Cycle Capital: The European Central Bank will cut interest rates. Will the US stock market be closer to a general rise?

Author: Cycle Capital Research

This week's data before the release of GDP on Thursday and PCE on Friday were relatively mixed. Compared with the heavyweight first-quarter GDP revisions and April PCE data, the core PCE, an inflation indicator that the Fed values, grew by 0.2% month-on-month, lower than the expected 0.3%. The unrounded value was 0.249%, so it was rounded down to 0.2%. Although it was still lower than the previous value of 0.317%, such a coincidental number made people doubt the possibility of data manipulation, and the actual decline was less than 0.1 percentage point. Such data basically would not change the Fed's view on inflation, so the market fell after a brief rise.

The core PCE 6-month annualized rate fell below 2% at the end of last year, which was also the time when the market was most optimistic. The past four months have been the first major setback in this round of inflation decline:

The U.S. Q1 economy grew by 1.3% month-on-month, announced a day earlier, which was a significant slowdown from 3.4% at the end of last year and the initial value of 1.6%. The growth of personal consumption expenditures (PCE), the main economic growth engine, slowed down more than expected to 2.0% in the first quarter, with an initial value of 2.5%. Personal spending increased by only 0.2% month-on-month, real spending fell by 0.1%, and spending on goods fell by 0.4%, consistent with weak retail sales in April.

Most of the economic data in the past month are negative, which is theoretically a good environment for current risk assets:

More and more data recently point to a slowdown in US consumer momentum. The current moderate growth in overall spending is supported by travel and entertainment projects, while all but insurance spending have slowed down, and the growth of rent payments has also slowed down across the board. Bank of America's CEO said in a speech last week that U.S. consumer spending through credit card payments, checks and ATM withdrawals has grown by about 3.5% this year, a significant slowdown from the growth rate of nearly 10% in the same period of May 2023. "Whether it is households or small and medium-sized businesses, these important customers of Bank of America are slowing down their purchases of everything from hard goods to software." (But spending growth in the eurozone, the UK and Canada is starting to improve)

Secondary market yields continued to fall on Thursday and Friday, but the cryptocurrency market lacked momentum and failed to form an inverse linkage. The correlation between Bitcoin and secondary interest rates has declined recently:

Stocks fell briefly after the PCE data on Friday, but quickly pulled back, showing that the stock market's strong momentum remains unchanged. However, among technology stocks, performance was differentiated, with Amazon, Microsoft and Google performing poorly, and only NV had a significant increase. As shown in the figure below, after the rebound on Thursday and Friday, the S&P 500 fell only 0.36% for the whole week, while the Nasdaq 100 fell 1.58% and the FANG+ index fell 2.94%. The software industry ushered in the worst earnings season in history, causing the overall decline of the technology stock index. The most eye-catching thing was that the cloud software giant Saleforce's quarterly revenue fell short of expectations for the first time in 18 years, and its guidance for this fiscal year was also inferior. The stock price plummeted by 20%, the largest daily decline in nearly 20 years, leading the drag on the stock index. Some analysts pointed out that the market style may switch in the future, and technology stock investment may become a "painful transaction."

Bloomberg analysis believes that the revenue of few software companies is currently boosted by AI. Although the software industry will eventually benefit from AI, it may take several years to establish it, and the performance improvement in the second half of this year is no longer expected. Some analysts also believe that the current sharp correction of software stocks provides investors with a good opportunity. Bernstein analysts believe that leading companies with higher profit certainty such as ServiceNow are more valuable for investment after the valuation is repaired. As funds' exposure to semiconductor stocks increased, net software exposure reached its lowest level in five years:

As funds' exposure to semiconductor stocks increased, net software exposure reached its lowest level in five years:

The US 2-year yield fell from a high of 5% to 4.88%, and the US10Y fell from 4.64% to 4.5%. The Fed minutes a week earlier pushed secondary market interest rates to a one-month high. Fed Chairman Powell vowed at a press conference after the meeting that the Fed's next move was unlikely to be a rate hike. However, the details of the meeting minutes revealed that Powell's "dovish" statement at the time may have largely overshadowed the voices of hawkish officials.

