The Factory Daily Letter
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US equity markets ended last week lower again (S&P 500 -1.2%), following the first week of positive returns since April. On Friday, US stocks closed mostly in negative territory as stronger-than-expected May jobs data exacerbated fears that the Fed will continue to hike rates to fight inflation. Nonfarm Payrolls (NFP) came in at 390K (vs 325K expected), down from prior’s 436K while the unemployment rate was unchanged at 3.6%. During the week-end, the White House also announced it could ease tariffs on some Chinese imports to fight inflation.
On Monday, US equities bounced back as declining Covid pressure in China propelled optimism among investors (Nasdaq Comp. +0.46%, S&P 500 +0.38%). Cyclical sectors such as materials, consumer discretionary and financials led the gains. Defensive sectors lagged. The US 10Y treasury bond yield rose 8 bps to 3.04%. Gold futures fell 0.3% to USD 1840/oz. The USD gained ground vs the EUR and JPY. In Europe, the Euro Stoxx 50 ended 1.45% higher, supported by European tech and Italian stocks.
At last week’s EU summit, leaders managed to agree to pursue a ban on the import of most Russian oil (holdout Hungary assenting on assurances that its energy supplies would not be disrupted) by way of a ban on seaborne Russian oil and petroleum products (imports via pipeline exempt at this stage). The agreement paved the way for agreement on a sixth package of sanctions that brings the EU closer in line with those imposed by G7 countries. The EU expects to cut 90% of its Russian oil imports by the year-end. Saudi Arabia was reported to have indicated preparedness to raise oil production should Russia’s output to fall substantially under the weight of sanctions and Thursday OPEC agreed to accelerate oil production in July and August in efforts to cool a crude price rally that has threatened to stall the global economy.
On the central bank front Fed Governor Bostic said the September ‘pause’ comment he made in his interview with MarketWatch the previous week should not be construed as a “Fed put” after Governor Waller last week pushed back on idea of a September pause (saying he supported 50 basis point rate hikes for several more meetings until inflation comes back to the 2% target). Speaking to CNBC Fed Vice Chair Brainard referred to 50 basis point rate hikes in June and July as reasonable adding that it was hard to see the case for a pause in rate hikes in September, (saying that if inflation improves then the Fed may dial it back to 25 basis points) adding more scepticism to the idea of a near-term Fed pause. From 1 June (last Wednesday) the Fed also started to shrink its $8.9 trillion balance sheet. The Fed’s short-term interpretation of recent labour market data (the ISM and NFPs – see next section) will likely remain that the US labour market threatens the wage and inflation outlook, and we consider it very likely to deliver on its guidance of two additional rate hikes of 50bps at the next two meetings (the first of which is next week on Wednesday 15 June), even if the reaction function changes over the summer (the impact of financial conditions on US growth likely to become increasingly significant vis-a-vis the more backward-looking inflation and wage growth data).
In Europe the key question ahead of this week’s (June) meeting currently sits around what the latest flash inflation data means for ECB monetary policy. A July rate hike is now ‘baked in’ and the debate remains whether it will raise the deposit rate by 25 bps or 50 bps at that meeting (recent upside surprises in inflation prints and the broadening of price pressures having bolstered the hawks’ determination to push through a 50 bps increase). Our economists’ baseline scenario is a 25 bps hike in July, September and December (bringing the deposit rate to +0.25% by year-end) while at this week’s meeting the Governing Council is almost certain to announce the end of net asset purchases under the APP (see ECB President Christine Lagarde’s blog here). The discussion around quantitative tightening has not yet begun, yet could do soon on account of reinvestment becoming increasingly unjustifiable. We do not expect the ECB to provide much clarity about a new backstop for peripheral spreads; instead, the first line of defence could take the form of more flexible PEPP reinvestments. The ECB is expected to confirm the end of the TLTRO 50 bps rate discount, and key data points between the June and July meetings will include June HICP (1 July) and the Survey of Professional Forecasters (available to the ECB before the July meeting).
