Friday brought down the curtain on the first half of 2023, an incredibly strong half-year for most global equity markets. The tech-heavy NASDAQ (+31.7% YtD) in the US and the Japanese Nikkei 225 (+27.2% YtD) have led YtD gains, although stock markets in most parts of the world have had positive returns so far this year. The strength of the technology sector as a driver is best illustrated by Apple, which amazingly passed $3 trillion in market capitalisation on Friday. Although global equity markets have largely reversed their dismal 2022 performance, bond investors have not been as fortunate with rates heading higher most of the year, especially at the shorter end of the yield curve. Stateside, both the 7-10 year and 20+year UST total return indices are just clinging to modest YtD gains of 1.9% and 4.6%, respectively.
For now at least the “recession-is-a-coming” fearmongers have been proven wrong. As this reality has lingered, investors have been emboldened as more and more pile into risk markets. The resilient economy has also encouraged investors to steer clear of bonds, especially shorter-dated bonds, since their yields are correlated strongly with central bank policy rates. You can see the 1H23 migration in yields in government bond markets in the table below for three key economies that are battling stubborn inflation – the UK, the Eurozone and the US.
In all three of these markets, the 2y-10y yield curve inversion became progressively more pronounced as the first half wore on, with core inflation proving persistently high and central banks having little choice but to increase their overnight bank rates to try to address this. In the US, the yield curve inversion steepened to above 100bps in the US for the first time since the early 1980s (baring for two days in early March because related to US bank crisis), as you can see in the graph below from FRED.
This last week of June provided perfect reminders of the two key drivers of the performance of financial markets YtD:
1. Stubborn core inflation which has spawned further monetary tightening from central banks in nearly all developed markets (aside from Japan), and 2. Amazingly tight labour market conditions, especially in services, that have sparked economic resiliency (in spite of higher interest rates) that was hardly imaginable at the beginning of this year. Tighter monetary policy to address rampant inflation and tight labour markets simultaneously are strange bedfellows when travelling in the same direction, making a mockery of the Phillips Curve (although I suppose this was acknowledged years ago with the onset of unconventional monetary policy during the GFC). Those investors that continue to shout “recession” have been wrong for this reason, although in my opinion, it will eventually prove to simply be a longer lag than expected rather than a total breakdown in this important bedrock of economic theory. Personally, I am in the school that does not believe any economy can withstand indefinitely tighter and tighter monetary policy, regardless of the euphoria currently characterising risk markets. My bets are placed accordingly, with my portfolio comprised mostly of defensive stocks and a larger-than-usual position of short-dated (one year and less) bonds. I will look at my portfolio again next week, following up on my article in February “The Great Reveal” in which I discuss my own portfolio.
MARKETS THIS WEEK
Friday provided a fitting end to the first semester of 2023, with encouraging inflation data in the US (May PCE, see further below) and parts of the Eurozone encouraging equity markets to continue their recent run. The reality is that whether there are one, two, three or even more increases in policy interest rates by the Fed, ECB and others, the end is near. Investors realise this now, and this is encouraging a dose of optimism that well-trumps concerns of a slowing global economy down the road. Of course, there are exceptions to this, most notably in the BREXIT-damaged UK (where inflation remains higher than in other G7 peers), and deflation-fearing Japan, which has a policy that feels like “easy forever”. Also, no one knows for sure how long the terminal rate will remain fixed in any economy before there is a hint of monetary policy relief. Nonetheless, investors seem perfectly prepared at the moment to accept “higher rates for longer”. The focus therefore will eventually turn to the upcoming round of S&P 500 earnings, and that old chestnut – China – the world’s second largest economy that just can’t seem to get going again.
With equities firing on all cylinders, it was a killer week for stock investors and a fitting end to the first half of the year. Bonds steadied after better-than-expected PCE data in the US, corporate spreads continue to show no concerns with credit deterioration, gold is hanging above $1,900/ounce and the price of WTI crude seems stuck in a rut around $70/bbl.
