Market update July 2023

Whilst the US economy is not showing signs of slipping into a recession, the European economy has experienced a decline in economic activity over the past three months with Germany in a technical recession. The catalysts of this slowdown are:

1. China failing to jumpstart their economy as hoped earlier this year, negatively impacting industrial production in Europe, and
2. The significant de-stocking cycle in the developed world as companies trim their excess inventories and brace for a recession.

If China succeeds in stimulating its economy, then the global manufacturing sector could see higher growth over the coming six months. And if a global recession proves an illusion then the de-stocking cycle will transition to a re-stocking cycle in the latter half of this year.

Financials conditions have significantly eased over the past three months, which should have a positive impact on risky assets and economic activity and can potentially compel the Fed to signal higher policy rates for longer. The global composite PMI reading remains well above 50 due to a strong services sector and remarkable improvement of South Korean exports over the past three months, suggesting a global growth resurgence is under way.

The US inflation rate declined from 5% y/y at the end of Q1 to 3% y/y by the end of Q2, while the total unemployment rate (full-time and part-time workers) in the US rose a bit to 6.9%, but still well below the long-term structural level in the US economy. The effective Fed Funds Rate rose to 5.08% compared to 4.83% as per our last market update in April.

Dangerous US equities and falling commodities

The AI hype has propelled US equities to their highest equity market concentration ever recorded, which inherently makes US equities riskier as market moves will increasingly be driven by fewer and fewer companies. In the case of the US, it also comes down to sentiment on technology stocks. Equity valuations are now the highest ever on semiconductor stocks. The overall US equity market valuation is now more than one standard deviation expensive again. Our view is that the US equity market is dangerously decoupling from the rest of the global equity market, and that investors should consider being underweight on US equities.

While US equities were on fire in Q2 and European and Chinese equities were more muted, the commodity market had a less positive vibe. The absent rebound in Chinese industrial production had a significant negative impact on commodities with industrial metals down 5.3% and energy prices down 2.3%. In agriculture, the decline was even more intense and was down 11% over the past three months. The declining commodity prices added substantially to the decline in headline inflation, while core inflation remains stubborn. A renewed energy crisis in Europe over the winter months, or China bouncing back, would quickly reverse the dynamics in global commodities reviving the fears of inflation, making the second half of the year a key test for markets.

The USD spot index extended its decline, down 1.7%, while the US 10-year yield rose 22 basis points over the past three months with a brief moment soaring above 4% in early July. Long-term US inflation swaps are still well anchored around the 2.5% level, and the 5Y/30Y yield spread declined 17 basis points over the past three months, reflecting the bond market’s worry over the economy despite the galloping equity market sending entirely different signals.

A growth bubble?

The excessive expectations around AI caused the global semiconductor industry to rally almost 20% in Q2 and the electric vehicles (EV) boom helped the global car industry to become the second-best performing industry group, up 17% in Q2. Both groups have now entered dangerous valuation levels reflecting unprecedented expectations for earnings growth, dramatically raising the stakes for the Q2 earnings season. If EV stocks and AI stocks fail to deliver on those expectations, equity markets could experience a hard reset lower.

The worst performing industry groups were telecommunication, materials, and food, beverage and tobacco. Telecommunication is experiencing a greater churn among customers due to inflation and the negative impact of higher interest rate expectations during Q2 on industries with a high debt leverage. Materials were impacted by lower commodity prices and several guidance cuts from European chemical companies during Q2. The food, beverage and tobacco industry group was impacted by growing earnings pain as these companies have reached the limit of their ability to raise prices, and several restructurings also dented sentiment in this industry group during Q2.