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Waiting for Godot?
Yesterday’s release of US PMI data for May showed an economy continuing to defy expectations of slowing growth. The manufacturing PMI, instead of showing a slight shift back into contractionary territory, remained positive and increased to its highest level in a year.
Similarly, euro area PMIs, also released this week for May, showed the manufacturing sector outperformed expectations (albeit the European manufacturing sector continues to contract), while the services sector held at a robust expansionary level. Of course, in this world where good news for the economy is bad news for financial markets, US equities lost ground (the S&P 500 was down by 0.7%) and yields on US 2-year Treasuries rose by around 7 basis points as markets no longer expect the US Federal Reserve (Fed) to begin their easing cycle until either November of December.
The weight of US economic data through to the middle of the June quarter has forced a revision higher of US GDP growth by economic forecasters from trend to above-trend growth. However, notwithstanding the string of better-than-expected growth outcomes, forecasters continue to expect a slowdown in US growth to below trend rates in the second half of the year.
In the US, the median growth rate expectations among Bloomberg’s panel of forecasters are for GDP growth to slip to a quarterly annualised pace of 1.3% in the September quarter and 1.5% in the December quarter. Trend growth in the US is around 1.8%.
In the euro area, GDP growth is expected to be at below trend growth rates of around 0.8% and 0.9% qsaar in the June and September quarters, respectively, before returning to above-trend growth of 1.6% qsaar in the December quarter. The other major global economy, China, is expected to see year-ended growth fall from 5.3% in the March quarter to 4.7% in the September and December quarters.
What if the consensus economic outlook proves to be wrong and the global economy continues to outperform expectations? We can conclude with some amount of confidence that it will mean a re-rating higher of interest rates.
But what of equities? The recent (i.e., the last month) negative correlation between interest rates and equities would suggest that the prospect of lower interest rates aligned with a rally in equities and higher interest rates were a catalyst for a sell-off in equities.
As interest rates have been driven by inflation outturns and (incidentally, stronger economic data), good economic news has proven to be bad news for equities. However, if we look over a longer sweep of data, such as the year to date, the correlation between equities and bond yields has been positive.
Year-to-date, the S&P 500 has rallied by around 10%, while US real and nominal 10-year bond yields have risen by 45bps and 60bps, respectively. Is the rally in the equity market over the year, despite the rise in interest rates, just to do with the shift in preference for technology stocks on the back of the exuberance around AI?
It is the case that technology stocks have outperformed over 2024. With the S&P 500, the Communication Services and Information Technology sectors have rallied by 20% and 17%, respectively.
However, the rally in the S&P 500 is broad based with Utilities up 11%, Financials up 10% and Industrials, Energy and Consumer Staples each up around 8%. Only the Consumer Discretionary (-0.1%) and Real Estate (-7.1%) have lost ground over 2024.
What can explain the strong performance of US equities over 2024 in the face of rising interest rates? One need not look further than the performance of the economy, which is reflected in analysts’ expectations of US company earnings.
Currently, IBES 12-month S&P 500 earnings growth is expected to be a very robust 12%. This contrasts to IBES analysts’ estimate of S&P 500 12-month trailing earnings (i.e., actual earnings over the last year) of just 4%.
Hence, if economic growth expectations were to be ratcheted up from here, we would expect an increase in the company earnings outlook to partially, if not fully, offset higher interest rate expectations (as has happened over the course of 2024). If economic growth were to prove weaker than current expectations, we would expect the fall in company earnings expectations to partly, or fully, offset the tailwind to equities from lower interest rate expectations.
Either way, short of a recession on the one hand and a reigniting of inflation on the other, we feel that on the balance of risks, equities will trend sideways over the remainder of the year.