Manic markets, monetary magic

By Stefan Löwenthal, Jürgen Wurzer

August 14, 2024

Central banks’ balancing act between inflation and growth in the age of artificial intelligence (AI)

As we navigate the latter half of 2024, the global economy finds itself at a crossroads as financial markets first experienced a dull couple of months, only to be interrupted by a spike in volatility. Despite the recent turbulence among tech giants like Tesla Inc. and Alphabet Inc. (Google), the broader equity market has posted solid gains year to date amid a belief in the economic “soft landing” narrative, buoyed by strong earnings, robust gross domestic product (GDP) growth, and a job market that refuses to cool down. Similarly, fixed income has performed admirably, with spreads continuously tightening during the seasonal lull in activity.

As markets are turning more volatile, we try to look through the noise as we delve into central banks’ ongoing dilemma of fostering economic growth while managing inflation against a backdrop of technological advancements and shifting market dynamics. We explore the potential implications of stubbornly high core inflation on global equity markets, and look into the diversification of momentum and the “AI theme” (as well as sectoral and regional dispersion more broadly). We also assess and the strategic positioning in credit markets, providing a roadmap for navigating this complex environment.

Highlights

• Economic resilience: We expect a robust economy, fuelled by strong job markets, rising household incomes, and fiscal boosts. Plus, tapping into homeowners’ equity could spark further growth.
• Financial ease: The current easy financial conditions hint at less urgency for rate cuts than markets anticipate.
• Persistent inflation: Inflation might prove to be stickier, driven by wage growth and rising rents, amid a tight job market and a housing crunch.
• Momentum diversified: The momentum factor now showcases a well-rounded sector mix, challenging the notion that it’s all about AI stocks and setting the stage for savvy stock selection.
• Credit caution: With valuations in high-risk credit markets looking overextended, a mix of short-term bills and defensive credit positions might be appealing.

Macroeconomic outlook

Over the Northern Hemisphere summer, the incoming macroeconomic data presented a mixed picture, revealing a continued divergence between hard and soft data. Notably, US GDP for the second quarter surprised markets by posting a robust growth rate of 2.8%, significantly outpacing expectations of 2.0% (source: Bloomberg). This positive deviation underscored the resilience of the US economy, injecting a dose of optimism into financial markets. However, July's nonfarm payroll report, purchasing managers’ indices (PMIs) and other leading indicators were painting a more mixed picture of the economic landscape.

This bifurcation in economic data might be partly explained by the emergence of mini cycles within the economy, characterised by distinct and desynchronised peaks and troughs across various industries. This phenomenon complicates the task of assessing where we are in the broader cycle, and it poses a challenge for investors and policymakers alike as they strive to interpret these mixed signals and position accordingly.

Encouragingly, headline inflation has continued to retreat from its highly elevated levels in the aftermath of the COVID-19 shock. However, core inflation – particularly within core services – remains stubbornly above pre-pandemic levels. Recent data even suggest a reacceleration in some areas, presenting a dual narrative of declining headline inflation compared with persistent and stickier core inflation – an ongoing challenge for policymakers.

Figure 1: US core inflation is declining from its peaks, but services inflation remains elevated

Sources: Bloomberg, Macrobond, Macquarie. Data from January 1960 to June 2024, based on US Core Personal Consumption Expenditures Price Index (US Core PCE).

Labour market

We continue to closely monitor wage growth developments, which are a key component driving service sector inflation. A useful indicator to track the underlying labour market dynamics is the Beveridge curve, which illustrates the relationship between job vacancies and unemployment. Its shape provides insights into the health and tightness of the labour market. We are watching to see whether it will flatten out, indicating a looser labour market similar to the 2010- 2019 period, or remain steep, as has been the case in recent months. The trajectory of the Beveridge curve might be critical in assessing whether wage-driven inflationary pressures ease or persist.

Figure 2: US Beveridge curve – litmus test for a return to “normal”

Sources: Bloomberg, Macrobond, Macquarie. Data from June 2009 to May 2024.

Recent labour market data present a mixed picture overall, indicating a continued normalisation from the COVID-19 aftermath. The quits rate, often viewed as a barometer of worker confidence in finding new employment, has returned to its pre-pandemic levels, suggesting stabilisation. However, other reliable labour market indicators, such as wage growth and job openings, suggest that the labour market remains even tighter than it was pre-COVID, and further cooling may be necessary to keep inflation in check.