If you would like to see details by asset class / market type, go to “The Tables” section below.
WHAT HAPPENED THIS WEEK THAT MATTERED?
Inflation data: The Fed’s preferred inflation barometer PCE was released Friday (BEA press release here), and figures for core PCE MoM and YoY for May were on target or even slightly better than anticipated. Headline inflation for May was sharply lower, driven by declines in energy prices. Core inflation was lower, but only modestly so. The Eurozone served up a mixed bag depending on the country, but the overall Eurozone had lower headline inflation, although core inflation actually rose modestly. Note that Eurozone figures are flash CPI for June (vs May PCE in the US); the Eurostat June flash CPI report is here. Equity investors in the US and Europe cheered the inflation data, with equities adding to their impressive weekly gains. Bond yields also moderated albeit only slightly.
ECB Forum on Central Banking: The “big 4” central bank heads all shared a panel discussion on Wednesday at the ECB Forum on Central Banking, held in Sintra, Portugal. I listened to most of the panel discussion, and you can find the 90 minute or so discussion on YouTube here from the YahooNews feed (starts 14 minutes in). The very interesting panel discussion was hosted by Sarah Eisen, CNBC, and featured ECB President Christine Lagarde, Fed Chairman Jerome Powell, BoE Governor Andrew Baily, and Bank of Japan Governor Kazuo Ueda. The take-away is clearly that three of the four central banks will almost certainly be raising rates at upcoming meetings to address stubborn core inflation, whilst the Bank of Japan remains an outlier with its ongoing accommodative monetary policy. You might also find the 25-minute opening remarks at the ECB Forum by IMF First Deputy Managing Director Gita Gopinath interesting. Ms Gopinath was similarly clear about the challenges bringing inflation under control would present for the global economy.
US bank stress tests: The Federal Reserve also released the results of its most recent stress tests on 23 large US banks, and all passed. The Fed’s commentary can be found here, and the actual results (PDF link) are here. These are the two paragraphs from the opening commentary that most grabbed my attention:
“This year's stress test includes a severe global recession with a 40 percent decline in commercial real estate prices, a substantial increase in office vacancies, and a 38 percent decline in house prices. The unemployment rate rises by 6.4 percentage points to a peak of 10 percent and economic output declines commensurately.
The test's focus on commercial real estate shows that while large banks would experience heavy losses in the hypothetical scenario, they would still be able to continue lending. The banks in this year's test hold roughly 20 percent of the office and downtown commercial real estate loans held by banks. The large projected decline in commercial real estate prices, combined with the substantial increase in office vacancies, contributes to projected loss rates on office properties that are roughly triple the levels reached during the 2008 financial crisis.”
WHAT’S AHEAD THAT MATTERS?
Recall that Tuesday is a holiday in the US as America celebrates Independence Day. Monday is a half day only, with little likely going on in US markets. Therefore, the real action will probably not pick up again until Wednesday. Things to keep an eye on in July, aside from June economic data which will begin trickling in, are S&P 500 2Q23 earnings, which kick-off with the banks on July 14th, and central bank meetings the last week of July.
Earnings quarter ended O/A June 30, 2023 (2Q for most companies):
Banks kick-off July 14 with JPM and CITI, then BOA, WFS and MS on July 18, and GS on July 19
“Magnificent seven”: AAPL, July 26; MSFT, July 27; GOOG (Alphabet), July 25; AMZN, July 25; TSLA, July 24; META (Facebook), July 27; and NVDA, Aug 23
Central bank meetings:
Federal Reserve (FOMC): July 25-26 (+25bps expected), Sept 19-20 (with updated projections)
ECB: July 27 (+25bps expected), Sept 14
Bank of England: Aug 3 (+25bps expected) and Sept 21
Bank of Japan: July 27-28 (you can’t possibly ask!) and Sept 21-22
The tables below provide detail across various global and US equity indices, the US Treasury market, corporate bonds and various other asset classes.
Corporate bonds (credit)
Safe haven and other assets