The political standoff over the debt ceiling had been holding back stocks over recent weeks, raising concerns over the risk of an unprecedented debt default. The relief rally on Thursday at one stage took the gains for the S&P 500 so far this year to over 10%.
Markets were also cheered by further indications from top Federal Reserve officials that there might be a pause in rate hikes at the central bank’s policy meeting later this month. Philadelphia Fed President Patrick Harker said that “we should at least skip this (June) meeting in terms of an increase” and that “we are close to the point where we can= hold rates in place.” Finally, global investors appeared to take some comfort from a larger-than-expected fall in Eurozone inflation for May.
But we still think the risk-reward balance for equities remains unfavorable, especially in the US.
The strength of the US labor market, along with stubbornly high inflation, do not yet justify a final end to the Fed’s rate hiking cycle. Investors are awaiting the US jobs report for May, which is released today. The consensus forecast among economists is that around 200,000 jobs were created over the month, with unemployment rising only a tenth of a percentage point from a recent 53-year low of 3.4%. It is worth noting that the initial payroll release has been stronger than expectations for the last 13 months in a row.
Another strong release would be in line with recent evidence that the US jobs market remains too hot for comfort from a monetary policy perspective. Job openings climbed again in April, after three consecutive monthly declines. In addition, the ADP’s report of private payrolls rose by 278,000 in May, which was above every economist’s forecast on Bloomberg.
Comments from Fed officials continue to fuel market uncertainty. While fed funds futures now only imply a roughly 20% chance of a rate hike at the 14 June meeting, down from around 70% this time last week, markets continue to price in a strong chance of one further hike at some point in the coming months. Some Fed officials continue to hint at the need for further tightening. St Louis Fed President James Bullard published an updated analysis suggesting that policy rates are “now at the low end of what is arguably sufficiently restrictive.”
So, even if the Fed keeps rates on hold at its June meeting, officials could signal they are probably not yet finished hiking through the dot plot—which charts the rate expectations of committee members.
The US equity market rally looks vulnerable—both due to its narrowness and elevated valuations. Equity gains continue to be driven by a small coterie of tech stocks. The FANG+ index, which tracks the 10 most traded tech companies in the US, was up 2% on Thursday, taking its gain for the year to 64.4%. By contrast, an equal-weighted version of the S&P 500, which dilutes the impact of these mega cap tech stocks, is down 0.7% so far in 2023, compared to a more than 9% gain for the standard S&P 500 index. Such narrow rallies have historically been less sustainable.
Meanwhile, the broad S&P 500 index trades on 18.5 times the next 12-month forecast earnings, a roughly 15% premium to its 10-year average. Valuations in the tech sector look especially stretched in our view, with the MSCI All Country World tech index now at a 25% premium to its decade average.
So, we continue to believe the recent US equity rally is unlikely to be sustained. We continue to prefer bonds to equities in our global strategy, favoring defensive, higher-quality segments of fixed income, as they offer both attractive absolute yields and a hedge against growth and financial stability risks.
Main contributors - Solita Marcelli, Mark Haefele, Christopher Swann, Linda Mazziotta, Jon Gordon
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