Markets Weekly podcast – 26 February 2024

Henk Potts (HP): Hello, it’s Monday, 26th February, and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets. My name is Henk Potts, Market Strategist with Barclays Private Bank. Each week, I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider the outlook for equity markets, which have been trading near all-time highs despite what continues to be somewhat of a challenging macroeconomic environment. And, finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Equity markets maintained their impressive upward trajectory last week. The stock markets in Europe and Japan joining their US counterparts by hitting record highs as investors bask in the encouraging earnings season, resilient economic data and expectations of lower interest rates, despite, of course, some caution about the exact timing of cuts.

In terms of equity-market performance, well, the S&P 500 traded comfortably above that 5,000 mark. In fact, the benchmark index jumped 1.7% last week, and was up 5% this month.

In Europe the STOXX 600 rose 1.6% over the week, its biggest weekly advance since July 2023, and is up 8.7% year to date.

Over in Japan, the Nikkei 225 finally registered a record high, surpassing its previous one set back in December 1989. Japanese stocks have been boosted by international demand, the weaker yen and strong gains in corporate earnings, which have helped to offset concerns around the ongoing weakness in the domestic economy.

Now, looking at Japanese equities, our Cross-Asset Class Strategist Dorothée Deck recently highlighted the investment opportunity in the region, saying that, over the long term, Japanese equities look particularly attractive. Cyclically adjusted P/Es are consistent, with total returns of 9.4% over the next 10 years. That’s versus 7.2% for global equities and 3.1% for US equities. That’s the best expected return out of the key regions that we monitor.

However, she points out that Japanese equities performed strongly in 2023 in local-currency terms, driven by that improvement in earnings and P/E valuations, and further upside now looks to be limited. Now, on a one-year view, those valuations don’t seem to compensate for that macro uncertainty and currency risk. Japanese equities, we should remember, are very sensitive to FX moves and potential strengthening of the yen, driven by the Bank of Japan’s intervention. 

Based on forward 12-month P/Es, Japanese equities are trading at a 9% premium to their 10-year average. Their forward dividend yield of 2.2% is also broadly in line with global equities. 

Now, we do know, of course, that earnings have been part of the driving force behind the rally. Last week, the poster child of the AI revolution, chipmaker Nvidia, smashed elevated expectations. Its fourth-quarter revenue jumped 265% compared to a year earlier. To remind you, its share price has surged 400% since 2021. 

Now, beyond the rarified world of Nvidia, the fourth-quarter earnings season has proved to be supportive. Looking at FactSet data last week, it showed the splendid earnings growth rate of the S&P 500 for the fourth quarter is at 3.2%, and a revenue growth rate of 4%.

The European earnings picture, as we know, is less bright, but has been better than expected. The fourth-quarter EPS growth has been negative, with pressure coming from basic resources, energy, and industrials.

Now on the macroeconomic side, investors digested the latest Fed minutes. In recent weeks, rate-cut expectations, as we know, have been pushed down. The latest minutes, I think, added to that evidence as members weigh up activity levels, labour market developments and, of course, the inflation trajectory.

The US economy has been more resilient than expected. Remember, the economy finished the year strongly, with GDP growth of 3.3% in the fourth quarter. And the latest Fed staff projection mentioned that activity was slightly stronger than in December. Now, in terms of the threat of inflation, good progress has been made from the peak. But the January 3.9% headline CPI print did surprise to the upside, due to stronger-than-expected increases in core services inflation. 

Looking at the Barclays inflation forecast, we see US CPI moderating to 2.8% in the fourth quarter of this year. We have it at 2.3% at the end of 2025. What does that mean in terms of the rate-cutting cycle? Well, we think it will start in June. We’ve got three cuts during the course of this year, so June, September and December, followed by four 25-basis point reductions in 2025. That will put the fed funds target range at 4.5% to 4.75% by the end of this year, and at 3.5% to 3.75% at the end of 2025.

Moving on to Europe, where the latest PMI data offered a slightly more optimistic perspective of activity in the region, the euro area flash composite PMI edged up to 48.9 in February. That’s the highest level that we’ve seen in eight months, although we should note that this still represents the ninth consecutive month of falling output.

Manufacturing continues to languish in deep contraction territory. Output in the sector has declined for 11 straight months and, actually, the rate of decline accelerated in February.

