Equity rebound continues as US inflation eases

What happened?

The rebound in equities has continued over the past 24 hours, with reassuring US producer price data adding to confidence that the Federal Reserve will be able to cut rates swiftly to support the US economy. The data showed wholesale prices rose by a monthly 0.1% in July, lower than the consensus estimate of 0.2%. This reinforced market optimism, as it suggests that inflationary pressures might be easing faster than anticipated.

The S&P 500 rose 1.7% on Tuesday and has now recouped more than half the ground lost since 16 July, when the index reached an all-time high. The retreat in the index from that record high appeared to reflect a combination of technical factors—including the selling of risk assets as some investors unwound yen carry trades—as well as greater concern over the potential for a US recession following weak US jobs data for July. Since the recent low on 5 August, equity market sentiment has been recovering. On Wednesday, Japan's Nikkei 225 index rose 0.6%. S&P 500 futures are flat at the time of writing.

Investor attention will now likely shift to the release of the July consumer price index and retail sales data later in the week for confirmation the US economy is slowing, but not too abruptly.

The VIX index of implied stock volatility, a popular measure of investor anxiety, continued to fall after having hit an intraday high of 65.7 early last week. At below 19, it now stands close to its long-term average. The yield on the 10-year US Treasury fell by around 6 basis points on Tuesday.

What do we think?

During last week’s equity market sell-off, we argued that the unwinding of the yen carry trade was likely to fade and that US recession fears looked premature. The subsequent market performance has underlined our view that investors should avoid overreacting to bouts of volatility, especially during periods of thin summer liquidity.

Of course, further swings are possible. Investors have been responding to data releases that in the past would not move markets—including weekly jobless claims and producer prices.

Markets are likely to remain sensitive to any disappointments from major upcoming releases, such as inflation and retail sales. Investors are particularly on alert for signs that US economic growth is slowing too abruptly and that the Fed has waited too long before cutting rates.

But we continue to expect a soft landing for the US economy, providing a positive backdrop for risk assets.

• The US labor market, while cooling, is still resilient. The weekly initial jobless claims last week provided a reprieve for the markets after the weaker-than-expected labor report for July triggered the sell-off, but less heralded was another encouraging data point: The Fed’s second-quarter household debt and credit report showed that only 3.2% of all debt is in some stage of delinquency, unchanged from the first quarter and a very low rate historically. This reinforces our view that the labor market and consumer spending should remain resilient as they cool down gradually. On Tuesday, a survey from the National Federation of Independent Businesses (NFIB) pointed to the highest confidence among small firms since early 2022.
• Investor positioning could turn into a tailwind. The unwinding of carry trades appears to be largely done, according to data from the US Commodity Futures Trading Commission. As of 6 August, leveraged funds’ Japanese yen positions shrank to the smallest net short stance since February 2023, with a net short position of 24,158 contracts; it was about 70,000 contracts in the previous week. There are now reports of hedge funds adding new long positions in stocks, with their overall net equity leverage back to multi-year average levels. Retail investors have also been buying the dip, with large inflows into ETFs in July and so far in August. Finally, corporate buybacks should soon ramp up as earnings season wraps up.
• Earnings are on track to grow at a healthy rate this year. Companies that represent more than 85% of the S&P 500 market capitalization have now reported their second-quarter earnings, and we maintain our forecast for an 11% earnings increase for 2024 overall. Seventy-five percent of companies have beaten earnings estimates, and nearly 60% have beaten sales estimates, in line with historical averages. Guidance for the September quarter has been decent, with revisions mostly in line with normal seasonal patterns. We also see no slowdown in AI spending, with monetization still picking up.

How do we invest?

A range of risks to markets remain. We believe investors will be hoping for inflation and retail sales releases that are neither too strong nor too weak. Geopolitical tensions have also been heating up: The US is reinforcing its military presence in the Middle East ahead of an anticipated Iranian attack on Israel, and the war between Russia and Ukraine is intensifying.

However, with economic and earnings fundamentals still good and the Fed likely to cut interest rates, our base-case scenario is for the S&P 500 to end the year around 5,900 and reach 6,200 by June 2025, versus around 5,434 at present.

Against this backdrop, we advise investors to:

Position for lower rates. With evidence that inflation is coming under control, the Fed should be freer to focus more on supporting jobs and growth. Our base case is now that the Fed will front-load rate cuts, with 100 basis points of easing in 2024. This is part of a broader global rate-cutting cycle for which we have been advising investors to prepare. As returns on cash are eroded, we think investors should consider investing cash and money market holdings into high-quality corporate and government bonds as well as diversified fixed income portfolios. These assets have recently shown their value, cushioning volatility in equity markets.

Seek quality growth. We believe quality growth is an appealing equity strategy, especially in periods of heightened volatility and amid fears of slowing economic growth. 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 expect quality growth to outperform, particularly if cyclical concerns mount.

Diversify with alternatives. With the potential for increased volatility from upcoming economic data releases, we view alternatives as a strategic source of diversification and risk-adjusted returns. Hedge funds not only have the potential to help stabilize portfolios during times of stress but can also take advantage of dislocations and generate attractive returns when other asset classes may struggle. Investing in alternatives does come with risks, including around illiquidity and a lack of transparency.