Investors Club podcast: Big tech earnings and BoJ rate hike (15:48)
CIO FX Strategist Teck-Leng Tan and CIO Equity Strategist Sundeep Gantori join Wayne Gordon and Daisy Tseng to dissect recent big tech earnings and the Bank of Japan's rate hike.

Thought of the day

What happened?

The S&P 500 fell 1.4% on Thursday and the yield on the 10-year US Treasury fell below 4% for the first time since February, as soft US data revived fears that economic growth could weaken too abruptly. The ISM manufacturing survey, which is closely watched by investors, showed activity contracting by the most in eight months. Initial claims for unemployment benefits, meanwhile, climbed to the highest level in almost a year. These signs of weakness came a day before the release of the US July employment report. While the consensus forecast is that the report will continue to point to solid job creation, a marked deterioration could further harm market sentiment.

The risk-off turn in markets comes after a 1.6% rise in the S&P 500 on Wednesday, on renewed enthusiasm among investors about the outlook for AI following more news of rising capital spending from top technology firms. The rally was given further impetus by indications from the Federal Reserve that policymakers have become more confident that the threat from inflation has passed and that a rate cut could be justified at its next meeting in September. However, market moves on Thursday pointed to investor concerns that the US economy is cooling too quickly and may require further support from the Fed. Fed funds futures indicate that three 25-basis-point cuts are now fully priced in for 2024—up from just two at the end of last week. S&P 500 futures pointed to a weak start, with a decline of 0.9%.

What do we think?

The US manufacturing survey data and initial jobless claims were undeniably weak. Investors may also be nervous ahead of the July payroll release today. Based on Thursday’s market moves, it appears investors have pivoted from cheering softer economic data due to the positive implications for inflation, to being concerned that GDP growth will slow too abruptly.

While we will be closely reviewing upcoming economic data, we presently consider recession fears to be premature. The disappointing ISM manufacturing survey data were at odds with the recent strength of industrial production, which rose 0.6% month-over-month in June, and 0.9% m/m in May. The recent GDP release showed the US economy growing by 2.8% y/y in the second quarter, above trend, while the Atlanta Fed's GDP nowcaster is still suggesting a 2.5% pace of growth. Retail sales data for June also topped expectations. At his press conference on 31 July, Fed Chair Jerome Powell indicated that the labor market—though cooling—remained resilient. The consensus forecast is that the US economy generated 175,000 jobs in July, a solid pace of employment growth, with unemployment steady at 4.1%. Additionally, Powell reminded markets that the Fed had plenty of flexibility to support the economy if needed, as rates are at a 23-year-high.

The bottom line is that recent data support our view that the US economy is headed for a soft landing rather than a contraction. In our view, this justifies two 25-basis-point rate cuts this year, rather than the three that the market is now pricing. We would need to see more concrete signs of weakness before shifting our view.

How do we invest?

US equity markets had been enjoying an unusually smooth rally until the middle of July. The S&P 500 had gone more than 350 trading sessions without a drop of more than 2%—the best run in 17 years. A return to higher levels of volatility was to be expected, especially as the Fed approaches the start of a cutting cycle and as investors await guidance from top tech firms on whether their heavy investments in AI are paying off. Meanwhile, political uncertainty remains elevated, especially ahead of the US presidential election in November. We suggest investors brace for renewed volatility but avoid overreacting to short-term shifts in market sentiment.

Against this backdrop, we advise investors to consider several strategies:

Seek quality growth. We believe seeking quality growth should apply broadly to investors’ equity holdings. Recent earnings growth has been largely driven by firms with competitive advantages and exposure to structural drivers that have enabled them to grow and reinvest earnings consistently. We think that trend will continue, and investors should tilt toward quality growth to benefit.

Position for lower rates. The global momentum toward lower rates continued to build on Thursday, with the Bank of England announcing the first cut of its cycle. The Fed also gave its clearest signal yet this week that a cut is on the way. With economic growth and inflation slowing, and central banks starting to cut interest rates, we see significant opportunities in the fixed income market. We believe investors should invest cash and money market holdings in high-quality corporate and government bonds, where we expect price appreciation as markets start to anticipate a deeper rate-cutting cycle. We expect quality bonds to perform well in our base case for a soft economic landing in the US, and even better in the risk case scenario of a recession, helping to cushion weakness in other parts of a portfolio.

Diversify with alternatives. During periods of changing interest rate expectations, equity-bond correlations can rise periodically and hedge funds with low correlations to traditional assets could help reduce portfolio volatility as alternatives fluctuate less. Data for the first quarter of 2024 indicate a turning point is nearing for private equity: valuations seem to have found a bottom and transaction activity, while down in US dollar value, is picking up in deal count. We believe return prospects for private credit remain attractive and anticipate high-single to low-double-digit returns for 2024 but selectivity is vital. That said, investing in alternatives does come with risks, including illiquidity and a lack of transparency.