On May 4, Fed finally gave a dovish meeting statement after the May FOMC meeting. The statement said outright that it will decide which "additional policy firming" may be appropriate based on data, rather than decide the magnitude of rate hikes based on data.
It implies that the current cycle of 500 bps rate hikes may probably hit the pause button. Market implied fed fund rate, which went down by about 20 basis points after the meeting.
Source: CNBC
Although Powell did not explicitly say in press conference that he would not raise rates thereafter, and that it was not time to discuss a rate cut, we believe that the market's focus will change from how high to how long thereafter.
Let's review the performance of major global asset classes and strategies in the last month.
I. Asset Performance Review in April
1. Major asset returns
Source: Bloomberg, data time period: 2023/4/1-2023/4/30
Since April, stock indices and bonds have outperformed in Europe and the US amid falling inflation and a pending recession, except for the Russell 2000 Small Cap Index, which continues to be affected by the small and mid-sized bank crisis.
Greater China equity indices have been relatively weak. China's real estate sales data fell back. The Politburo meeting at the end of the month pointed out that the endogenous momentum of the economic recovery is still insufficient, depressing the performance of equities.
It also caused a sharp fall in industrial metals, which are closely linked to the demand for China's economic recovery. Gold, $Gold - main 2306(GCmain)$ on the other hand, benefited from the bank crisis and the resurgence of the U.S. Treasury ceiling issue, breaking $2,000 and continued to move upward.
2. Major strategies’ gains
Source: Bloomberg, data time period: 2023/4/1-2023/4/30
In terms of strategies, JP Morgan Global Macro strategy continued to perform solidly, while the Equity Neutral closed slightly negative.
II. Market Interpretation
1. Who is right: Fed or the interest rate market?
In a press conference following the May FOMC meeting, Powell noted that the economic forecasts of Fed officials, in general, point to a shallow recession with a lower level of rising unemployment than the historical average.
The reason is that there is still a large amount of unmet hiring demand in the labor market. The unemployment rate does not rise even though job openings have declined (the latest April nonfarm payrolls report showed the unemployment rate slipping again to a record low of 3.4%). All of these are historically unprecedented.
Therefore, Powell believes that the US economy will achieve modest growth this year. Based on this logic, Fed will not cut interest rates this year until inflation returns to about 2%.
However, both Fed Funds Futures and OIS traders are pricing in a rate cut to about 4.3% by the end of this year, which means the Fed Fund Rate will be about 75 basis points lower than it is now.
Source: Bloomberg
Meanwhile, US 10 Yr and 3 Mth Treasuries are already deeply inverted, while the degree of inversion between the US 10 Yr and 2 Yr Treasuries is narrowing. It suggests that the interest rate market has priced in an imminent US recession. Historically, the US economy has fallen into recession within two years under the same circumstances.
Source: Bloomberg
Who is right: Fed or interest rate market? We think the Fed is right, at least in terms of short-term data.
ISM manufacturing PMI, which reflects the level of manufacturing boom among large U.S. companies, began to rebound in April. The price subcomponents increased the most, new orders increased and inventories fell, and the employment prosperity also surpassed the key 50, all of which indicate that the U.S. manufacturing boom rebounded.
Source: Bloomberg
Markit PMI, which reflects the sentiment of US small and medium-sized businesses, has returned to above the 50 mark for both manufacturing and services.
Source: Bloomberg
Overall credit growth in the US has indeed stalled amid the banking storm, but the total remains at a high level. US commercial bank assets loans & leases Real Estate SA (blue line, left axis) and US commercial bank assets loans & leases Consumer SA (orange line, right axis) are both at new highs, while US commercial bank assets loans & leases Commercial & Industrial SA (white line) have declined.
Source: Bloomberg
The central contradiction between the Fed's judgment and interest rate market pricing is that there is a transmission lag in the impact of the benchmark interest rate on the economy. The impact of a high interest rate environment on real economic demand often takes at least six months to manifest itself more clearly. In other words, interest rate market pricing recessions are designed to anticipate what will happen at the end of the year. And the Fed's decision at the moment, is based on current data.
The question is when macroeconomic data will support the Fed's pivot. When will the turning point, such as the end of November 21, when Powell abandoned the words of "temporary theory of inflation". come? This will ultimately shift the economic cycle from stagflation to recession.
