Financial update from Brewin Dolphin - 2 June 2023
The Weekly Round-up
Friday 2 June 2023
In her latest weekly round-up, Janet Mui, our Head of Market Analysis, analyses the US federal debt ceiling deal and its impact on the market, and US employment data.
Global stock market sentiment turned positive towards the end of the week. There were a few catalysts, which we will discuss in detail. After weeks of negotiation, the debt ceiling deal has finally passed in the Congress. The path to the deal was by no means smooth sailing, but there was arguably less drama than most had expected. We never really saw the slump in stocks going into the final weeks of the negotiations, like the case back in 2011. It showed markets were rather sanguine about a deal, even though near-term maturity segments of the US treasury markets displayed more nervousness.
Going back to the details of the deal, there have been concessions from both sides, but overall, the cut spending in real terms is not as bad as thought, so hopefully, the economic impact will be modest. The debt ceiling will be suspended until 1 January 2025, which will be after the next presidential election. The concession is for non-defence discretionary spending to remain flat for 2024 and to limit the increase to 1% for 2025. Since spending is going to be much lower than inflation, it is effectively a cut in real terms.
Other highlights of the deal include expanding work requirements for some food stamp recipients, claw back some Covid-19 relief funds, cut Internal Revenue Service funding, restart student loan repayments and speeding up energy projects. There were pushbacks and voices of discontent from some figures in both the Democratic and Republican parties. But as the old saying goes: A good deal and an exit deal happens when both parties are unhappy.
Eventually, the deal was passed in the House with a vote of 314-117, which was a rare instance of bipartisan accord in a polarised Washington. In fact, the vote outcome on the debt ceiling suspension was one of the most bipartisan in recent history. While the deal involves lower spending cuts than expected, on the flip side, it also means the debt and budget deficit issues are not much improved.
The outcome was well received because the US was running dangerously low on cash reserves and Treasury Secretary Janet Yellen warned it would run out of money by 5 June. There was a rally in US equities from last Friday on hopes of a deal. However, it is worth highlighting that the US equity rally so far has been driven by a handful of mega cap tech stocks, in particular those companies which are geared towards artificial intelligence (AI).
Notwithstanding the boost from AI and the seemingly cautious stance toward the US among investors (which is an attraction from a contrarian perspective), there are reasons to not turn overly optimistic about the US at this juncture. For one, tech stocks look extended compared to the broad US market. The last time the 20-week rate of change in tech stocks compared to the S&P 500 was this extended was during the run-up to the TMT bubble. Meanwhile, the gains in the US have been led by only a handful of names. Excluding Microsoft, Nvidia, Apple and the FANG, the S&P is down a touch this year. There are other technical signals which suggest caution. For instance, the Nasdaq 100 index is now at a record high relative to the Russell 2000 small-cap index. The Nasdaq 100’s relative strength index is back above 70, the threshold for overbought, which some consider a precursor to a selloff. Despite this near-term valuation issue, we believe the growth in AI looks set to develop into a long-term structural tailwind that benefits the US equity market disproportionally.
As the dust settles on the debt ceiling deal, investors will turn their focus on economic fundamentals and monetary policy direction. With regards to the US economy, there is some conundrum going on. The purchasing manager index and ISM index both suggest that the US manufacturing sector is in contraction.
Though a rather small part of the economy compared to services, it is regarded as a cyclical area which is exposed to the fluctuations of the state of economic activity. Even though new orders remained weak, the peculiar observation is that companies continued to increase hiring. That also resonated with a rebound in US job openings back to above 10 million. Why are firms so optimistic on hiring? One reason presented by the ISM was that companies are trying to hold on to workers because they worry about rehiring them. They have experienced how difficult it was to recruit the right people after the pandemic, so they prefer to wait and see. After all, the US economy has remained more resilient than many have expected.
Indeed, the latest headline US jobs report delivered another jaw-dropping figure. The US created 339,000 jobs in May, compared to expectations of 195,000. That was the 14th consecutive month of above-consensus outcome. In addition, April’s bumper payroll was revised higher from 253,000 to 294,000. Interestingly, the unemployment rate has picked up from 3.4% to 3.7%. This is because the household survey showed a 313,000 decline in employment in May and a 440,000 increase in the number of job seekers. The good news is that despite the rise in employment, wage growth continued to slow. Average hourly earnings rose by 0.3% month-on-month as expected, down from 0.4% in April. The year-on-year (YoY) measure slowed more than expected from 4.4% to 4.3%, and it has come a long way down from nearly 6% YoY last year. Worth noting is that average weekly hours have been steadily falling, which could be a sign that despite a slowing economy, companies are hoarding labour, asking them to work fewer hours instead of letting them go.
What does this mean for Federal Reserve policy? The report didn’t change market pricing of Fed policy path that much. Overall, the Fed has a very tough job. On the one hand, inflation and wage growth is slowing. On the other hand, there is clear evidence of a still strong labour market with sky-high job openings but a limit to how much the labour participation rate can rise. This means that inflation can continue to stay sticky and above the 2% target for some time. Markets are pricing in a “skip” at the next Fed meeting and a high chance of a 25-basis point rate increase in the July meeting. One key development which is developing in line with our call is that interest rate cuts expectations have been dialled back significantly. We do not think rate cuts are likely this year. We believe that the Fed will prioritise taming inflation back toward 2% and hold rates at restrictive levels.
China’s economic data
Turning to China, economic data has been generally underwhelming – well, relative to expectations. When everyone’s expectation is sky-high, even good data is not enough to please. Take as an example the consensus expectation for China retail sales for April. It was expected to grow at 22% year-on-year. The out-turn was 18.4% YoY, which was not bad but it disappointed. Arguably, the more disappointing part, which indeed warrants more attention, is the slow recovery in the property and industrial sectors. The rebalancing act of growth drivers from a fixed investment / infrastructure binge to consumption (and toward self-sufficiency) is the aspiration of the Chinese authorities and such a trend is moving in the right direction. However, this also means less need for fiscal stimulus and explains the underwhelming credit data so far. It is hard for the property sector to rebound meaningfully because this area is so driven by policy, sentiment and liquidity.
Clearly, investors have been disappointed, and the reopening rally quickly fizzled out. The Hang Seng China Enterprise index has entered bear market territory while the domestic Chinese equity benchmark CSI 300 index has wiped out its year-to-date gains. On Friday, Chinese equities staged a rebound, which could be partially due to bargain hunting and the conclusion of the debt ceiling deal. Furthermore, Bloomberg reported that the Chinese government is working on a new basket of measures to support the property market. Not many details are released yet but this is music to the ears of those who have been eagerly waiting for stimulus. Alongside Chinese equities, industrial commodities and currencies sensitive to China have bounced nicely.
It has been a good week in terms of market news, and we can finally move on from the debt ceiling saga. Potential China stimulus is adding further optimism to end the week on a high note. Even better, it looks set to be sunny and warm this weekend!
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