Imagine the following : A person is sitting an a room, where his upper body is exposed to a temperature of 50 degrees Celsius and his feet are in a bucket of ice , at -10 degrees. On average, we could say that the temperature of the room is 20 degrees, which are ideal conditions. I am not sure that the person in that room would share our view, however. Moving to the real world, we experience a similar situation wherever we look in the financial system and the economies, as we will explain below.
In a year with the highest interest rates in two decades and the collapses of banks, the US economy on paper is holding up relatively well. Statistics paint a rather ok picture. The US consumer appears to be healthy, as Retail Sales have been resilient and GDP growth is far from a recession level. But when we dig further, we also find the highest credit card debt in history and delinquencies on car loans taken by the so-called sub-prime customers reached last month a multi-year high (sub-prime is characterized the creditor whose financial health is of lower quality and prone to a default). The lower-income people are having trouble making payments on their debts and purchases, as their pandemic-related savings are now almost gone. Manufacturing is in recession and company bankruptcy data show the highest number in many years.
At the same time, there is an atmosphere of partying like "there is no tomorrow" in the Technology sector, with the artificial intelligence craze having re-ignited the animal spirits. Companies are spending billions (which they don't have, some of them) on ordering semiconductors to accommodate the hunger of the AI "beast" and equity analysts are rushing to incorporate huge growth of revenues for related companies in their models for the years to come. People are enjoying cocktails at parties and receptions talking about their stock market gains. Ourselves, being observants from far away, we can only humbly admit that three years after the pandemic, a lot of things do not make sense. In times like these, we prefer to stick to our principles of investing, which call for diversification, quality and staying away either from gloomy forecasts or extreme partying.
The rating agency Moody's downgraded several US regional banks, providing its own contribution to this "parallel universes" analogy, in the same week that Nvidia's announcements showed that it is the winner-who-takes-it-all, in the semiconductor industry. Moody's said that it may downgrade some of the nation's biggest lenders, warning that the sector's credit strength will likely be tested by funding risks and weaker profitability.
The August PMIs presented a deteriorating macro-economic picture both in Europe and the US. The Eurozone Composite PMI fell by 1.6 points to a 33- month low of 47.0, the third consecutive reading below the neutral level of 50, thus increasingly hinting that GDP growth might be contracting in the next quarter. Germany was at the heart of the weakness. The Services PMI dropped by a substantial 2.6 points to 48.3, which is the weakest since early 2021 and suggesting that following a period of strength and resilience the sector is now contracting again. Forward-looking PMI indicators suggest further weakness ahead. Aggregate new orders suffered a further decline and one-year business expectations remained weak. In a similar fashion, the US Services PMI fell to 51.0 from 52.0, holding above the 50 level, and Manufacturing moved further lower into recessionary levels to 47. The view that we had for some time now that the consumer will eventually say enough-is-enough or simply cannot afford high prices in the Services industries (hotels, restaurants, airlines etc.) is now becoming a reality in the data.
Mr. Powell's speech at the Jackson Hole symposium did not offer any new insight. As we expected, he said that although headline inflation has dropped, more work needed to be done. He chose to focus on the core CPI, which excludes energy and food related expenses and he said that two months of good data is not enough. He also mentioned again that below-trend-growth in the economy is needed and the labor market must cool down, in order to make sure that inflation drops below their 2% target. These are politically correct words for saying that a mini-recession would be welcome in the fight against inflation, something that we have been advocating for quite some time now. Mr. Powell also put an end to the speculation that the FED will change the 2% target to a higher number. All in all, the way we read his comments is that if they do not see further material deterioration in the jobs market and economic growth, the FED will have to raise one or maybe two more times and remain in high interest environment for much longer than originally thought.
China provided more stimulus to the economy and took measures for the stock market. The central bank lowered interest rates on 1-year loans by 10bp, but left the 5 year ones unchanged. The 1-year cut was also slightly less than expected (15bp). But most importantly Chinese authorities issued guidance on easing home mortgage rules and asked financial institutions to boost stock investments. This morning it announced a cut by 50% on the stamp duty tax on stock market transactions, to 0.05% and that the new listings (IPOs) will slow down, in an effort to increase demand for stocks and lower supply (hoping prices will go up). The local markets remain undervalued and under-owned, providing opportunities that only the very brave seem to be willing to embrace at this moment.
Equities managed to eke out gains, after three consecutive weeks of losses. Nasdaq, rebounded 2% after its 10% drop from the July peak, but the S&P500 as well as most European indices rose by less than 1%. The good results and guidance by semiconductor company Nvidia failed to ignite a move higher. Defensive sectors (Staples, Healthcare, Utilities) did not follow the rally, as their stocks were sold by investors in order to buy the stocks which had fallen the most in the previous three weeks, namely Tech-related names.
Bonds were volatile and finished the week on a slightly negative note. The recent sell-off has made US bond yields rise to 15-year highs again. The US 2-year is now trading at 5.10% , as the market is pushing back on the view that rate cuts could take place in the first quarter of next year. The mortgage rate spiked to 7.25%, the highest in twenty years, and this is expected to hurt the already vulnerable real estate market.
Chart of the Week : The US stock market is also experiencing "parallel universes".
The table below shows the yearly returns of the widely used S&P500 index for the last 20 years, as well as the performance of the S&P500 equal-weight index, and their difference on the last column. The equal weight index smoothens out the large weights of some stocks which impact disproportionately the index and is considered to be a better gauge of the real performance of US equities, as all 500 (or so) companies carry the same weight. So, while the S&P500 index is up 15% this year, the equal-weight index is up just 4%. It is thanks to just 5-6 stocks (living in their own universe) that the US equity market performance looks so impressive.
Moving to a historical analysis, we see that the S&P500 has under-performed by almost 60% the equal-weight index in these 20 years. We also see is that exactly 50% of the time the two indices perform better than the other. In the period 2017-2021, when we had the Trump-era tax breaks and then the pandemic, the S&P500 equal weight lost the battle for 4 consecutive years, as Technology outperformed all other sectors. Technology's weight on the index has now reached more than 25%. We can also see that after the rally in 2020, the equal weight index came back in vogue in 2021 and 2022. Another interesting observation is that it is very rare for the difference in yearly performance to exceed 10%, either positive or negative. In fact this happened only 1 time, and that was 2009, after the financial crisis. This year so far, we are experiencing a 10%+ difference already in favor of the S&P500, due to the Tech-related out-performance. History has shown that this is not sustainable. The S&P500 equal weight index could perhaps be a better place to be for the next 12-18 months.
• 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.
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• Sources: Chart of the Week : KSH, Factset , Cover photo: Sefira Lightstone