Now, on a regional basis, Germany and France continue to contract, while peripheral Europe is starting to show some signs of stabilisation. In contrast to the bleak manufacturing backdrop, there was an up-tick in services output, which recovered to the neutral 50 mark. Services employment has picked up, and new orders are showing a recovery in demand. The report suggests that the eurozone economy is stabilising, but growth is still expected to flatline in the first quarter.

In terms of the UK, well, the PMI there offered a positive surprise to expectations. Flash composite PMI edged up to 53.3 in February, driven by an improvement in manufacturing output and steady services growth. The future output expectations measure was attributed to expectations of a recovery in consumer demand, reduced borrowing costs and a reduction in terms of that squeeze on disposable income. The UK economy now looks to have stopped contracting and has begun to weakly expand, I think, in the first quarter.

So, that was the global economy and financial markets last week. Global equities, as we’ve been talking about, continued to move higher in recent weeks, reaching an all-time high. There seems to be, however, a growing disconnect between equity prices and the current state of the economy. So, I’m pleased to be joined by the aforementioned Dorothée Deck, to discuss this in more detail, starting with the consensus view on the economy.

Dorothée, great to have you with us today. We’ve talking about this great debate in recent months about the impact of the aggressive policy tightening over the course of the past couple of years, and whether or not that would push the economy into recession. Where do we stand today? What is the consensus view amongst economists? And how does that compare with your own expectations?

Dorothée Deck (DD): Hi, Henk. Thanks for having me. So, as you’ll remember, at the start of last year the vast majority of economists expected a recession at some point in 2023. The probability of a recession then was estimated at about 70% in the US, 80% in the eurozone and 90% in the UK. So, a pretty high degree of conviction.

Now, a recession hasn’t materialised, and what’s happened instead is that inflation has come down faster than expected in major economies while growth has remained resilient, and this has allowed the market to become increasingly confident that central banks would cut rates during the course of the year.

Now, some of these expectations have been pared back recently, but interest rates are still expected to come down over the coming months. So, the narrative and the consensus view amongst economists has shifted from the “hard landing” of the economy a year ago to a “soft landing” today.

Now, how does that compare with our own expectation? Well, we continue to expect global growth to moderate over the coming months, mainly due to the lagged impact of higher rates on the economy. We’ve experienced one of the most aggressive policy tightenings in history, and we have yet to see its full impact on the real economy.

So, we see global growth declining from 3.1% in 2023 to 2.8% in 2024, and 2.9% in 2025. We’ve recognised that the risk of an imminent recession has diminished in recent months, as the economy has been more resilient than expected, but we don’t think the risk has fully disappeared. We actually expect some developed market economies, like the eurozone, to flirt with a technical recession in the coming months with growth hovering around 0%, but the risk of a significant contraction appears to be limited at this point.

The UK and Japan did finish the year in a technical recession, or one with two consecutive quarters of negative growth in real GDP, but those declines were relatively contained. So, if we see a recession, we think it will be a shallow one due to the absence of major imbalances in the system, at present.

HP: OK. So, some of the recent economic data releases have been relatively encouraging. Can you expand on that? Is there a chance that we might be too conservative in our current economic forecast?

DD: Absolutely. So, if we look at the most recent data releases, they have surprised positively, especially in the US and the eurozone, where labour market and business surveys have been more resilient than expected. As a result, we’ve seen a significant increase in consensus for US GDP growth forecasts, to 1.6% for 2024 versus only 0.6% back in August. 

Similarly, we are seeing tentative signs that the global manufacturing cycle may be bottoming out. So, after 15 months in contraction territory, the global manufacturing index was back to a level of 50 for January, which is the limit between expansion and contraction. So, of course, it’s still early days and one reading doesn’t make a trend, but that development is worth flagging, because if it is sustained an improvement in the global manufacturing cycle would be positive for risk assets.

So, to answer your question, yes, there is a possibility that we might be too conservative in our forecast and that the US economy continues to grow at a healthy pace and doesn’t land. A “no-landing” scenario is not our base case, but we recognise that there are risks around that view.

HP: OK. Let’s get into the investment strategy element of this. Assuming we are too conservative in our macroeconomic forecast and global growth turns out to be more resilient than expected, what are the prospects for equities, especially given the fact that we’ve already seen this 20% rally globally over the course of the past few months?