China’s State Council announced several new measures to try and stabilize the worsening employment conditions (by supporting SMEs in the hardest-hit sectors) and help the industrial sector and supply-chains (by introducing policies that would allow enterprises to quickly reopen to full capacity).
On the macro front the US ISM manufacturing PMI index rebounded to 56.1 in May (versus a decline to 54.5 expected) from 55.4 in April. The new orders sub-index also bounced (to 55.1 from 53.5). However the new orders-to-inventories ratio remained weak while the ISM employment sub-index was also unexpectedly soft at 49.6 - signalling contraction in manufacturing employment. The non-manufacturing index however fell to 55.9 in May vs 57.1 points in April (and missing estimates of 56.5).
The swathe of monthly labour market data showed job openings falling to 11.400 million in April (from the record high of 11.855 million in March), while the quits rate was unchanged at 2.9%. The ADP report showed that private businesses in the US hired 128K workers in May, well below forecasts of 300K. The US employment rate remained unchanged at 3.6%, while Friday’s non-farm payrolls report showed that the US economy added 390K jobs in May, beating forecasts of 325K. The labour force participation rate edged up to 92.3% while average hourly earnings rose by 10 cents (0.3%) to $31.95 (the same pace as April and slightly below expectations of a 0.4% gain).
Also worth noting is that the index of mortgage origination fell against last week as the sharp rise in mortgage rates continue to upset the housing sector. New mortgage volumes are down c. 15% from last year's levels in May (which, pandemic aside, would be the biggest annual drop since mid-2014). Versus 2019's average level, the weekly index is down 14%.
In Europe, news at the beginning of last week was euro-area headline inflation rising to 8.1% year-on-year YoY in May (from 7.5% in April) while core climbed to 3.8% from 3.5% (with preliminary indications that food and energy inflation were the major factors). Headline rose across all major economies: HICP up 1.0 percentage points (pp) to 7.3% YoY in Italy, 0.9 pp to 8.7% YoY in Germany, 0.4pp to 5.8% in France and 0.2pp to 8.5% YoY in Spain. Other euro-area data included retail sales which rose 3.90% in April MoM, missing forecasts of a 5.4% rise with rising prices weighing on food, drink and tobacco sales.
Elsewhere, Chinese official PMIs remained in contraction territory in May, despite a rebound from April’s weak readings, reflecting ongoing weakening momentum even as Covid containment measures are lifted very slowly. The official manufacturing gauge coming in at 49.6 (up from 47.4 in April); the non-manufacturing PMI also jumping 5.9 points to 47.8 in May (compared to 41.9 in April). Overall, the composite PMI bounced back to 48.4 (up from 42.7 in April), in contraction for the third consecutive month since March this year.
What’s coming up this week?
Much of Europe is closed Monday, but will return from holidays ready for the ECB meeting (Thursday). On the other side of the Atlantic it will be Friday’s inflation and sentiment data holding the market’s attention:
- Monday: China Caixin PMIs; EA global construction PMIs;
- Tuesday: Japan household spending; Germany factory orders; US trade balance;
- Wednesday: EA Q1 GDP (third estimate); US wholesale inventories;
- Thursday: ECB rate decision; US initial jobless claims;
- Friday: Japan PPI; US inflation; Michigan Consumer Sentiment; and 5-year inflation expectations (prel. Jun);
What themes and topics have we been following?
- Has the US passed peak inflation? The same could support cyclical outperformance;
- The tip of the iceberg or a summer rally? We discuss the indicators supporting our call for a summer rally;
- Riding the rebound: in last week’s Technical View we identified tactical opportunity in US biotech and Chinese tech;
- June seasonality: screening for the seasonal best and worst;
We revisit each of these in summary below and as ever wish all our readers a good week ahead.
Is US inflation peaking?
If so, cyclicals could rebound
It is (protracted) rising inflation, and speculation around how the Fed might act to control it, that has been largely responsible for this year‘s poor US equity market performance to date; and the Fed is now tightening into a slowing post-Covid recovery growth cycle. However, and while the expected path of inflation will continue to determine Fed policy, market pricing of the same as well as recent data and economists’ long-term inflation expectations have now started to moderate, while bets are building that the Fed may pause it’s rate hike trajectory after the summer in order to take stock of its effectiveness versus the impact it is having on the economy.
