Market movements over the last few weeks have been defined by macro factors: mainly the risk of sticky or rising inflation and the repricing of interest rate risk. Although the underlying trend is very much the same, there were four distinctive features about last week's market performance that we would like to highlight in terms of the correlation between rates and equities, the USD, commodities and real interest rate yield curves.
i. Regarding correlations, the positive co-movement between bonds and risk assets seems to be moderating, as earnings on average are beating expectations and providing support for the latter.
ii. In terms of the USD, the upward pressure on the currency is moderating, as DM yield curves are playing catch-up to US rates. European sovereign yields surged broadly, with 10Y Italian BTP yields reaching 4% for the first time since December 2023 and 10Y Bunds breaking above 2.6% for the first time since November of last year
iii. Turning to commodities, there has been a catch-up of industrial vs. oil, contrary to in previous weeks, but overall, the S&P GSCI is up 2.3% month-to-date. While somewhat underwhelming compared to its return of 8.7% in 1Q24, this is attractive relative to equity and bond indexes. The S&P 500 is down 2.9% MtD and the NASDAQ 2.8%, while the Barclays Capital US Long-Term Treasury Bond Index is down 6.1% and the US Aggregate Bond Index is down 2.4%.
iv. And finally, real interest rate curves are steepening both in the US and Europe, which historically has been associated with a more upbeat economic scenario.
All this suggests an improving perception about the global economic cycle, even outside the US. From a macro perspective, and ahead of the FED meeting this week, it appears that US policy is not as restrictive as the FED is suggesting. Indicators such as financial stimulus, credit conditions index, net interest payments, and strong monetary growth are all potential reasons why the current monetary stance is not that restrictive.
In terms of inflation, the latest CPI prints confirm that the disinflationary process in the US has paused, mainly as a result of strong consumer demand, while higher commodity prices are adding upward pressure to transport and logistics costs. In our view, not only has disinflation stalled, but near-term momentum, potentially unfavourable base effects over the summer months, and core component dynamics suggest the risk is to the upside.
Against this backdrop, the odds are that nothing from the FED’s upcoming meeting will alter our expectation of no rate cuts before September, in line with our 2Q24 House View report. However, in our view, this message is already embedded in current OIS curve expectations and is unlikely to hurt the market. In addition, the FED could use its May meeting to announce plans to begin tapering quantitative tightening, a positive development in terms of liquidity provision, in order to reduce the odds of a repeat of the September 2019 repo market crisis. If confirmed, this could provide some relief to treasury markets.
Although valuations of equity and credit markets remain tight, the earnings season is still providing support. 1Q24 continues at a healthy pace with nearly half of the MSCI USA and STOXX 600 members having already reported results, with some of the largest US IT names also having already reported their numbers. So far, we have seen more positive numbers in the US - with an aggregate c.10% earnings surprise vs. c. 6% in the case of Europe, which means a better earnings season so far in the US than in Europe when compared with previous quarters. Furthermore, the US has managed to deliver a more balanced beat across sectors, while there have been more discrepancies in Europe, which so far is mainly relying on Financials and Materials. Overall, the current earnings season looks supportive for equities with management messages looking broadly optimistic for 2024 and companies maintaining their healthy dividend/buyback plans unchanged.
This said, underneath the surface, higher-for-longer increases idiosyncratic risks, and micro factors become increasingly important, suggesting more range-bound markets and rotation into quality, low-leverage and low-CAPEX intensive companies.
This dispersion has two major implications: i) it prevents a major increase in volatility, which could lead to an additional unwinding of CTA and the strategies particularly linked to volatility; and ii) this also means more range-bound markets, if we take the S&P 500 as reference, 5% in yields would mean a 4,850 level excluding the possibility of any other major changes associated with earnings.
Actionable idea: as previously discussed looking at 1Q24 results so far, European banks are emerging as the clear winners in the current earnings season in Europe with the highest earnings surprise. Despite the strong 2024 delivered so far, earnings momentum remains robust and very few question that their bottom lines in 2024 will be even better than in 2023. In line with what we recently anticipated (see our recent note on European banks) these banks are the main beneficiaries in the current ‘higher-for-longer’ environment, in which the odds of recession are diminishing. With provisioning firmly under control, this is arguably a goldilocks scenario for these banks and hence we maintain our Overweight stance, also supported by top-notch shareholder remuneration and inexpensive valuations.