In addition, the dynamics of immigration could influence future wage growth. As illustrated in the left chart of Figure 3, the population of foreign-born workers has been expanding at a faster pace than that of the native-born population in recent years. This shift has momentarily interrupted a multiyear trend of increasing relative wage growth, as seen in Figure 3’s right chart. This implies that foreign-born workers have been earning relatively lower wages than they were before the pandemic. If the previous trend were to resume – potentially as a result of more stringent immigration policies – this could represent an additional source of inflationary pressure that may not be fully accounted for in current inflation expectations.

Figure 3: Population growth has been a key driver for the labour force and possibly wage inflation

Another key component of core services inflation is the housing market. Here, the “lock-in effect” (homeowners being reluctant to sell their homes amid rising mortgage rates) has significantly contributed to unusually low housing turnover. According to estimates from the Federal Housing Finance Agency (FHFA), there has been a staggering 60% decline in home sales, and it could take many years for this to normalise again. A prolonged period of low housing turnover could be another source of structurally higher services inflation, as the scarcity and high price of available homes for sale might force people to rent, potentially driving up costs for renters and contributing to overall inflationary pressures.

Central banks

Balancing inflation and growth continues to be the key focus for central banks globally, as they strive to rein in inflation back to target levels. Notably, the European Central Bank (ECB) has already initiated an easing of its monetary policy, fuelling speculation that the US Federal Reserve (Fed) might soon follow suit. However, market expectations regarding rate cuts have proven to be highly volatile this year. We continue to expect that, unlike what the market currently anticipates, the Fed won’t cut very much in the coming 12 months amid a more elevated core inflation environment.

Meanwhile, financial conditions have already shown signs of easing, making additional cuts potentially less necessary. Banks seem to be in good shape, with solid earnings reports amid favourable interest rate margins, and well exceeding regulatory capital reserve requirements. Complementing this positive scenario is the latest Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), which indicates a trend towards more lenient lending conditions. This has historically been a precursor to declining default rates, further reducing recession risks.

Households

Similarly, households are exhibiting encouraging signs of resilience and recovery, in spite of some evidence that the majority of consumers have already deployed any excess savings accumulated in prior years. As inflation recedes from its peak levels and wages continue to rise, there has been a notable improvement in real income growth across major economies. This positive shift in household finances is bolstering consumption, providing a tailwind for economic activity. And there might be more to come.

An innovative pilot program for secondary mortgages by Freddie Mac1 might represent a significant development in the financial landscape for US homeowners. By providing an alternative to traditional cash-out refinancing, this program could serve as a catalyst for unlocking substantial untapped equity for millions of Americans. It could allow homeowners to access additional funds without refinancing their entire mortgage at higher rates. This financially viable option might enhance homeowners’ flexibility and could stimulate economic activity further – an interesting development to watch.

Fiscal policy

In addition to comparably easy financial conditions and the resilience of the household sector, we also believe that fiscal stimulus will remain strong in the near term. Fiscal expenditures authorised in recent years include allocations that will only begin to be spent in coming quarters, suggesting a sustained flow of fiscal support into the real economy. Historical trends further reinforce this outlook, indicating that government spending tends to peak in the year following a presidential election.

Moreover, the US Treasury has played an increasingly active role in markets by targeting a greater share of its issuance in short-dated Treasury bills, which some believe has a similar effect to quantitative easing (QE) by reducing the supply of longer-dated securities available to the market. Additionally, the Treasury General Account has amassed more than $US750 billion, which is poised for deployment at the Treasury’s discretion. All these factors lead us to believe that fiscal spending could present an upside surprise for economic growth beyond current expectations.

Recent fiscal policies notably supported manufacturing construction, as clearly depicted in Figure 4. This rise in manufacturing investment is poised to boost future GDP as the output from these newly operational factories comes online. Additionally, the transition from destocking to restocking of inventories could represent another growth catalyst, although the pace of this inventory cycle adjustment will vary among sectors due to differences in demand anticipation, market dynamics, or supply chain challenges.

Figure 4: Manufacturing construction spending has increased significantly in recent years

Sources: Bloomberg, Macrobond, Macquarie. Data from January 2002 to May 2024.

Global developments

Looking at other regions, China’s real estate sector, once a powerhouse of economic growth, is still facing significant challenges. In 2014, rate cuts spurred a surge in home purchases, but the same strategy has not stemmed the decline in new home sales in the present scenario. From 2017 to 2022, real estate was a major contributor to China’s GDP, accounting for an average of 35%. However, this figure has sharply fallen to less than 20%, a level last seen in 2005.

