Growth fears trigger another painful summer market drawdown
In Short
Markets were spooked by the sharper deterioration of the US labour market and by the fear that, the easing bias introduced by the Fed for its September meeting may have come too late and that it is ultimately behind the curve in fighting a possible downturn.
Highlights:
- Souring manufacturing sentiment and worse than expected employment data have raised fears of the Fed falling behind the curve in providing accommodation to an economy running out of steam. Moreover, disappointing sentiment data (e.g., PMIs) and further evidence of a struggling German economy raised concerns about the sustainability of the EA recovery.
- The weakening in activity and the labour market is undeniable and the odds of a mild recession in early 2025 have risen to around 1/3, but looking beyond payroll data, we do not see large scale job destruction in the short term, as the drivers of domestic demand (chiefly disposable income) are not tanking. Indeed, the non-manufacturing ISM today came out slightly above expectations, signalling ongoing expansion.
- The Fed will emphasise its easing bias more strongly, helped by benign inflation prints. Another batch of poor activity data over the summer will very likely lead to three 25bp cuts this year (vs. between 100 and 125bp of cuts currently priced by the market, including 50bp by the Sep. meeting). The repricing of the ECB rate policy looks slightly excessive: we stick to our year-end 2025 expectation at 2.5% (vs. market priced near 2%, from currently 3.75%).
- In recent days, core yields have accelerated the downward trend that began in July. Further declines cannot be ruled out in the short term, but along with central bank pricing, the move looks slightly stretched. Still, we would gradually buy the deep in Euro rates if the rally reverses.
- In credit markets, the recent concerns about the strength of the US economy haven’t really translated into massive HY/IG as well as Fins/Non-fins decompression so far, which is somewhat surprising. Indeed, demand remains resilient, driven by the still elevated all-in yield, absence of supply over summer months and the low share of tech in credit indices, especially in Europe. CDS, more correlated to equities, have under-performed cash. If fears of US recession are confirmed spreads will have to reprice further but for the time being, we remain relatively constructive given our expectations of 1/ peaking defaults 2/ strong technical and 3/ attractive carry versus government bonds. Still, credit spreads will look relatively expensive if macro evidences on a deep deterioration accumulate. Position for decompression (preference for safer segments).
- A perfect storm of a BoJ rate hike and FX intervention, higher risk aversion and lower US yields have pushed the JPY sharply up pushing the TOPIX into descent and contributing to the global risk-off sentiment.
- Equity markets carried some risks before the current slump, namely high positioning, negative macro surprises and elevated US valuation. US soft landing uncertainties and raising doubts about AI returns on huge capex expenditures have added to disappointing consumer-related firms’ results and a spike in the yen. From peak, the Topix is down 20%, EM 6%, S&P 500 9%, Nasdaq 17%, Stoxx 50 nearly 13%, while EU cyclicals are down 7% vs. Defensive.
- Short term, markets remain at risk, as elevated risk-on positions may need more time to reverse. Increased volatility also represents headwinds to firms’ confidence. For now, it looks worth maintaining a tilt towards defensive sectors versus cyclical ones.
- On the positive side, the Q2 reporting season, after nearly 380 US firms reported, shows a 5% positive earnings surprise, similarly to Europe (300 have reported). Furthermore, US unit labour costs look supportive for firms’ margins and US GDP numbers are not falling over the cliff (Q2 and projections on Q3 higher than 2%). G4 Cash Flow minus Capex spread remains high and positive, net equity issuances low, while buybacks linger. Central banks are also becoming more accommodative, which will improve financing conditions and, finally, ex-US valuations are not expensive.
- We remain on the cautious side but, as historical experience shows, panic is enemy of wise decisions. Fundamental conditions remain decently good for the time being and markets are repricing high positioning and Tech euphoric sentiment which could lead to better entry point in the future. In Europe we keep the preference for UK or for Europe Ex Emu vs Emu. We stay tactically prudent on US stocks, with most of the Mag 7 reporting this week.
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