2. Net Interest Margin (NIM) of US Banks Further Shrinks, Potentially Marking a Turning Point For Recession
The impact of a high interest rate environment on the economy first manifests in the elimination of the irrational prosperity that emerged during the era of zero interest rates and excessive liquidity. The expansion of balance sheets of small and medium-sized banks, small and mid-cap growth stocks who are heavily reliant on financing from private equity (PE), as well as commercial real estate highly sensitive to interest rates, are the weakest links in a high interest rate environment.
According to barrel theory, the length of weak links in the US economy is what we need to focus on, which largely depends on how fast the NIM of US banks is shrinking.
As we pointed out in Q1 Review: Where Are Opportunities After Bank Crisis & OPEC Production Cut?, the quantity problem in the US banking crisis has temporarily been resolved, but the price problem (shrinkage of NIM) is likely to continue deteriorating.
The core reason is that the interest rates banks can offer on deposits are much lower than market rates. As of April 17th, the average interest rate for US bank savings accounts was only 0.39%, which is 4.5% lower than the market rate for the same period! No wonder even $Apple(AAPL)$ has launched the Apple Savings Account (click to learn more: Apple Launched 4.15% APY Account? But Tiger Vault Offers a 4.81% Yield!).
Source: Bloomberg
The narrowing of net interest rate spreads for US banks is inevitable. This is because the rising cost of deposits on their liability side is almost inevitable, while the amount of credit on their asset side has much more room for downside than upside as borrowing demand decreases in a high interest rate environment. However, in the latest earnings information, the interpretation and outlook of major banks on net interest margin are ambiguous, for example:
JPMorgan Chase expects net interest income to increase from $7.4 billion to $8.1 billion in FY2023 due to reduced pressure on deposit costs if Fed cuts interest rates before the end of the year. However, the baseline assumption in its FY2023 outlook is for moderate deposit outflows throughout the year.
Citi sees its net interest income increasing due to higher credit card balances.
……
Only large regional bank PNC Bank directly pointed out in its financial report that its net interest margin had decreased by 8 basis points, as its interest-bearing deposit costs increased by 59 basis points year-on-year to 1.66%.
According to Refinitive data, among the 603 US stocks with a market value of more than $1 billion in the GICS second-level industry classification as banks, 54 are expected to see a net interest margin decline of more than 10% in the next year.
We believe that narrowing the net interest margin is is a long and painful process for the US financial system. As more small and medium-sized banks are on the verge of bankruptcy, the overall credit tightening of the US economy will accelerate, eventually forcing the Federal Reserve to pivot to rate cuts, and the economic cycle will fall into a recession.
3. Most US companies exceeded expectations during the earnings season
However, the performance of most companies in the latest earnings season of the US stock market was quite impressive, and there is no sign of a recession yet.
According to Credit Suisse's statistics, as of May 5th, 420 companies in the $S&P 500(.SPX)$ have announced their latest earnings, of which 74% have exceeded expectations, with an average surprise rate of 7.1%, which is much higher than the 4.2% in the past five quarters.
Among the primary industries of the US stock market, the consumer discretionary sector, with $Amazon.com(AMZN)$ as the largest weight, has contributed the most to earnings beating expectations this season.
Source: Credit Suisse
Although the EPS of the 420 S&P 500 component companies that have reported earnings is still down 2.4% year-on-year, Wall Street analysts have raised their earnings forecasts for the S&P 500 by the end of 2023, which supports further rebound in the US stock market from the fundamentals.
Source: Refinitiv
III. Conclusion
As the current round of rate hikes by Fed is coming to an end, the market's focus has gradually shifted from funding to macroeconomic data and corporate earnings.
In the short term, as US macroeconomic data is still positive and recent earnings season results are pleasing, and the issue of narrowing bank interest rate spreads will take time to further ferment.
We believe that the market risk appetite will further increase in the short term, and the recession expectations priced in by the interest rate market may be revised, so high-quality assets in the US stock market, such as tech stocks with a certain earnings model and energy stocks, are expected to rise further, or even experience a melt-up.
In the medium term, we will closely monitor data from various dimensions, pay attention to the process of narrowing net interest margins of US banks and the impact of resulting credit tightening on the economy, and adjust the weight of asset allocation accordingly.
Allocation suggestion: 30% money market funds + 20% US tech stocks (including AI concepts) + 20% US oil and gas stocks + 20% Greater China stocks + 10% gold
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