DD: Well, that’s an important point, because, as you’ve said, equity markets have already moved quite a long way in a short space of time. So, they are now back to their all-time highs globally, in line with their previous peak of November 2021. So, in that sense, global equity prices already reflect a fairly optimistic macroeconomic outlook. And to use the same landing analogy, global equities appear to be discounting a no-landing scenario where economic activity reaccelerates from current levels and corporate profits rebound sharply. So, that’s at the broad index level.

Now, under the surface, there has been a lot of dispersion in returns lately, and certain areas of the market have lagged in the recent rally. That means that, despite the recent moves, attractive opportunities remain for investors who wish to position portfolios for a continuation of this “Goldilocks” environment. To be clear, for this scenario to play out, you have to believe that we’ll see an immaculate disinflation, where inflation continues to moderate without a significant deterioration in the labour market while growth remains resilient

HP: I’d like to drill down a bit further into some of the detail, if I may. Which areas of the market look best positioned to benefit in a no-landing scenario?

DD: So, historically, the main beneficiaries of an improvement in economic activity have been sectors like chemical companies, auto manufacturers, financial services, basic resources and banks. These sectors have tended to outperform the broader market globally in periods of improving economic momentum. And, in contrast, telecommunications services, consumer staples, utilities and healthcare sectors have tended to underperform by the most.

Now, if we take valuations into account, three sectors actually stand out as being both positively correlated with the business cycle and cheap. That’s autos, basic resources and banks. Those sectors trade at a significant P/E discount to their 10-year average, ranging between 18% and 27% globally.

Similarly, small-cap equities appear well positioned to benefit from a pick-up in the manufacturing cycle, the declining rates and easy credit conditions, and they’re also supported by cheap valuations and depressed sentiment. To be more specific, small caps have underperformed large caps by close to 20% globally in the past three years, and by as much as 25% in Europe and the US. They’re now trading close to their historical lows on a relative basis, at a 3% P/E premium relative to large caps, which is significantly below the 38% premium enjoyed in the past 10 years. 

And the reason why they have underperformed is because they are generally more sensitive to the business cycle and credit conditions relative to large caps, and they have been hurt by the weakness in the manufacturing cycle, higher rates and tighter lending standards. 

In terms of sector composition, small caps are overweight cyclical sectors, such as industrials and materials, and underweight more defensive sectors, such as tech and communication services. Their earnings tend to be more sensitive to changes in rates, as they’re often more highly leveraged and hold a larger proportion of their debt in variable rates.

And, finally, small caps are also more vulnerable to tightening in lending conditions given their heavier reliance on the banking system for their finance needs, while large companies can tap capital markets. So, as those headwinds dissipate, small caps should benefit proportionately more.

HP: OK. We’ve certainly covered a lot of ground today. How would you sum up the key message for investors?

DD: So, to sum up, global equity prices are discounting a much more optimistic macroenvironment than the one we expect. If the market is correct and global growth turns out to be more resilient than we expect, it is still possible to find pockets of the market which have lagged in the recent rally, and would perform well if the no-landing scenario plays out, being mainly small caps, autos, basic resources and banks.

Having said that, the most likely scenario, in our view, is that global growth will continue to decelerate and remain below trend for a while. And, given the level of valuations and positioning at present, this environment would favour a more defensive portfolio positioning, as laid out in our ‘Outlook 2024’.

HP: Well, thank you Dorothée, for your insight today. We appreciate you putting the macroeconomic environment and recent market movements into perspective, and what it means from an investment-strategy standpoint.

Moving on to the week ahead, where the focus this week, I think, will be on the personal income spending and the PCE price index in the US, on Thursday, and the euro area inflation print on Friday.

We expect US personal income to increase three-tenths of 1% month on month in January, led by wage and salary income. We project personal spending to have risen by three-tenths of 1% month on month, stepping down from that robust seven-tenths of 1% month-on-month increase we saw in December, likely owing to a pullback in spending post the holiday-season surge. And we estimate that core PCE accelerated four-tenths of 1% month on month, that’s 2.8% year on year in January, led almost entirely by core services inflation.

In terms of Europe, we expect headline inflation to decelerate to 2.5% year on year in February, and the core reading to moderate to 2.9% year on year. That’s due to base effects and weak momentum.

And with that, I’d like to thank you once again for joining us. I hope you’ve found this update interesting. We will, of course, be back next week with our next instalment, but, for now, may I wish you every success in the trading week ahead.