Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Low recession probability, strong earnings, and US inflation
Peter Garnry
Chief Investment Strategist
Key points
- Market volatility and economic outlook: Despite recent market volatility, the probability of a US recession remains low at 25-33%, supported by stable indicators suggesting 2% real GDP growth. Concerns are growing over the sustainability of AI spending, as investors question whether current investments will yield adequate revenue and profits.
- Positive earnings performance: Approximately 90% of S&P 500 companies have reported Q2 earnings, showing positive surprises in revenue (+0.8%) and earnings (+3.9%), with utilities leading the sector gains, while consumer discretionary and technology sectors faced challenges. Notable revenue surprises came from companies like Eli Lilly, Ford, and First Solar.
- This week: The key events to focus on this week are ZEW on Tuesday providing fresh insights on the Eurozone economy in August, US July CPI on Wednesday which will be key for the Fed’s rate decision in September, and finally Home Depot earnings on Tuesday as the home improvement retailer is a key barometer on consumer spending on big ticket items.
Volatility is back: Still low probability of a recession
As we described on Monday, a perfect storm hit the financial market due several factors hitting the market at a compressed time period. Markets take on their own life when volatility increases a lot because they suddenly deviate from fundamentals as risk reduction decisions become important. The important questions for markets in the medium-term are whether we get a recession or not and whether AI spending is sustainable.
At this point our view is that the US economy is not approaching a recession and we put the probability of this scenario at 25-33%. High frequency economic indicators such as the Dallas Fed Weekly Economic Indicators are still suggesting 2% real GDP growth and is not reflecting a significant deterioration in the economy that warrants a big selloff or at this point a 50 basis point cut in the Fed’s policy rate at the September meeting. It requires a big negative shift in macro indicators for the Fed to do 50 basis points, because if they do 50 basis points and the economic indicators are not weak enough it will send a signal that they are panicking, and that in itself will make the market panic.
The sustainability of AI spending is still very much an opening question and a key debate that has been raging during the Q2 earnings season. This is because investors are beginning to worry that AI investments are too high relative to what they can generate in revenue and profits.
Earnings recap: There is nothing to worry about
Around 90% of S&P 500 companies have reported Q2 earnings and the aggregate figures show a +0.8%-points and +3.9%-points surprise on revenue and earnings respectively. The big winner on a sector level has been utilities which have seen the largest positive price reaction around earnings but also driven by the largest aggregate earnings surprise. Electrification and the boom in electricity demand from AI datacentres definitely play a role in this surprise. The consumer discretionary sector has seen the worst price action around earnings releases while information technology has delivered the second-worst aggregate earnings surprise which is also explaining the decline we have seen across technology stocks. Across single stocks some of the biggest surprises on revenue have been Eli Lilly (reported yesterday), Ford Motor, Albemarle, First Solar, and Devon Energy.
What if Google is the biggest casualty of AI?
Financial Times is running a story today about how Perplexity popularity is surging rapidly this year as more and more people use AI systems such as Perplexity as a substitution for Google search. Recently Perplexity has opened up for running advertisements on the platform for non-paying users putting the company at more direct competition with Google. Alphabet (Google’s parent company) shares are down 15% from the peak in July and while the company is still doing well it is worth paying attention to Perplexity and the changing landscape around search engines as Google advertising revenue tied to Google search was 57% in 2023. One of the drivers behind Perplexity is reports of Google search deteriorating in quality and the irony is that generative AI will pollute the Internet to a degree where it becomes increasingly more costly for Google to maintain high quality searches.
Next week: ZEW, US CPI, Home Depot earnings
Macro will dominate next week’s trading action and below we highlight the key events to watch.
- ZEW: European high frequency indicators from the Bundesbank are suggesting that activity levels are improving and that is also what the expectations index in the ZEW survey has shown this year except for a setback in July. Economists are expecting the setback to continue in the ZEW August survey on Tuesday with estimates at 35.0 down from 41.8 in July.
- US CPI: This week has seen a big repricing back and forth of the FOMC rate decision in September from guaranteed 50 bps cut to the market saying it is a 50/50 call on whether we get 25 or 50 bps. A lot of the decision from the Fed will hinge on incoming macro data and here the US July CPI figures on Wednesday will have a big weight. Economists are looking for core CPI YoY to decline to 3.2% down from 3.3% in June. Any upside surprise to inflation will scale back the market’s bets on significant rate cuts
- Earnings: Around 90% of the S&P 500 Index has reported Q2 earnings, but the calendar next week remains interesting. The key earnings releases to watch next week are Home Depot (Tuesday), Pandora (Tuesday), and Tencent (Wednesday). Home Depot is part of the US economy that is suffering from higher interest rates and the sheer size of Home Depot makes it a market mover. Pandora is interesting because the rollout of lab-grown diamonds can play havoc in the jewellery industry. Tencent is China’s largest technology company and thus plays a big role for Chinese equities, but also emerging market indices.
Previous weekly equity market updates
- Election drama, Tesla bounce, and earnings kick-off (5 July 2024)
- US election heats up, Alfen rout, and Micron earnings (28 June 2024)
- French election, king Nvidia, and FedEx earnings (21 June 2024)
- Tech rally, inflation surprise, and EU trade war (14 June 2024)
- AI bonanza drives new highs and dangerous index concentration (7 June 2024)
- Chinese setback, AI woes, and ECB decision (31 May 2024)
- Nvidia earnings, electrification boom, and bubbles (24 May 2024)
- New all-time high on speculative stocks comeback (17 May 2024)
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