ECB and European stocks

Due to stubborn inflation in the euro zone's service sector, CPI rebounded to 2.6% year-on-year in May from 2.4% in April, exceeding market expectations of 2.5%, causing Germany's 10-year government bonds to hit a new high since November last week. Although higher-than-expected inflation is unlikely to prevent the ECB from cutting interest rates this week, it may give the ECB more reasons to suspend interest rate cuts in July and slow down the pace of interest rate cuts in the coming months. (In addition to the ECB, the Bank of Canada will also cut interest rates this week, and the Bank of England is expected to cut interest rates in August)

Lower interest rates and rising economic activity are the best environment for stock markets to perform well. The eurozone economy has escaped five consecutive quarters of stagnation. Economists expect Europe's GDP to grow positively this year and next (+0.8%, +1.4%). If the momentum can be maintained, the outlook for European stocks is optimistic, especially when interest rates in Europe are cut earlier/more than in the United States. Figure 3:

Goldman Sachs believes that in the case of improved activity, the utilities and real estate sectors, which are usually sensitive to interest rates, will not benefit so much from the rate cut. Instead, small-cap stocks and companies with weaker balance sheets will benefit more:

The valuations of European stocks in major global markets are relatively low compared to history:

Swings in the rate cut

The decline in yields in the United States is accompanied by an increase in expectations for rate cuts, which are expected to rise to 36bp this year, just under 1.5 times, and 76bp about 3 times next year. Comments from Fed officials show that a July rate cut may require a significant improvement in inflation figures and a significant weakening of labor market data in the next two months.

Currently, the market is quite divided and no unified view has been formed, so the amplitude of the pricing swing will still be large, ranging from 0 to 4 times, and the overall rightward bias will be larger. For example, Bank of America expects to cut interest rates only once in December this year, while Goldman Sachs expects to cut interest rates twice starting in September.

PCE needs to maintain a month-on-month growth rate of 0.2 or lower, and the year-on-year figure is expected to decline only in the fall:

In the face of the recent rebound in prices, the level of monetary policy dovishness in emerging market countries, which is usually used as a leading indicator, has declined:

NV receives a little challenge

Affected by the news that the United States is conducting a national security review of the development of artificial intelligence in the Middle East and may slow down the issuance of export licenses for chips to the Middle East, chip stocks such as NV and AMD fell at one point, but NV and AMD still closed up 4.9% and 3.6% respectively for the week. It is not clear how long this review will last, nor is it clear what counts as "large-scale exports."

In addition, UBS pointed out in its latest report that Nvidia may have a "VVVVIP" customer, and this mysterious customer contributed 19% of Nvidia's total revenue in fiscal 2024. UBS speculates that this customer may be Microsoft. Such highly concentrated revenue has caused market concerns and poured some cold water on NV's rise (but not much). NV's stock price has risen 130% so far this year, with a market value of more than $2.7 trillion, just one step away from Apple (although its revenue is expected to be only one-third of Apple's this year). However, NV's biggest positives recently are the stock split and inclusion in the Dow Jones Industrial Average, both of which usually bring considerable buying, and it is difficult to see NV falling significantly before they happen.

In China

The Hang Seng Index fell 2.8%, and the CSI 300 fell 0.7%. TH Junyan, PMI unexpectedly fell to the contraction range, and the general decline in domestic and foreign demand was the main negative news.

However, risks related to real estate have eased in recent weeks due to more policy easing and support:

About 90% of Chinese companies have reported 1Q24 earnings, with overall earnings growing 0 year-on-year, but the market expected a 20% increase for the full year, and there seems to be a huge gap between the actual data and expectations

Fund Flows and Positions

Global stock and bond funds saw modest inflows in the week ended May 29.

• Equity Funds: Global equity funds had positive net inflows (+$2 billion), down from the previous week (+$10 billion). The US saw small inflows, while other G10 regions were mostly negative.

• Bond Funds: Global fixed income fund inflows slowed, with lower inflows into government, IG credit and high yield bond funds.

• Sector Flows: Technology funds attracted the largest inflows. Most sector funds, with the exception of technology and industrial funds, have seen net outflows year to date. Hedge funds and mutual funds have continued to increase their exposure to stocks this year, with hedge fund net leverage approaching its highest level in the past year and mutual fund cash balances falling to a historic low of only 1.4%:

Hedge funds and mutual funds have continued to increase their exposure to stocks this year, with hedge fund net leverage approaching its highest level in the past year and mutual fund cash balances falling to a historic low of only 1.4%: