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August 14, 2023 - A lot has happened while we were away...



The end of July and beginning of August was quite eventful with respect to news as well as market developments. For starters, we had several central bank meetings and decisions, and interesting inflation numbers for July, out of Europe, US and China. The US government lost (again) its AAA rating on its debt, this time by rating agency Fitch, in a move that we "forecasted" in our June 5th weekly review. The second quarter US earnings failed to provide the necessary catalyst for equity markets to move higher and the Italian government dropped a bombshell on the country's banks by declaring a 40% extraordinary tax on their profits, which it later tried to present less harsh than it appeared. Last but not least, Nasdaq proceeded with the first rebalancing of its indices in decades, to cut the weight of Technology companies. Bond and equity prices have corrected lower during these first two weeks of the month. We will now look into the details of the latest developments.


The FED raised interest rates by 25bp to 5.50% as expected, but offered no guidance for the next meeting in September. The market was quick to conclude that the FED is getting in a "every-other-meeting" hike mode, as it has paused in June and now it raised again, while it showed that September could be another pause. But the FED Chairman pushed back against this rationale, saying that the central bank will decide on a meeting-per-meeting case, according to the data that will have been published in between. As a reminder the FED's official forecasts are for one more hike until the end of the year, which means that if it is not September, then it could be either November or December (there is no meeting in October). Of course, the FED might chose not to raise again, essentially scrapping their own forecasts, which will not be the first time to do so.


The ECB also raised rates by 25bp to 3.75% and chose to go into "data-dependent" mode, in sympathy with the FED. This was well communicated in advance however, as two of the most hawkish members of the committee (the German and the Dutch) had said in interviews days before the meeting, that September is not a done deal. The adoption of the "data-dependent" language, in a similar way as the FED, leaves all options open on the table. The market still believes that one more hike will take place before year end, to take the depo rate to 4%.


Finally, the Bank of England followed the example of the previous two and chose a 25bp rate hike, although there were voices calling for 50bp. In the accompanying statement the central bank did not offer any guidance, but mentioned for the first time that the monetary policy is now restrictive, acknowledging the lagging effect of the previous interest rate hikes. But it also highlighted its fears for inflation to remain high due to the higher than expected wage growth. All in all, another one or two hikes should be expected by the Bank of England in the next three months, as the country demonstrates the worst inflation profile of all other large, western economies.


Fitch stripped the US government from its AAA rating, downgrading it to AA+. This move follows the S&P, which downgraded the US debt back in 2011 and now two of the major three rating agencies do not rate US Treasuries as AAA anymore. Although this downgrade seems as a surprise to many market participants, the cover story of our June 5 weekly review had raised this exact question, as we thought it was only a matter of time that the US will lose again its AAA rating. The debt ceiling debate, the huge fiscal deficit, the skyrocketing interest rate expenses due to the FED's hiking campaign and the debt dynamics (now above 120% of GDP and similar to Italy...) made us think that such a downgrade would eventually be inevitable. Although this move does not make the US Treasuries less safe than what they were a few days ago, it could add pressure on their prices as demand might weaken at a time when supply is fast increasing (the US is issuing more debt as we speak, after the debt ceiling increase agreement). The US 10-year bond yield rose by 20bp to a new high for the year at 4.22%, but finished the week at 4.12%.


Inflation remained close to the June levels, both in Europe and the US. After the big drops of the previous months, partly the result of the "base effect", the July CPI numbers showed little, if any progress, on both sides of the Atlantic. The US headline number rose to 3.2%, up from 3% in June, while the Core CPI was announced at 4.7%, slightly down from the 4.8% number of June. In the Eurozone, the headline number is still above 5%, at 5.3% dropping slightly from 5.5% in June. Core CPI remained unchanged at 5.5%. Looking into the details of the US inflation report, we would highlight that the biggest contributor to inflation was Energy, with fuel prices up 3% for the month. On the contrary, electricity prices fell by 0.7% in July and used car prices dropped by 1.3%. Most other categories rose by 0.2% to 0.4% for the month, as expected.


China's inflation fell into negative territory, or in other words deflation. In July, the CPI dropped by 0.3% on a yearly basis, after being flat in June. This is seen as yet another sign that consumer demand in the country has failed to recover strongly after the Covid restrictions were relaxed, raising speculation that more stimulus both by the government and the central bank are on their way. It is also another "lesson" that for inflation to move significantly lower, consumers must stop buying things either willingly or unwillingly (recession). We have been mentioning this several times in the last months and partly explains our reluctance to join the euphoria group of investors who believe in the perfect scenario that inflation in the western world will miraculously fall to below 2% without the consumers being obliged to cut down expenses dramatically.


The US labor market continues to exhibit signs of slowdown, which is the (indirect) goal of the FED anyway. The monthly non-farm payrolls for July were announced at 187k, which together with June's similar reading, constitute the lowest of the last 3 years. The weekly initial jobless claims spiked to 248k last week, the highest since end of June. Of course both numbers have been volatile, and periods of improvements can be spotted in the last 24 months of data. However, looking at the direction of travel it is obvious that jobs growth is slowing down, albeit at a speed not enough to bring inflation meaningfully down. Wage growth has slowed down to 4.5%, but remains relatively high.


Equities and bonds have corrected lower in August. After the peak at the end of July, the broad equity indices are down about 3% both in Europe and the US in this period, which historically is not usually friendly to risky assets. Nasdaq has been the worst performer in August so far, with a 6% drop. The hype about artificial intelligence has waned after the quarterly results and primarily the guidance offered by the likes of Apple and Microsoft, which disappointed the greedy traders who had propped up their shares in the last few weeks (June-July).


The second quarter US earnings reports were better than expected on profits, less so on revenues. Only 59% of the companies which have reported so far have beaten the revenue forecasts, which is the lowest of the last three years. At the same time, cost cutting as well as pricing power has helped companies maintain their profit margins. The end result is that for the S&P500 companies the quarterly profits seem to be down about 3% vs last year, better than the -5% which was expected before the earnings season started. There has been no meaningful change for the third quarter numbers yet.


Chart of the Week : US jobs' growth is trending down.



The chart shows the monthly non-farm payrolls in the US, for the last two years. This figure, although it should not been taken at face value as it is just estimates and not real data, shows the health of the jobs market. What interests us is both the absolute number as well as the direction of travel of the monthly non-farm payrolls. It is obvious that since the FED started raising rates in April of 2022, the monthly number has been trending down. There have been months when the number spiked, but a new low usually followed in the next 1-2months. We are now at the lowest level since the pandemic. Still however, an almost 200k monthly figure is far from recession levels and unemployment as measured by another survey is estimated at 3.5%, a multi-decade low. Only if we get to the first negative number for non-farm payrolls, the market will start discounting again that a recession will appear sooner rather than later.


Disclaimer

• The content of this document has been produced from publicly available information as well as from internal research and rigorous efforts have been made to verify the accuracy and reasonableness of the hypotheses used. Although unlikely, omissions or errors might however happen.

• The data included in this document are based on past performances and do not constitute an indicator or a guarantee of future performances. Performances are not constant over time and can be positive or negative.

• This document is intended for informational purposes only and should not be construed as an offer or solicitation for the purchase or sale of any financial instrument and it should not be considered as investment advice. The market valuations, views, and calculations contained herein are estimates only and are subject to change without notice. Any investment decision needs to be discussed with your advisor and cannot be based only on this document.

• This document is strictly confidential and should not be distributed further without the explicit consent of Kendra Securities House SA.

• Sources: Chart of the Week : Factset, Cover photo: istock

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