US inflation is starting to show signs of peaking, and economists and markets have been taking notice
Historically, cyclical stocks have tended to benefit from inflationary environments, and moreover equity markets have posted positive performance after inflation has peaked. Over recent weeks however, most US cyclical sectors have been underperforming due to the broad risk aversion across markets that has sent many into oversold territory.
However, the PCE price index (which is the Fed’s preferred measure) suggests that US inflation may now have peaked: in April it rose 0.2% (headline) and 0.3% (core), headline slowing 6.3% YoY (vs March’s record high of 6.6%); core going from 5.2% to 4.9%. This while the Bloomberg consensus also expect inflation to abate over the coming months. The 10-year break even suggests markets are also pricing a cooling:
So what might this mean for markets?
On Thursday we presented our own crude analysis of past periods of peaking inflation and associated asset performance, and broadly concluded that while peaking inflation is unlikely to be enough on its own to restore the positive trend in equities, it is nonetheless a necessary precondition. Key messages were as follows:
- Peaking consumer price inflation (CPI) has often coincided with an equity market bottom (exceptions being 2001 and in 2008 when markets continued to fall past the peak). European markets follow a similar pattern;
- Global commodities have historically fallen following peaks in US inflation;
- Treasury yields also tend to fall as inflationary pressures ease, the US Treasury curve steepening as the front end falls further and faster than the longer end;
- Inflation has historically peaked during periods in which the Fed funds rate has been either been steady or coming down; and
- The US economy has historically been slowing or even contracting when inflationary pressures have been easing (and on more recent data the US ISM manufacturing index (our proxy for activity) has managed to remain in expansion territory – 2008 the exception).
So it is that if the US did indeed pass peak inflation in March as the PCE index suggests, the historical patterns broadly imply that a short-term rebound in equities could be on the cards:
With the other side of its mandate (“full employment”) largely fulfilled, it is how inflation (“price stability”) is expected to determine Fed policy over the coming months that will continue to drive markets. Our central scenario is that the Fed will decide to pause the the hiking cycle at the end of the summer as the effects on inflation and economic growth become more apparent (see more on this in our letter “Great expectations of an expeditious Fed”).
However, the outlook on inflation remains notoriously difficult to predict (even Janet Yellen admitted to getting it wrong last week) and longer-term investors might indeed prefer to ‘sit this one out’ in the absence of more clarity. That said, it is our view that prevailing circumstances could nonetheless support the prospect of a summer rally (see next section) driven by oversold cyclical names - particularly if our global macro scenario of peaking inflation, a Fed pause and a steeper Treasury curve materialises. If US inflation really has peaked, it would constitute a solid step towards a better macro environment for equities (while in the shorter-term the technical signals suggest that the market has reached a local bottom).
So see last Thursday’s letter on US inflation again here for a deeper dive into the historical data and a screening of U.S. cyclical stocks (ex. energy and commodities) that are scoring well on the quants and that also appear to offer attractive upside potential.
The tip of the iceberg or a summer rally?
We make our case for a summer rally
The poor market price action that we have seen this year has done some serious technical damage to indices, damage that the recent rally has so far not managed to repair. So is this year’s correction the “tip of the iceberg” with much more unseen downside still to come?
Perhaps. But earnings are still supportive, sentiment is extremely negative (a contrarian bull signal) and the recent price action is not characteristic of past bear markets. The summer does tend to feature lower volumes and falling equity markets, (June in particular – see the section on June seasonality below), but it is also often at this time of year that significant market movements can take place, both up and down. Moreover, whether we are about to ride a new bullish wave or whether are on the verge of a bear market rally, the risk/reward in US equities is currently looking very attractive and while the buy and hold trend-followers may be sitting on the side-lines, the short-term strategists are now preoccupied with assessing whether or not conditions are ripe for a rally - regardless of whether the longer-term trend has or has not turned negative.
