Summary
Volatility rose as the rotation from mega-cap tech stocks to the broader market continued
Developed market equities outside the US benefited from this rotation
Defensive sectors (healthcare, utilities) performed well; cyclicals (communication services, technology, consumer discretionary) declined
Earnings challenges and slowing European economic growth negatively impacted cyclical stocks
June’s US Personal Income and Outlays report showed slowing consumer spending and lagging income growth
Consumers are increasingly dipping into savings to maintain spending
The US economy grew at an annual rate of 2.6% in Q2, exceeding expectations
Inflation shows signs of easing, with the core Personal Consumption Expenditures (PCE) indicator nearing the US Federal Reserve's (Fed) target
The yen strengthened by 2.4% against the dollar ahead of central bank meetings this week. Hedge funds reduced bets against the yen as global carry trades unwound
The yen’s rise negatively impacted Japanese equities, which fell by 5.6% last week
A weaker yen previously benefited Japanese companies by boosting international earnings and attracting foreign investors
Chinese equities fell sharply as unexpected rate cuts by the central bank failed to boost economic confidence
This Wednesday: Federal Open Market Committee (FOMC) rate decision. No rate cut expected, but Powell may signal future cuts. Fed funds futures suggest a rate cut in September
Wednesday: Bank of Japan (BoJ) rate decision. BoJ may hike rates as well as reducing their bond purchases. This could impact yen short positions and support the currency’s recent strength
Thursday: Bank of England (BoE) rate decision. A 50% probability of a rate cut this week, or if not a likely cut in September. UK services inflation remains sticky suggesting any rate cut may be a one and done for now.
Markets last week
Equity rotation continues amid rising volatility
Volatility has continued to rise, driven by an accelerated rotation in investor positioning. In recent weeks, there has been a notable exodus from the small cohort of mega-cap technology-related stocks that have dominated index performance. Investor capital has flowed into the broader market and smaller companies, benefiting developed market equities outside of the US.
From a sector standpoint, defensives stood out during a week of wavering risk sentiment. Healthcare and utilities ended in positive territory; consumer staples held up well while cyclicals were the worst-performing sectors. Communication services (particularly interactive media), technology (large-cap tech and semiconductors), and consumer discretionary (broadline media and automobile manufacturers) all experienced significant declines.
A challenging earnings week for cyclical stocks exacerbated their underperformance compared to more defensive peers. Signs of decelerating economic growth in Europe led to negative share price reactions to earnings reports.
The rotation into smaller companies comes hand in hand with the rising likelihood for interest rate cuts. Smaller companies tend to have higher levels of debt and therefore will benefit from a fall in borrowing costs. So long as the soft-landing scenario remains intact - where the economy cools enough for inflation to fall back in-line with the 2% target while simultaneously avoiding a recession – such a rotation is likely to find momentum.New insights into the US economyThe latest Personal Income and Outlays report for June shows that US consumers are increasingly feeling the pinch. While spending is still growing, it’s slowing down, and income growth is lagging. This suggests that consumers are dipping into their savings to maintain their spending habits. With the labour market cooling, consumer spending could continue to slow as the year progresses.
The US economy is bifurcated with high interest rates taking their toll on lower income households while those with more savings continue to spend and benefit from higher interest rates. With this bifurcated nature, surface economic growth has remained buoyant, continuing apace in the second quarter at an annual rate of 2.6%, well ahead of consensus.
Inflation continues to show signs of easing, with a few months of the core PCE indicator now close to the Fed’s target. This progress supports the case for interest rate cuts in the coming months. A rate cut could provide significant relief for struggling consumers as well as the broadening of equity market performance.Japan
The yen strengthened 2.4% against the dollar, continuing the sharp rebound that began on 11 July when the currency hit its lowest level against the dollar since the 1980s. This surge has been driven by Japan’s intervention to support the hitherto weakening currency. Hedge funds last week were reducing their oversized bets against the yen as global carry trades (borrowing in a low interest rate currency to lend in a high interest rate currency) unwound.
The future of this yen rally depends on upcoming decisions by the BoJ, the Fed, and other major western central banks. Carry traders are uneasy about potential tightening of Japanese monetary policy, which contrasts with expected rate cuts by the Fed, the European Central Bank (ECB) and the BoE. These likely moves would close the interest rate gap and reduce the attractiveness of the carry trade against the yen. The BoJ, the Fed and the BoE have their policy meetings this week. The volatility is unwelcome for carry traders who prefer stability. The yen’s recent rally has been bolstered by its status as a defensive currency amid heightened risk aversion from a tech selloff in equity markets.
The rebound in the yen has had negative consequences for Japanese equities as they slipped -5.6% in local currency terms last week. A weaker yen benefits Japanese companies’ as they often have significant international earnings and therefore high profitability when converting those overseas earnings back to the local currency. The weak yen also attracts foreign investors who can buy more yen-denominated assets with their own currency when the yen is weak.China
Chinese equities dropped sharply as unexpected rate cuts by the central bank failed to boost confidence in the economic outlook. The People’s Bank of China cut its medium-term lending facility rate by 20 basis points to 2.3%, its first reduction since August 2023, and lowered the seven-day reverse repo rate. These moves are aimed to support growth after disappointing GDP figures and general weak economic conditions in China. The lack of significant policy measures from the recent Third Plenum meeting added to the bearish sentiment.
The week ahead Wednesday: FOMC rate decision****Our thoughts: The forces are aligning for the Fed to cut interest rates with progress on disinflation picking up again in recent months. The clear softening of the labour market and the slowdown in consumer spending all tip the scales in favour of policy easing. Promisingly, the US economy has maintained a solid rate of growth, with just the right amount of cooling to see inflation fall back towards target. Although the Fed is unlikely to cut rates this week, Powell is expected to imply incoming rate cuts.
There is no FOMC meeting in August as the Fed heads to Jackson Hole, Wyoming, for the annual Economic Policy Symposium. The next opportunity for a rate cut is in September. Fed funds futures put only a 4.5% probability of a rate cut this week, with a full rate cut priced in for September.Wednesday: BoJ rate decision****Our thoughts: The BoJ is expected to take further steps towards policy normalisation by hiking rates and fading out bond purchase programmes. This comes as inflation and wage growth have finally picked up, aligning with the BoJ’s long-term objectives. In June, Governor Ueda signalled a ‘sizable’ reduction in bond purchases. Combined with a rate hike, these measures could significantly impact yen short positions, increasing the momentum behind the recent reversal in the currency’s weakness. Japanese inflation in June rose to 2.2% and could offer an opportunity for the BoJ to increase interest rates for the second time in 17 years, having done so already this year.Thursday: BoE rate decision****Our thoughts: Swaps put a 50% probability on the BoE cutting rates this week, if they don’t they are likely to cut in the September meeting. UK inflation has been stickier than hoped, particularly services inflation which remains at 5.7%. Headline inflation is inline with the target on an annual basis, but it is expected to tick up again in the coming months. This suggests that any rate cut might be a one-off for now, particularly as the UK economy appears relatively firm, and there is no need for the BoE to cut rates immediately.
Markets for the week
Sources: FTSE, Canaccord Genuity Wealth Management