Top-down view May 2023

With the FED being close to the end of the interest hiking cycle, some investors take a bullish equity view on the back of “history repeats itself”.

Accordingly, some market participants are now expecting rate cuts to come as soon as in quarter 3/23; Actually, they expect 3 to 4 cuts in 2023 and another 3 to 4 in 2024. Consequently, the reference interest rate is expected to move at least 2 full percentage point lower over the next 18 months! This view assumes the following background.

• Currently, the head-line inflation is at 4.9%, while core inflation is still stubbornly high at around 5.6 %. To align them with the FED mandate, both are supposed to decline by more than 3 full percentage points in the next 18 months,
•  The US economy to go through a soft landing,
• Corporate earnings to grow by more than 12% in 2024, and
•  Inflation in Europe to normalize faster than anticipated. As of now, the expected rate of inflation for 2023 is expected to be around 6.5%, but the optimistic analysts consider the rate of inflation to be around 5% by the end of 2023.

Here is our detailed view:

1.  We don’t consider that the rate of inflation is to fall as quickly as expected, since wage inflation has not yet translated into the market,
2. While there is a soft landing expected, it is unclear for now what comes next,
3. Corporate earnings: The present corporate earnings trend is positive, including forecasts. But, they reflect most often an artificial accounting construct which is in contrast with what happens at the level of SMEs,
   

More broadly speaking, the economic reality points to some more pain as:

• Macroeconomic risks have decreased in most developed market countries. Many economies have proved resilient against ripple effects from the war in Ukraine, but EM market depend largely on China for raw materials and other cheap consumer goods. With the US-China trade war going on and lingering concerns around Taiwan, markets should consider a sudden China decoupling. Given this, developed market countries are not in the best possible position to negotiate the long-term outlook.
• Labor market remains tight with more than 250k new jobs added in April and with wages up by more than 4.4 % YoY.
• The fractional cost of higher raw material and services prices are now reflected in the ISM index – The ISM tracks prices paid by manufacturing companies, and the index bounced back in April to 53.2 points from 49.2 points in March. We note that the volatility of this index is above average for now, hence another dip below 50 might be possible.
• After a long period of home-price growth, housing prices start to stabilize. The owner-equivalent rents index, which expresses the amount homeowners would have to pay in rent to equal the cost of owning their home, has been cooling lately. If housing prices restart to rise, which can be expected, given that there is a shortage in the market, it could translate to the CPI to stay high.
  
• The US led regional banking crisis is to spread-out trouble into the broader industry. While the banking crisis is not over yet, we note that the overall credit conditions have tightened in the course of 2023 and the ratio of SMEs obtaining new lines of credit has declined. On the positive side, we note though that Banks are much better capitalized now than in 2008.
• First Quarter EPS beat estimates by about 6.5% and earnings guidance held-up much better than expected. But the true picture is that Q1 earnings are down by more than 16% YOY and this is the highest decline in over 20 years for the comparable period. There is a positive outlook for EPS growth, but this comes with a conditional set-up of a solid macro backdrop, and this is not guaranteed according to our analysis. The market expects the best of all, interest rate cuts and durable growth, which can be questioned in the event the FED does not start lowering interest rates in Q3/23.
• According to a survey undertaken by AlphaWise, one needs to expect a change in US consumer behavior. Accordingly,

1. Consumers are expected to spend more on essentials like groceries and household supplies,
2. They are expected to spend less on discretionary items, c) they most negative net spending intentions are consumer electronics, leisure activities, home appliances and food away from home.
3. High-income group, which held up with the spending up to now, indicate that going forward to have negative spending intentions across the board!

• The ongoing public debate around the debt ceiling is ultimately USD negative. This together with geopolitical tensions have fueled fears of a global “dedollarization” in favor of other less tradable currencies. In theory, an increased level of competition can only be positive. But, on the other hand, the competition from other currencies (versus the USD) is expected to hurt demand for the U.S. Dollar, which could unfold in an increased speed of loss value. While the depolarization will continue, markets (and companies) are expected to “choose” between BRIC (in essence China) and Western economies. The advantage of DM currencies (and its reserves held across the globe), is that they are fully tradable, have a very high reliability, and are fully transparent and credibility. The disadvantage of currencies such WON, RUB, ZAR, amongst others, that they are not fully fungible. Example: search suggest that Russia sits on the equivalent of USD 2billion of Indian Rupees, which it can use in either way.
  

This main risk of the global depolarization is the fact will hurt China economies first. China in retaliation could block exports of raw materials and goods that are crucial to Western economies. If so, DM economies would be hurt in a second phase as they were to reoriented once more the supply chain and endure temporary disruptions.