So on Friday we presented the rationale behind our call that we could see an equity market rally (led by cyclicals – see the section above) over the summer, focussing on several signals in particular and which we attempt to summarise here:
Firstly, the best performance tends to come at the beginning and the end of a bull market (a tendency that suggests that the current one has more room to run). Moreover the recent price action is not characteristic of the beginning of a bear market: strong and rapid back-to-back rallies tend to occur during market major bottoming processes (as illustrated below) while the closest historical 100-day correlations also imply we are currently seeing either a local low or a significant bottom.
Secondly, sentiment remains depressed (the bullish implications of which we have discussed previously) while we also note that reference to ‘recession’ is currently at levels that have historically tallied with US equity market bottoms:
A rare instance of three days of advancing volumes as a percentage of total (and reaching 80%) is a signal that tends to precede further gains, while the McClellan oscillator going above 300 for the first time since 2020 indicates an end to the selling pressure (and has on several occasions in the past indicated a market bottom). Neither signal has in the past preceded a bear market:
The recent rally may also have invalidated the bearish technical scenario now that the index has moved back above the neckline of the bearish head & shoulders pattern: an upside break of the resistance at 4,170 could force the technical bears to reconsider their scenarios on the S&P500:
Also worth a mention is how the contagion mechanism by which equities sold off now appears to be unfolding in the reverse (bullish) direction. The prospect of peaking inflation (and possibly peak Fed hawkishness), coupled with the easing of Covid restrictions in China has been allowing the recovery across the more speculative parts of the market to advance. Accordingly, if this bullish (or less bearish) mood were to continue, inflows could return to the majors and fuel a much-needed summer rally. Moreover, and as we discussed Thursday (and as summarised in the section above), we think conditions are such that the same could be driven by cyclical names.
See Friday’s letter for more detail on the market signals supporting our call for a summer rally.
The technical view
The more opportunistic could find opportunity in US biotech and Chinese tech
Investors got a reprieve from a painful sell-off as the Dow Jones Industrial Average and the S&P 500 rallied to close their best week since November 2020 and erased May’s losses in an encouraging sign that the market could be forming of a local floor (just when investor sentiment got a little lift from FOMC minutes that were interpreted as ‘less hawkish-than-expected’ revealing discussion around the possibility of a policy pause in September to see how the economy reacts to higher rates).
It remains our view that a stronger market catalyst is required before longer-term investors will be lured back and the long-term technical outlook remains challenging (an upward break of 4,400 on the S&P500 a key requirement here). However as we wrote in our technical letter last week the rally that brought an end to the 7-week losing streak was encouraging and the risk off ratio has been rebounding. To some extent the market behaviour may have been related to month end short-selling dynamics, however there are several reasons why we considered the speculative rally could have further to go. The correction that started in January can be broken down into a classic zigzag correction and the low made at around 3,800 could mark an important local low before the positive momentum resumes in a new upward sequence: it corresponding to the wave (5) of the full bullish sequence of the post Covid-crisis period. In the short term, the next technical resistances are at around 4,276 (the 50-day SMA).
In any event, the risk/reward remains positive in the short-term, and we think we could see more from the more speculative corners of the market (that led the selling and have been leading in the rebound). See last week’s Technical View again here for screenings of US bio tech and Chinese tech sectors (that appeared on the verge of breaking out as we wrote) for our screening of names that were not looking so oversold (RSI) and showing upside potential.
Equities tend to follow the year-to-date trend, while others pivot
What do the seasonal trends tell us about the month of June? June is a distinctly average-to-weak month in terms of historical equity market performance (currently running at an average of -0.1%). It also underperforms May across the sector indices (perhaps unsurprisingly given May’s strong seasonality).
On a sector basis, healthcare is the best sector performer, followed by communications and technology.
It can however be a pivotal month for other asset classes: marking the end of the best “window” of the year for crude oil, and heralding the beginning a fall in the US dollar.
See last Wednesday’s letter again here for our main takeaways from June’s trends and for our regular screening of the month’s seasonal ‘best’ and ‘worst’ in US and European equities.
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