaller banks are likely to be cautious with lending due to the delayed impact of monetary policy tightening, deteriorating balance sheets, depressed stock prices, and potential deposit flight. Historically, tight credit conditions have led to economic slowdown, as evident in current and leading economic indicators in the US and Europe.
Despite these challenges, the stock market continues to exhibit strong momentum. Although investor sentiment has shifted from bearish to bullish in the past six months, it has not reached extreme levels. The robust momentum in stocks may persist, leading to a more neutral stance towards stocks, while exercising caution in credit markets where upside potential is limited. Fundamental deterioration needs to become more widespread before investors take notice. The S&P 500 has performed well in 2023, with a 5.25% gain last month and an overall increase of 18.66% by the end of July. Concerns about rising interest rates, economic growth slowdown, and high inflation have eased in recent months, and the regional banking crisis earlier in the year was short-lived. Notably, technology stocks, growth stocks, and cryptocurrencies have been the top performers this year as investors' appetite for risk assets has returned. As we move into the latter half of 2023, inflation seems to be subsiding, but analysts and economists remain wary of the Federal Reserve's ongoing battle with inflation and the possibility of a looming US recession.
Key Takeaways
Service sector growth slows, while the manufacturing recession persists
Central bank rhetoric remains hawkish, causing yield curves to invert further
Global stock markets enter bull market territory while credit remains well bid
Debt ceiling, inflation, and Fed pause fuel equities
In June, US equities experienced a rise, influenced by the US Senate's approval of the debt ceiling bill, a cooling CPI inflation rate of 4% (the lowest in over two years), and the Federal Reserve's decision to pause its rate-hiking cycle for the first time since March 2022. As expected, the Fed refrained from raising rates at its latest meeting, but the FOMC signaled potential future rate hikes and no rate cuts until the end of 2023, as emphasised by Jerome Powell during his press conference.
While headline inflation slowed to 4% in May, core inflation only saw a slight decrease to 5.3% year-on-year from the previous month's 5.5%. Economic activity remained soft, with the ISM Services Index falling to 50.3 in June, and manufacturing continuing to be in a state of contraction.
Despite concerns over the growth outlook, the stock markets showed resilience, with the S&P 500 breaking out of its recent trading range and entering bull market territory. Investors seemed to overlook the deteriorating growth concerns during this period.
Overall, the rise in US equities during June was driven by the debt ceiling approval, cooling inflation, and the Federal Reserve's pause in rate hikes. Investors should closely monitor economic indicators and the Federal Reserve's future actions to make informed decisions about the market's direction.
US inflation slows to a 2-year low
In the market performance, consumer discretionary, materials, and industrials sectors took the lead, while utilities, communication services, and consumer staples experienced the most significant declines. Notably, growth and momentum-oriented stocks outperformed value stocks during this period, and small and mid-cap companies showed stronger performance compared to large-cap names.
Upward revision in GDP but unemployment jumps
The initial reading of the first-quarter real GDP growth was revised higher to 2.0% annualized, surpassing its initial value of 1.3%. This upward revision was a result of improved consumer spending and exports.
However, the unemployment rate experienced a notable increase in May, rising to 3.7% from 3.4% in April. This figure represents the highest unemployment rate since October 2022 and exceeded market expectations.
Regarding inflation, the Personal Consumption Expenditures (PCE) index for May showed a decline, reaching 3.2% month-on-month, down from 3.8% in April.
In the manufacturing sector, the S&P Global US manufacturing PMI experienced a continued decline, concluding June at 46.3. This downward trend was influenced by weakening production and employment numbers.
Fundamentals, not macro variables, will drive value performance
In the first half of this year, there has been a noticeable trend of value stocks underperforming growth stocks, with a performance differential exceeding its typical range. This divergence began in March, triggered by concerns about the banking crisis, leading investors to expect easing of monetary policy to address economic weaknesses. Despite elevated interest rates and inflation, analysts believe these factors may not be the primary drivers of the relative performance between value and growth styles. Instead, value stocks tend to be influenced more by common-sense investing principles than macro variables like interest rates.
