“Nobody said it was easy?“
Coldplay, The Scientist
Last week, we discussed the prospects for a notable pickup in volatility after the equity wobble into last week’s close. We focussed on the ECB meeting, which left the policy rate unchanged and offered a more cautious narrative around the cadence and depth of the European rate cut path - whereby, on the one hand…there was a clear emphasis on the fact that the ECB considers domestic price pressures remain high, services prices remain elevated and that headline inflation is expected to remain above target until well into next year (when labour market balance sees wage pressure easing)… but on the other hand there was also clarity on the fact that risks to economic growth remain on the downside. That credit dynamics remain weak. Investment remains weak. And ultimately that, the path of rates is likely to be lower.
It remains unclear what that means for the magnitude and cadence of the ECB easing cycle. While arguing that they will continue to guide monetary policy driven by (i) the ECB assessment of the inflation outlook, (ii) the dynamics of underlying inflation, and (iii) the strength of policy transmission. In reality, we are more inclined to see the ECB reaction function tied more closely to growth - specifically, growth weakness.
US exceptionalism?
In the US this week, data was relatively scarce. However, the first look at Q2 growth was stronger than expected - around 2.8% q/q annualised. Most of the growth came from real private final domestic demand, suggesting that the consumer remains resilient despite signs of moderation in broader metrics and forward-looking surveys and earnings reports. There were also bigger than expected contributions from inventories and government expenditure that would lead to a less convincing breakdown for the quarter if, as was the case in Q1, consumption ends up being revised significantly lower.
This data may well divide the FOMC, depending on their preconceptions of the growth path and the relative tightness of monetary policy. Glass half full, or half empty.
Equity sentiment
Last week we also discussed the importance of disinflation and the rate-easing cycle on sentiment towards corporate valuations. The Magnificent 7 stocks, for example, are demonstrably cash-generative and have strong (monopolistic) pricing power - thus, a backdrop of rising inflation and high rates is a net positive. Recent de-grossing or rebalancing across countries and sectors, therefore, makes sense against a backdrop of falling inflation and rising rate cut expectations for smaller companies to outperform (companies with lower pricing power and higher relative debts should see outsized relative benefits)
We have argued consistently over recent months that the Fed's sensitivity to weaker growth (higher unemployment) is asymmetric, given that policy is clearly in restrictive territory and inflation has moderated significantly. However, equity market volatility - perhaps to the extent we have seen over recent weeks - can also play a role in creating an asymmetric dovish Fed reaction function.
Macro Tailwinds
If we take a step back from the near-term volatility and position adjustments that have been dominant in markets this week, we would argue that little has changed from a macroeconomic perspective. We continue to see supply and demand rebalancing across the global economy as constructive for continued disinflation and growth moderation (as prices and labour markets normalise and fiscal expansion-driven momentum wanes). Ultimately, continued disinflation and growth moderation should be supportive for Equities and risk assets and negative for the dollar (trough of the dollar smile).
The Long and Short of it
As the Opening Ceremony of the Olympic Games in Paris signals the start of what should be an incredible gathering of the world’s finest athletes, it also likely signals summer holidays for many. Next week, central bank policy meetings will be held at the Bank of Japan, Bank of England, and the Federal Reserve. Markets are pricing 7bps of rate hikes in Japan, 11bps of cuts in the UK, and almost nothing in the US. There may be many interesting events in Paris next week, but financial markets still have a lot to focus on … to quote Coldplay “pulling the puzzles apart”!
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