The Month Ahead

US equity markets made gains in July, although there was clear divergence in their performance – indicating a market rotation is underway. For once it wasn’t the mega cap technology names making waves. As of 23 July, the NASDAQ 100 Index and the S&P 500 Index are up 0.7% and 1.8% respectively, but it’s the small cap-biased Russell 2000 Index and the cyclical-biased Dow Jones Index which have made the biggest gains, up 9.6% and 3.3%.

The rotation out of technology names and into small cap and cyclical names began mid-July, when June’s US inflation report showed the lowest level of inflation in the US for three years. With annual inflation creeping ever closer to the central bank’s 2% target level, and the month-on-month reading showing an actual fall in prices, it was seen as a sign of possible Federal Reserve (the Fed) cuts ahead.

European equities clawed back some of their losses from June, following elections in France and the UK. A late scramble for votes in a second round of polling saw no clear winner in France’s election, but the CAC 40 Index is 1.7% higher. Meanwhile, it was a landslide victory for Keir Starmer, the leader of the Labour Party in the UK, although the FTSE 100 Index is broadly unchanged over the month.

Following a period of underperformance from New Zealand equities, the NZX 50 Index is up 6.0%. While recent data paints a bleak outlook for the economy, the prospect of rate cuts from the Reserve Bank of New Zealand (RBNZ) is boosting the performance of local companies.

Global government bond markets were mostly higher, as inflation data showed that central banks are winning in their fight against price increases. In the US, bonds reacted positively when Jerome Powell, chair of the Fed, said the bank wasn’t necessarily going to wait for inflation to hit its target before cutting rates.

As we head into August, the same key drivers remain front-and-centre, namely inflation and central bank policy. Things are also heating up on the US political front.

Late in July and early in August, we’ll see key central bankers in the US, Japan, UK, Australia and New Zealand meeting to discuss and set monetary policy in their respective economies. While we’ve seen good progress on the inflation front in the US, the Fed is expected to leave interest rates on hold. While Powell acknowledged the idea that central bank policy works with “long and variable lags”, he reiterated the bank’s view that it’s looking for “greater confidence” in inflation returning to its target level before cutting rates. It’s for this reason that most investors are focused on the Fed’s September meeting for a potential cut, giving the bank another couple of months of inflation readings – and economic data.

Where we are most likely to see a move is at the Bank of England, but even then, it’s not a done deal. Annual inflation there fell back to the bank’s 2% target in May, but inflation remains sticky, with June’s reading remaining at this level. While the pressure is on to deliver cuts, the bank has said it’ll only cut interest rates once it’s confident inflation will remain under control. The bad news is that core inflation (which excludes food and energy prices) remains at 3.5%, and wages are growing at a much faster rate than the headline rate of inflation.

Australia and Japan are the only major banks where there’s a risk of higher interest rates. Japan has only just begun raising rates following years of deflation, while Australia’s Reserve Bank may have no choice but to resume rate hikes. Annual inflation there jumped to 4% in May, well up on its 3.4% in February. Before it meets however, members will have June’s inflation data to ponder over.

Over the past few months, we have seen a significant downturn in New Zealand economic data. Unemployment has risen for four straight quarters and is expected to have risen again in the second quarter when Stats New Zealand releases the latest employment report on 7 August. The growth situation is also benign. While GDP data for the first quarter moved back into positive territory (+0.2%), of concern is that GDP per capita fell 0.3%, its sixth straight quarterly decline, which suggests the country is suffering from a productivity slump.

Adding to the pressure for cuts has been the slump in the retail sector. Retail sales have declined in eight of the last nine quarters, while the Companies Office reported 629 liquidator appointments in the second quarter of this year, 36% higher than the same period last year.

While most market participants, including us, expect the timing of the first RBNZ rate cut to be at November’s meeting, it might not be too big a surprise if it came at its next meeting – on 14 August – given the challenges being faced by businesses and households at present.

In July, Former President Donald Trump accepted the Republican Party’s presidential nomination for November’s election. But it now looks as though he’ll be facing off against Kamala Harris – with Joe Biden officially stepping out of the race. While Harris is still to receive an official nomination, she’s clearly the front-runner, with current President Biden throwing his weight behind her and few others in the Democratic Party looking as though they’ll challenge her.

It certainly puts the spotlight back on the political arena and has thrown open the race for the White House. Markets have had a bit of a run up given the prospect of a Trump victory, especially following the recent assassination attempt - which many believed bolstered the chances of seeing Trump back in office for a second term. It partly caused energy, financial and raw material stocks to rally, and big technology stocks to sell off. Harris being in the race has certainly injected an element of uncertainty, and we’ve seen a slight reversal in these trades. As we head into August, the immediate focus for markets will be on whether she can secure her nomination, understanding what her key policies are and whether she can give Trump a run for his money.

In recent times we have been defensively positioned, with an underweight to international equities and an overweight to domestic and international fixed interest. Since publishing our last Month Ahead, we have added to our domestic fixed interest overweight, reflecting our view that the New Zealand economy will be weaker than expected, and could prompt the RBNZ to cut interest rates sooner. If rate cuts do come early, it’s a scenario in which bonds should outperform, and our overweight position would be of benefit.

We have also taken our underweight to international equities back to a neutral position. We had been of the view that growth would slow and eventually tip the world’s economies into recession. However, we now believe the probability of this has diminished, given further signs of an easing in inflation rates, still-robust employment data in some of the major economies and expectations of strong earnings growth for many companies in upcoming reporting seasons. This should be more supportive of international equities going forward, and so have removed our underweight position.