Many of the drivers that fueled the outperformance of growth stocks over the last decade, such as the expansion of global digital advertising, growth in cloud services, and the surge in streaming platform subscriptions, now seem to be reaching maturity. As a result, this could create pressure on the margins and returns of numerous growth companies. Analysts anticipate a multi-year reset of growth and earnings estimates, which they believe will act as a tailwind for value stocks in the years to come.
Throughout the past ten decades, value stocks have outperformed in various environments characterized by growth, interest rates, and inflation, highlighting their resilience in generating long-term alpha. This track record indicates the enduring nature of value investing's potential to deliver consistent returns.
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Earnings Season
The rise in interest rates is putting pressure on both U.S. consumers and corporations, leading to increased borrowing costs, which in turn affects investment and economic growth. Additionally, inflation has raised input costs for U.S. companies, resulting in tighter profit margins and impacting earnings.
During the first quarter, S&P 500 companies reported a year-over-year decline of 1.2% in earnings, with seven out of eleven market sectors experiencing negative earnings growth. As the second-quarter earnings season approaches in July, analysts are anticipating a significant slowdown in growth. Consensus estimates from Wall Street suggest a year-over-year drop in earnings of 6.5% and a 0.4% decline in revenue for S&P 500 companies during the second quarter.
For the full year of 2023, analysts project a modest 0.7% earnings growth for the S&P 500. However, their outlook varies for different market sectors. The energy sector has the highest percentage of "buy" ratings from analysts at 64%, followed by communication services (62%) and information technology (60%). On
the other hand, the consumer staples sector has the lowest percentage of "buy" ratings and the highest percentage of "sell" ratings.
The current consensus 12-month analyst price target for the S&P 500 is 4,808, which suggests approximately 8% upside potential from current levels.
Despite the strong rally off its October 2022 lows, Jeffrey Buchbinder, chief equity strategist for LPL Financial, believes the bull market may soon require a breather. However, he notes that the impending end of the Federal Reserve's rate-hiking campaign, along with the resilience of the economy and corporate America, contributes to a neutral equities view from a tactical asset allocation perspective, as per LPL Research.
During the second quarter, JPMorgan Chase, Citigroup, and Wells Fargo surpassed expectations, posting higher revenue and profit figures. This period included the fallout from three of the four largest bank failures in U.S. history. JPMorgan's net interest income last quarter was 44% higher than the same period last year, while Wells Fargo and Citi reported interest profits of $13.2 billion and $13.9 billion, representing increases of 29% and 16%, respectively.
In the second quarter, major indexes rallied as U.S. banks reaped the benefits of higher interest rates. However, the sector's outlook has been clouded by challenges such as lower consumer spending, slower loan growth, and increased deposit retention costs.
The results come after a turbulent first quarter, during which Silicon Valley Bank and two other lenders faced failures.
Despite the obstacles posed by higher rates and economic uncertainty, there are indications of a revival in the investment banking sector, which has contributed to share gains for certain banks. Deals and trading were hampered in the past due to these factors, but the recent improvements are encouraging for the sector.
Economic Outlook
The economic cycle follows a recurring pattern of four main phases: recovery, expansion, slowdown, and contraction. While each cycle may vary in duration and scale, these stages remain relatively consistent.
Currently, the global economy appears to be in the slowdown phase, as evidenced by a two-track pattern. Global manufacturing and trade have experienced a clear deceleration, leading to cautious business sentiment. However, labor markets have remained robust, and the services sector has benefited from a surge in tourism.
Although economic growth is slowing, there are no immediate signs of an impending recession. Nevertheless, late-cycle vulnerabilities have emerged, including concerns about the health of US regional banks, declining home sales and prices in various countries, and weaknesses in US commercial real estate.
Recent turmoil in the banking sector, such as the failures of three US regional banks and the UBS-Credit Suisse forced merger, is expected to be contained due to strong policy actions. However, there is a potential for financial conditions to tighten, potentially dampening economic growth.
