Yesterday could’ve been worse. A more than 6% drop in Nvidia (NASDAQ:NVDA) somehow limited the S&P 500 gains, but many stocks in the S&P 500 gained yesterday after the latest GDP update came in better than expected and pointed out that the US economy has grown 3% in the Q2 versus 2.8% printed earlier. The consumer spending almost doubled, as well, to 2.9% from 1.5% printed a quarter earlier. The cooldown in the GDP prices was less, but core prices eased more than expected. All in all, the US economy rebounded in Q2 but the rebound didn’t increase price pressures. In plain English, the data tasted exactly how investors love it – with the additional sweet topping – for the Fed rate cut expectations – that it has slowed in Q3 but slowed from a higher mark.
So there was reason to cheer the latest growth update yesterday. The US 2-year yield rebounded a little but settled around the 3.90% mark, the 10-year yield is at 3.86% - the gap between the two has almost closed: a positive sign for those who expect a soft landing, and the US dollar rebounded. The US Dollar Index recovered on the thinking that the Federal Reserve (Fed) will start cutting rates in September, yes, but a 50bp cut is probably not needed straight away.
But note that activity on Fed funds futures still gives a one-thirds chance for a 50bp rate cut from the Fed in the September meeting and the Fed is seen cutting rates by 100bp from now to the end of the year – a scenario that implies that we will see a sharp slowdown from the current quarter. Happily, the data is not *that* alarming. Therefore, I believe that there is room for trimming the Fed cut expectations to between 50-75bp cut this year, and that should justify a further positive correction in the US dollar and a further rotation in the S&P 500 toward the growth-friendly, cyclical stocks – including energy and financials.
Europe vs US
Rotation from tech to other sectors, which is also called the reflation trade, is believed to be positive for European stocks. And indeed, capital inflows into the European stocks outpaced inflows into the US markets in the Q2 – precisely boosted by the expectation that the global rate cuts would be better for the reflation-friendly European stocks than their technology-heavy American peers (and also because the European Central Bank (ECB) started cutting rates before the Fed). And the Stoxx 600 has been greatly benefiting from it. Yesterday, the index almost matched a record high that was printed back in June and remains attractive for investors who look for interesting valuations to get away from highly valued American stock markets. And despite this year’s rally, the European stocks remain significantly cheaper than the ones across the Atlantic. In numbers, the Stoxx 600 offers a PE ratio of around 14 well below the S&P 500’s average 21.
The problem is that the rate-cut expectations alone cannot infinitely attract investors to the old continent. Europe is slowing, its airline and luxury businesses are not doing well – the Chinese woes have a significant negative impact on the most influential luxury brands – so much that the British Burberry and EasyJet risk dropping out of the FTSE 100 index shortly. And Bloomberg Intelligence revised its consensus EPS for the Stoxx 600 down by 1.4% this year, and 1.6% for next year. Over in the US, the technology stock investors are preparing for challenging times yet the S&P 500’s non-Magnificent 493 stocks saw their growth expectations more than double and should see the benefits of the upcoming rate cuts. And if the Fed can offer the US economy a soft landing, there will be nothing to stop the US indices from outperforming its European peers.
PCE Watch
Today, the US will release the latest core PCE index, the Fed’s favorite gauge of inflation. The data is expected to hint at a tiny rebound in July. A stronger-than-expected read could lead to a further US Dollar recovery. But even in that case, the Fed doves are more interested in jobs data than inflation figures. What would really change the game is strong jobs data from the US next week.
Currencies
The US dollar’s latest rebound pulled the EUR/USD lower yesterday. Softer-than-expected German and Spanish inflation updates helped bringing the ECB doves back to the market. Inflation in Germany even fell below the ECB’s 2% target! The combination of less dovish Fed expectations and more dovish ECB expectations sent the EUR/USD all the way down to 1.1070. The pair is consolidating near the 1.1075 this morning. The aggregate CPI data from the Eurozone will likely confirm the slowing price pressures in the Eurozone in a way that let the ECB consider a clearer path for easing its policy. The EUR/USD could find a good reason to return below the 1.10 mark – especially if we welcome a strong jobs data from the US next week.
Elsewhere, the USD/JPY consolidates a touch below the 145 mark amid a mixed bag of data released in Tokyo earlier this morning. The data showed a slower rebound in industrial production, a bigger-than-expected slowdown in retail sales, a larger-than-expected rise in the unemployment rate, and stronger-than-expected inflation during late summer. We believe that ongoing price pressures will likely keep the Bank of Japan inclined toward normalization. However, if economic fundamentals deteriorate further, the BoJ could quickly reverse course and extend support to the economy. This would hinder the Japanese yen's recovery and potentially enhance carry trades.