This downturn signals a critical need for China to address its real estate woes to pave the way for economic recovery and growth. Furthermore, the Third Plenum, a key meeting of China’s leadership, did not reveal meaningful additional measures that could invigorate the sector. This ongoing crisis in China’s real estate market not only impacts domestic growth but also has repercussions for global economies, particularly dragging down Europe’s economic performance due to the interconnected nature of global trade and investment.

We will now look into the investment opportunities that emerge in the context of these multifaceted economic developments.

Asset class implications

Equity markets have benefitted from the solid economic backdrop, growing earnings, and more benign inflation prints. However, the second quarter of 2024 in particular saw continued dispersion between the largest US technology companies such as Amazon.com and Microsoft Corp. compared with the rest of the market. Just like in 2023, the 10 largest stocks of the S&P 500® Index are responsible for more than half of the total market return year to date.

US equities

In that context, a striking visual is the rolling 3-month z-scores of relative performance between the S&P 500 Index and other benchmarks for various parts of the US equity market, such as the large-cap Russell 1000® Growth Index and Russell 1000® Value Index, the small-cap Russell 2000® Index, or the S&P 500® Equal Weight Index. In an exceptional move through mid-July, growth outperformed the broad market by more than two standard deviations, while value underperformed by more than three. But with mean reversion unfolding quickly towards the end of July, relative market movements don’t currently provide any guidance.

Figure 5: Relative equity market performance has been massively distorted, but July led to quick mean reversion

Sources: Bloomberg, Macrobond, Macquarie. Data from 3 January 2020 to 26 July 2024.

However, what stands out in these developments is that despite the strong returns of the momentum style factor – which captures the tendency of winning stocks to continue outperforming and losing stocks to keep underperforming – over the past year, its valuation spread appears surprisingly cheap. This anomaly is partly explained by the changed sectoral composition within momentum quintiles, where information technology (IT) stocks are now more evenly distributed across both the top and bottom quintiles. We believe this debunks the myth that momentum is equal to the AI theme, i.e. comprising a simple “long-IT/short-everything-else” logic. Instead, momentum is more aligned with being long in financials and industrials, while being short in real estate, staples, and healthcare.

The more balanced distribution of expensive tech stocks across momentum quintiles contributes to the seemingly low valuation spread. Additionally, the presence of tech stocks in the bottom quintile reflects the market’s efficiency in distinguishing between AI winners and losers (the “debate stocks”), hinting at either a more rational market potentially averting a bubble burst or, more pessimistically, the early stages of a bubble burst beginning to unfold, especially within the context of high valuations in large-cap growth stocks.

Figure 6: The momentum anomaly – style factor returns look extended but not expensive

Sources: MSCI Barra, FactSet, Macquarie. Data from 3 January 1997 to 26 July 2024.

Generally, a bigger bifurcation between winners and losers within sectors or industries – as seems to be happening now around AI – could prove to be good news for active managers in the months to come. High industry dispersion often correlates with stronger manager alpha, as the ability to discern and select the best-performing stocks becomes crucial. This scenario, marked by significant performance variances within sectors, offers skilled managers a prime opportunity to use their expertise and insights, thereby enhancing returns relative to passive strategies.

Figure 7: High return dispersion is often a fruitful environment for active managers

Sources: Bloomberg, Macrobond, Morningstar, Macquarie. Data from January 1991 to April 2024.

Global equities

Looking at equity markets outside the US, relative earnings momentum has seen a more significant improvement in Europe and Asia recently. However, this positive development has not been mirrored in the relative equity market performance between the regions, potentially setting the stage for a near-term catalyst that could drive outperformance of European markets compared with their US counterparts. From a valuation perspective, we believe Europe continues to present a compelling case for investors across a variety of metrics, such as Price-to-Earnings ratios. This combination of underappreciated earnings momentum and attractive valuations could position Europe favourably relative to the US in the months ahead.

Figure 8: The improving outlook for Europe has not been reflected in relative equity market returns

Sources: Bloomberg, LSEG Datastream, Macquarie. Data from 31 December 2009 to 18 July 2024. Europe, Australasia, Far East (EAFE) are the most developed geographical areas of the world outside the US and Canada. These regions are commonly referred to by the acronym EAFE, and many different exchange-traded funds (ETFs) and mutual funds focus their efforts on investing in companies in these regions.

Similar observations can be made about emerging markets and China. Despite the potential parallels, China remains an unloved equity market for reasons detailed in the macroeconomic section, potentially making it an interesting investment opportunity from a contrarian standpoint. However, this interest hinges on the presence of a near-term catalyst that could shift market sentiment and dynamics, potentially unlocking value for investors willing to go against the prevailing market trends.

