Markets relieved as storm recedes
After two months of summer, the storm seems to have receded from markets, bringing some clarity, at least for the coming months. It’s been a summer without much movement, with a very positive July for the stock market and a more negative August, leaving the indices at practically the same levels as at the end of June.
However, there was much debate about Fitch’s downgrading of the U.S. Treasuries, the downturn of the Chinese economy, or the change of course in Japan's monetary policy. Undoubtedly, these are important issues that can affect the future of the markets structurally, but in the short term they've hardly had any effect.
Growth prospects are undoubtedly the main driver of everything that happens and, in this respect, data hasn't been good, with a very clear downward trend. This, which in theory should be a warning for the stock market, has been more of a support for the stock market indices in the hope of getting support from the central banks. The notion that “bad news is good news”, which has prevailed in investor sentiment since 2014 (the year we started talking about deflation), doesn’t make much sense to us in the current scenario. This is particularly evident as inflation continues to significantly exceed the targets set by the Central Banks, and both the Fed and the ECB maintain a resolute stance against the expectation of interest rate cuts. The storm may be receding, but that is not a sufficient reason to assume that it hasn’t already caused damage that remains hidden from view.
Inflation: the great overlooked factor
One of the conclusions we can draw from the events of the summer is that inflation has shifted to the sidelines in the eyes of the market. Price trends continue on a pronounced downward trajectory (Chart 3) as a result of the normalization of production chains, consumption and raw materials. The (challenging) question is where these trends will ultimately stabilize. Inflation expectations among economists have seen little recent movement (Chart 4), but there has been an adjustment in the market-discounted expectations. This upward shift, albeit at manageable levels, has resulted in an increase in real interest rates (due to more substantial nominal rate hikes), which are the most useful tool for tempering economic overheating (Graph 5). Movement has been stronger in the United States, driven primarily by the Fed’s swift action in raising interest rates and the recent dip in inflation. This positions the American central bank with greater flexibility to stimulate the economy should the need arise. In contrast, the ECB faces more limited maneuverability, given that real interest rates have not yet entered positive territory (or become contractionary).
Growth shows signs of slowing down
The robustness of the world's largest economy, the United States, stands in contrast to the increasingly evident fragility in China and Europe. The latest series of confidence surveys among purchasing managers in European and Chinese companies clearly signal a slowdown anticipated by these companies in the months ahead. In addition to these subdued PMI readings (Chart 6), other lagging indicators, such as industrial production, trends in foreign trade, and even downward revisions in GDP for Europe, also reinforce this trend. That said, the U.S. economy is not impervious to this global weakness. In fact, cracks are emerging in the previously robust labor market, marked by a 0.3% uptick in unemployment in August and a growing labor force participation rate as individuals seek to return to work. What remains certain is that the vitality of the American corporate sector, the rise of artificial intelligence, and a highly expansionary fiscal policy all provide tailwinds for the United States, which other countries don't have. The "culprit" behind the sluggish growth is undoubtedly the trajectory of interest rates. Much has been said about why economies remained resilient despite the rigorous monetary tightening witnessed over the past 15 months. However, it should come as no surprise that the rise in interest rates is beginning to take its toll on sectors such as durable goods consumption or the chemical industry, which are the first to feel the effects of interest rates fluctuations in their businesses. Ultimately, this influence is expected to extend to the real estate market, which, historically, experiences the impact of restrictive monetary policy later on.
The drain continues
Recent data reveals that the Fed has reduced from its balance sheet by a total of $1 trillion, encompassing assets that were part of pandemic-era stimulus programs. This milestone is significant, especially when compared to the previous balance sheet reduction effort in 2017, where they managed to reduce it by "only" $700 billion, mainly due to emerging tensions in the interbank market. In the case of the ECB, their program has already achieved a reduction of €1.6 trillion, with most of it resulting from banks returning funds obtained through the TLTRO programs (the famous liquidity injections offered by the ECB to banks for obtaining low-cost financing and stimulating lending in a very depressed economy). It is reassuring that, despite their strong addiction to liquidity, markets have performed so well amidst such a significant drain. While there have been isolated incidents (like the pension funds situation in the UK or the minor banking crisis in the US), overall, Central Banks are likely content with how the process has unfolded so far. And that might be the area of greatest concern: the things we don't know that we don't know. It’s entirely reasonable to anticipate that monetary tightening and the withdrawal of liquidity could potentially trigger unpredictable systemic failures that will inevitably come to light. Preparing for them is paramount.
While the storm may be receding, lightning is still visible. In essence, although growth appears to be holding, the overall trend is clearly downwards, especially in Europe, and the impact of rising interest rates is beginning to make itself felt (and will likely do so even more). Central Banks are maintaining a firm stance (as indicated by discussions at the annual Jackson Hole symposium), though the market remains skeptical that they won't support growth if it falters. Additionally, balance sheet reduction programs pose a substantial liquidity risk. For the market, the “soft landing” scenario continues to be the baseline expectation, and any short-term market fluctuations will depend on whether the data alters this outlook. For now, all indicators are pointing in this direction: declining inflation rates, early signs of weakness in employment, and analysts’ expectations that corporate profits will turn positive in year-on-year terms starting in the third quarter of the year (Chart 8). Central Banks have also announced that their monetary policy decisions will increasingly hinge on data, which implies heightened volatility (especially if data begins to strengthen again). Therefore, we conclude this monthly market report with a call for caution: it's not an opportune time to increase risk in portfolios, but it’s still premature to position in sectors/assets that benefit from interest rate cuts because, barring unforeseen events, rates don't appear likely to fall until well into 2024.