Current Equity Exposure |
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Equities continued to advance in June following more evidence of cooling inflation and renewed expectations of policy rate cuts. The S&P 500 and the Dow climbed by 3.6% and 1.2%, respectively, while the technology-heavy Nasdaq outperformed by rallying 6.0% for the month. Markets seem optimistic about the outlook of easing policy, pricing in two interest rate cuts this year, while the median dots from the FOMC suggested only one cut. We believe that we are in a higher-for-longer interest rate environment and expect a shallow path for rate cuts, given our prospects for moderate economic growth and a bumpy road towards slower inflation. Also, there is an extreme level of stock concentration, with the largest 20 Stocks accounting for 75% of S&P 500 gains year to date. While we expect technology to continue fueling economic growth, we remain cautious and view this trend as unlikely to be sustained. Overall, we anticipate a bumpy process in the “last mile” on inflation, high for longer policy rate and moderating growth. With this backdrop, we maintained our allocation to U.S. equities at 48% and our international equity exposure at 69%. |
The Factors |
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Valuation
Valuation metrics for equity remained negative. P/E increased from 24.7 at the end of May to 25.7 at the end of June.Forward P/E increased to 22.7 at the end of June from 21.8 at the end of May. Inflation-adjusted valuation metrics continued to be negative. Equity valuation metrics relative to bonds remained negative with high bond yields. |
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Sentiment
U.S. manufacturing activity contracted again in May, with the ISM manufacturing index falling to 48.7 in May from 49.2 in April.The University of Michigan Consumer Confidence Index continued to fall in June to 69.2 from 69.1 in May, despite downward revisions of inflation expectations. The NAHB index declined to 43 in June, with elevated mortgage rates weighing on sentiments. |
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Technical
Technical indicators were positive overall, with positive momentum and fear signals outweighing neutral reversal signals.The S&P 500 was 12% above its 200-day moving average, 5% above the 100-day average, and 4% below the 50-day average. The VIX index was relatively flat with low realized volatility and settled at 12.5 at the month-end. |
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Macroeconomic
Nonfarm payrolls rose by 272,000 in May, stronger than consensus expectations. The initial jobless claims drifted upward, with the four-week moving average edging up to 236,000 as of June 22.Retail sales rose slightly in May by 0.1% following a weak April. U.S. industrial production increased sharply in May by 0.9%, far exceeding consensus expectations. |
What's Driving the Markets?Cooling Inflation: In May, inflation moderated more than anticipated, with the headline CPI remaining unchanged from April, resulting in a decrease in the year-over-year inflation rate from 3.4% to 3.3%. Gasoline price (down 3.6% from a month ago) was the primary driver for the softer headline CPI in May. Core CPI (excluding food and energy) grew 0.2% in May, with year-over-year growth slowing down from 3.6% to 3.4%. Once again, shelter inflation drove most of the increase in core CPI, rising 0.4%. Also, the PPI (producer price index) unexpectedly experienced its biggest drop in seven months, contributing to signs that inflationary pressures are easing. The PPI for final demand decreased 0.2% in May, following a 0.5% jump in April and bringing down the annual rate to 2.2%. While May appears promising in the fight against inflation, extrapolating individual inflation reports is tricky, and a single print is unlikely to change the Fed’s immediate-term strategy. Furthermore, year-over-year CPI comparisons will be a bit difficult in the second half of the year, given the relatively low inflation in the second half of 2023.
Central Banks’ Policy: As widely expected, the Federal Open Market Committee left the fed funds rate unchanged at 5.25% to 5.5%. However, the market’s interpretation of the committee’s latest Summary of Economic Projections was slightly hawkish as June’s median projection showed just one cut this year, compared with three cuts forecasted in its March meeting. At the same time, the median forecast for GDP growth remained unchanged at 2.1% for 2024, despite a weak Q1 GDP of 1.3%, indicating that the committee believes that the U.S. economy will still be relatively resilient for the rest of the year. Although the Fed’s data-dependent approach suggests that we cannot put much weight on its policy signals in one meeting, one theme stays consistent – Chairman Powell reiterated that the committee was not confident enough that inflation was consistently on track back to its 2% target, despite a slowing labor market and the moderating May CPI. June’s FOMC meeting occurred after the Bank of Canada and the ECB (European Central Bank) both cut rates earlier this month. Technology Sector and AI: The technology sector has seen a 28% increase YTD, nearly quadrupling the S&P 500 excluding the tech sector. The market cap-weighted S&P 500 increased by 15% this year, while the equal-weighted S&P 500 (SPW Index) was up only 5%. Since the end of 2022, the tech sector has soared 100% compared to a 24% rise in the rest of the index. Investors' preference for high-quality stocks and market focus on AI were the primary drivers for the dominance of the tech sector. AI has significantly boosted corporate earnings for tech firms. For Q1 2024, much of the earnings surprise was concentrated in Mag7 compared with the rest of S&P 493 (9.9% vs. 1.6%). However, for this momentum to persist in the second half of the year, the largest companies will likely need to consistently revise their earnings estimates higher, which could be challenging given the already high consensus for earnings growth. |
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