Market Musings 090623: Economic Pessmism v Market Optimism

Market Musings 090623: Economic Pessmism v Market Optimism

Stock markets climb the wall of worry

Monthly Vox Markets Macro Video (with Paul Hill)

Macro Investing Masterclass with Chris Watling & Edmund Shing

Weekly Podcast

Everything you need to know about the Nasdaq’s performance year-to-date

• Drivers of the stellar performance of the Nasdaq 100 this year

• Can the trend continue?

• What smart investors should be doing right now

Summary

• Plenty of reasons to be pessimistic

• But stock markets seem to contradict this, reaching new highs

• Focus on mid-/small-cap stock now - confirm large-cap momentum or not?

• Economic concerns now in Europe

• But inflation is coming down, probably to come down faster

• Sectors/Themes: Global semiconductors, Circular Economy

Contrasting Perception and Reality

As is quite frequently the case, the outlook for the global economy looks somewhat grim. Bad news abounds:

• The ongoing Ukraine conflict is the biggest war in Europe since WW2;

• Inflation rates have reached multi-decade highs over the last few months, squeezing households;

• Central banks in US and Europe have been forced to aggressively raise interest rates over the last year, causing problems for both corporate and household borrowers as mortgages and loans become much more expensive;

• US regional banks remain very stressed due to deposit flight, driving lower availability of loans to companies and households;

• Commercial Real Estate markets are suffering given more expensive financing rates, and with office building demand under pressure from the Work From Home trend;

Global recession has been expected for some time now. In particular, the US Leading Economic Indicator points clearly to impending recession.

Source: Conference Board

Inflation rates in the developed world remain higher than is comfortable for central banks, even after central banks have raised interest rates quite aggressively over the last 12 months or so to levels not seen in 15+ years.

But stock markets reflect optimism?

And yet, despite this barrage of pessimistic news flow, stock markets around the world seem to tell a different story.

A number of stock markets around the world have hit multi year highs including the Japanese Nikkei 225, the French CAC 40, the German DAX and even now the Swedish OMX stock indices.

Nikkei 225 and Euro STOXX 50 indices well above 2020 levels

Source: tradingview.com

In the US, the technology-heavy NASDAQ 100 index has certainly led the way with the top 7 mega-cap companies rising over 50% alone in the year to date.

Source: Traderade

Why is there today this obvious disconnect between recession worries and high inflation rates on the one hand and the optimism priced into stock markets on the other?

For one thing, not every stock market is illustrating investor optimism. Notably, if we look at small cap stocks around the world they have clearly underperformed. This is largely due to their heavier reliance on the domestic economy. Not only is this true in the UK and Europe but clearly also true in the US where the Russell 2000 Small cap index has massively underperformed the NASDAQ until very recently.

By now, everyone should know that the top seven stocks in the US are driven by some sort of AI bubble. These seem to represent the only motor really driving the key S&P 500 index higher.

Watch: Will Mid- and Small-Cap Stocks Catch Up?

I think it's important for investors today to watch smaller cap indices like the Russell 2000 to see whether this rally will broaden out to more stocks in the near future. That is the condition for a true new bull market in my view.

Source: tradingview.com

The global economy is doing better than expected for now

Since late last year, economists have been forecasting recession, particularly in the US. The stock market seemed to agree in October 2022. Hence we experienced a sharp fall in global stocks from January until October of that year, reflecting this growing fear of recession and therefore an anticipated drop in corporate earnings.

But as of today, economic momentum in the US, Europe, and even in China as well has surprised to the upside and been stronger than economists had predicted back in late 2022.

Looking at current activity indicators, such as the Atlanta Fed GDPnow indicator, we seem far from a US recession at the moment. This GDPnow indicator is currently registering a healthy 2.2% (annualised) growth rate for the second quarter of 2023.

Source: Atlanta Fed

But some concerns in Europe

Admittedly, in the Eurozone, economic momentum has clearly slowed of late, led lower by retail sales in France and Germany. The volume of retail sales (i.e. taking out the price effect) has fallen quite sharply in volume terms in these countries. This is clearly due in large part to (a) the more expensive interest rates for borrowing plus (b) very high inflation rates, which has hurt the consumers ability to spend.

Falling German retail sales (% change on year)

Source: tradingeconomics.com

But do not ignore the fact that there are also positive economic indicators even in Europe, notably the employment market, Eurozone employment reached its highest ever level in history in Q1 of this year, substantially higher than in the pre COVID area era or even in Q1 20, before the effects of the COVID lockdowns had started to hit the European economy.

Source: tradingeconomics.com

Inflation starts to come down quickly

In addition, inflation rates are falling rapidly in some areas, such as in the US headline inflation is coming down quickly, and also in certain countries in Europe, notably Luxembourg, and Spain.

In Spain, headline inflation has already fallen to just under 3%. Now it is true that Eurozone and the UK inflation rates remain far higher at the moment, but they are also on a falling trend. Bear in mind that Spanish inflation typically leads Europe inflation as a whole by about three months. So what is happening today in Spain should happen in Europe over the next three months, i.e. the inflation rate should continue to fall substantially.

This is important both for stocks and bonds. Clearly, for bonds it is important that inflation rates return closer to the central bank targets, as this will allow central banks to slow the rate of hiking or even to pause their rate hike cycle. This would clearly be better for the economy, because it means that central banks are no longer applying the brakes so dramatically to the economy to slow growth and demand.

In turn, this is therefore somewhat better news looking forwards for corporate earnings outlooks.

Conclusion: Semis, Circular Economy Themes still work

While I am cautious on Nvidia post the AI-related surge in share price of late, I still like global exposure to the Semiconductor sector overall, given the secular trend to needing greater processing power, memory, storage and sensors for today’s and tomorrow’s world.

In addition, I also like the Circular Economy theme as the need to be more energy efficient, recycle more and to make greater use of the sharing economy (think Uber, Airbnb) really takes off.

Source: tradingview.com

Have a great week ahead,

Edmund