Analysts should be mindful of the lagged effects of aggressive monetary policy tightening on the economy. A cautionary example is New Zealand, where the Reserve Bank of New Zealand's aggressive policy tightening resulted in a technical recession. Other economies may soon experience the delayed impact of policy tightening, potentially leading to issues like labor market weakness, deteriorating household balance sheets, and reduced consumption.
The unresolved war in Ukraine remains a concern, with the potential for further conflict to impact the global economy in new ways.
While Developed Market (DM) economies are expected to gradually slow down, Emerging Market (EM) economies are anticipated to outperform. China's economic recovery has been uneven, with slowing exports and manufacturing activity due to weaker global demand, but domestic consumption is supported by tourism and services spending. China's short-term growth may disappoint, but a positive outlook is projected over a 24-month timeframe, given the significant build-up of Chinese Yuan deposits. As business and household sentiment improve, these deposits could lead to a surge in investment and spending.
The Chinese government is aware of growth risks and has initiated interest rate cuts and targeted stimulus measures to support the economy. Analysts foresee China's 2023 GDP growth at 5.6%, well above the International Monetary Fund's global growth forecast of 2.8% for the same year.
Asia and ASEAN are expected to benefit as China's economy gains strength and global demand rebounds, boosting regional exports. Many regional central banks have already begun to pause their rate hike cycles to support economic growth.
How To Invest after July
The S&P 500 is on track for its strongest performance since 2019, and historically, a robust first half of the year often indicates continued positive momentum in the second half. In the past, when the S&P 500 followed a year of negative returns with at least a 10% gain in the first half of the subsequent year, the index has averaged an 11.8% gain over the next six months.
To mitigate recession risk concerns, investors can adapt their strategy by reducing exposure to stocks and increasing cash holdings, taking advantage of rising interest rates. High-yield savings accounts insured by the Federal Deposit Insurance Corporation (FDIC) currently offer more than 4.5% interest, and these rates are expected to rise further in July if the Federal Open Market Committee (FOMC) continues raising rates.
According to the LPL Financial Tactical Asset Allocation Committee (STAAC), the current risk-reward balance between stocks and bonds appears relatively even. The STAAC recommends a neutral stance on style, favoring developed international equities over emerging markets, and large-cap stocks over small-cap ones. Among the sectors, the industrials sector is highlighted as the top overall pick, while communication services and technology sectors are considered top ideas based on technical analysis.
Although historically value stocks have outperformed growth stocks during periods of elevated interest rates, this trend has reversed in 2023. So far this year, the Vanguard Growth ETF (VUG) has seen a 32.7% gain, while the Vanguard Value ETF (VTV) is up by only 1.2%.
Certain market sectors are considered more defensive due to their relatively stable earnings, making them resilient during cyclical downturns in the economy. The health care, utilities, and consumer staples sectors are typically considered lower-risk, defensive sectors that may outperform during economic downturns and may lag during periods of higher investor risk appetite.
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Conclusion
As the market enters a bull phase, the potential for a recession remains a concern, underscoring the importance of vigilant monitoring of market indicators and economic developments. Though credit markets appear stable presently, it is prudent for investors to exercise caution. Economic growth has slowed, but an immediate recession is not imminent. Hence, a strategic approach involving longer-term investment themes and consideration of defensive sectors is advisable to navigate market risks and mitigate noise.
This news recap is written by Gotrade Indonesia in collaboration with Valbury Asia Futures, a Bappebti regulated broker.
Source: Zurich Insurance, Fidelity International, Forbes, UOB, Reuters
https://www.forbes.com/advisor/investing/stock-market-outlook-and-forecast/
https://www.zurich.com/economics-and-markets/publications/monthly-investment-insights
https://www.uob.com.sg/personal/invest/market-outlook/2h2023/2023-outlook.page
https://www.reuters.com/business/finance/us-banks-second-quarter-earnings-results-charts-2023-07-21/