Equities vs. fixed income

Overall, there is a cautiously optimistic view that global equity markets could continue to perform well as we navigate a comparably solid economic backdrop, which could support earnings growth. However, it’s important for investors to approach the markets with a degree of caution, as seen by the equity risk premium and yields in comparison to fixed income. For example, the dividend and buyback yield of the S&P 500 Index is only 3.5%, compared with the 10-year US Treasury yield of 4.2% (source: Bloomberg).

Admittedly, valuation metrics in equity markets might be somewhat skewed, particularly due to the outsized influence of the mega-cap technology names in the US. However, signals such as fear and greed indicators and options-based models suggest a degree of complacency among market participants, underscoring the need for vigilance. While there are reasons to be optimistic about the potential for equity markets to continue their positive performance, it is crucial to proceed with caution, keeping an eye on valuation discrepancies and market sentiment indicators. This is further evidenced by the spike in volatility in early August.

Figure 9: Fear and greed indicators and options-market based models signal complacency

Emerging markets debt

Turning to fixed income, absolute yields continue to remain at levels that seem exciting to investors who witnessed the low/negative yield period before the COVID-19 pandemic, but spreads are coming under increased scrutiny. A good example is the emerging markets (EM) hard-currency bond spread. Excluding the CCC-and-below rated segment of the market (countries like Egypt, Pakistan, Nigeria, and Ukraine), the spread sits at its lowest level since the 2008 global financial crisis. Hence we recommend staying cautious.

Figure 10: EM hard-currency bond spreads skewed by the lowest-rated countries

Corporate credit

It is a similar story for high yield credit. Spreads are near their historic lows, providing little compensation for the additional risk. Traditionally viewed as a harbinger of recession, the yield curve inversion has now persisted for more than 500 days, marking its longest duration on record. While this extended inversion seems to be less predictive in the current economic cycle, it is adding to the challenges faced by policymakers and investors in interpreting the signals from financial markets, and hence justifies a cautious approach towards credit markets, in our view.

Figure 11: High yield spreads are near their lows as the cycle is prolonged

Sources: Bloomberg, Macquarie. Data from 30 December 1988 to 23 July 2024.

One of the few areas that we don’t find overly expensive within fixed income is investment grade corporate bonds. Currently, spreads are slightly below long-term median levels, meaning they are neither excessively rich nor cheap. Moreover, the absolute yields on offer are compelling, presenting an attractive proposition for income-seeking investors, in our view. Importantly, the carry these bonds provide acts as a safety net, offering some cushion against a potential further rise in yields should inflation remain elevated. We believe this combination of factors makes investment grade corporate bonds a noteworthy segment within the fixed income universe, especially for those looking to navigate the current economic landscape with a measure of prudence.

Figure 12: Duration-adjusted risk premium of investment grade credit seems fairly priced

Sources: Bloomberg, Macquarie. Data from 4 January 2010 to 24 July 2024.

Real assets

Lastly, our outlook for real assets remains largely unchanged. We continue to view the asset class as a potentially meaningful value-add to investors’ portfolios, particularly against the prevailing inflation backdrop. Within real estate and also infrastructure, companies have taken steps to reduce their sensitivity to interest rate fluctuations, shifting the focus towards profitability as the critical factor for future success. Meanwhile, in the energy sector, refiners face the prospect of declining profitability due to narrower crack spreads; however, the overarching driver of global oil demand – and consequently, price – will hinge on overall economic growth. And while the price of gold appears elevated relative to fair value models, gold retains its allure as a potential hedge against geopolitical uncertainties, underscoring its relevance in a well-rounded investment strategy. Consequently, we think that real assets as a heterogeneous asset class not only offer diversification within themselves but may also provide a crucial layer of inflation protection for traditional portfolios that may lack this feature.

Conclusion: Views at a glance

The investment environment is poised to remain challenging in the foreseeable future, marked by elevated geopolitical risks. Amid higher dispersion across and within sectors, there emerges a broader opportunity for exploiting relative value opportunities, accessible through both top-down assessments and bottom-up stock picking. This scenario underscores the importance of risk-based portfolio construction as an approach to navigate the uncertain environment, prioritising probabilistic outcomes and enhancing the potential for resilience and growth in this cycle.

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¹ https://www.fhfa.gov/news/news-release/fhfa-announces-conditional-approval-of-freddie-mac-pilot-to-purchase-second-mortgages

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