Economic data continues to point in opposing directions, as do markets, with equities seeming to price in a recovery, while bond markets are signalling there will be a recession.
With many economies transitioning from post-lockdown reopening momentum to trend (or below trend) rates of growth in the face of higher central bank policy rates, we see it as inevitable that the data will point in different directions.
To start in Asia, China’s year-on-year GDP figures disappointed market expectations. Even though many investors had hoped for a strong rebound in growth after the lifting of the country’s tough zero-Covid policies, as was the case in the US and Europe, this recovery has not materialised.
We believe one key reason is the lack of fiscal support for households, in notable contrast to the US and Europe. As a result, many people in China had to run down their savings to support themselves through multiple lockdowns and they now have no extra money to spend even now that the restrictions have been lifted.
The struggles in China’s property market have added to the malaise felt by households. They have also dampened investment. None of this has helped the performance of Chinese equities, which have declined this week, in contrast to the gains for most major equity markets. China’s is also one of the few equity markets with negative returns year-to-date.
The more recent data show few signs of an improvement. We believe Beijing will feel under increasing pressure to push through fresh stimulus to shore up growth. All eyes are now on the Politburo meeting set to take place in the next couple of weeks. Without more easing measures, Beijing is unlikely to reach its GDP growth target for the year.
US consumers still eager to spend
In contrast to the disappointing Chinese data, core US retail sales grew by 0.6% month over month in June, which was a little stronger than expected and came alongside a minor upward revision to the May numbers. In our view, these figures show that despite the significant increase in interest rates over the last year, and still high inflation, the US consumer is still eager to spend.
We see two main factors underpinning this resilience. One is that savings levels are still high. The nearly USD 2 trillion in stimulus provided by the Biden administration in 2022 continues to support growth (though it also has forced the US Federal Reserve to raise interest rates by more than would have been required otherwise).
The second key factor is the strength of the labour market. The number of job openings rose in the latest month, and with the unemployment rate low and wage growth high, people feel confident that they can spend with little risk of unemployment.
At the same time, US industrial production has been weaker than forecast, though this is just a continuation of the trend of a struggling manufacturing sector offset by a healthy, consumer demand-supported services sector.
Strong earnings expectations
As markets digest the latest data, reporting on second-quarter US earnings has begun. It is still early days, with just 68 S&P 500 companies having reported, but early signs are encouraging.
Market expectations were low. Earnings were forecast to fall by 6% compared to the year-ago quarter, although excluding the energy sector, earnings were expected to be flat.
So far, results have beaten expectations by 5% (see Exhibit 1), with the cyclically important, interest rate-sensitive banking sector doing well.
Whether this trend continues will be crucial for any further returns for equities. Even as the inverted US yield curve signals a recession ahead, consensus estimates for the next several quarters see corporate earnings rising by 6%-14% (ex-energy).
The expectations are particularly high for the technology sector, which has been the main contributor to US equity gains this year. If investors begin to perceive those forecasts are unrealistic, markets could suffer a setback.
Treasury yields to decline further?
The combination of mixed economic data, after the better-than-expected US consumer inflation data from the prior week, has kept US 10-year Treasury yields at around 3.75%, down from the 4.1% peak they reached on 7 July. We anticipate further declines in Treasury yields as US growth continues to decelerate and recession risks rise (also see our Quarterly Fixed Income Outlook).
The cuts in the fed funds rate that the market has priced in for the first quarter of 2024 could occur under two quite different scenarios.
If a recession materialises, the Fed could begin cutting rates to support a recovery.
Alternatively, if inflation continues to decelerate while growth is more sustained, the Fed could conclude it has accomplished its goal of a soft landing.
Either way, interest rates are likely to fall, but the implication for equities is clearly quite different.