Investors have interpreted most recent data releases as supportive of a positive outlook for the US economy, but there are risks ahead.
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Markets are keeping the extra interest rate cut by the US Federal Reserve (Fed) they priced in after the shock – downward – revision to US non-farm payrolls data at the start of the month (see Exhibit 1).
Though labour market data is typically considered a lagging indicator, the low level of job creation appears sufficient to convince investors that the Fed needs to lower rates, and soon. The probabilities of a rate cut at September’s meeting of the Federal Open Market Committee (FOMC) are currently 83%, according to the CME’s FedWatch.
Signs of inflation do exist
One reason such expectations remain is that July’s consumer price index data was interpreted (incorrectly) as showing that inflationary pressures had remained subdued, with little evidence of price gains due to the US import tariffs.
Most headlines highlighted that monthly core goods inflation increased from just 2.4% in June to 2.5% in July (at an annualised rate), but this overlooked several factors.
While goods inflation was contained, services inflation was not. Core services prices excluding shelter rose at a 5.9% annualised monthly rate (see Exhibit 2), reversing the downward trend from earlier in the year and suggesting the Fed needs to remain vigilant.
The modest increase in core goods inflation was primarily the result of a big fall in the prices of information tech commodities such as computers and smartphones, which had dropped at a 15% annualised rate in July. If this decline were excluded, core goods prices would have risen at 3.2% annualised.
These signs of stronger inflationary pressures were mirrored in the producer price index, which showed a much higher-than-expected 0.9% gain in July. Markets had expected a rise by just 0.2% after a zero reading in June.
One hopes the market’s confidence about the benign outlook for inflation is warranted, but thinking about potential negative catalysts, an inflation surprise from August’s CPI report should be near the top of the list.
US consumers are resilient, Chinese reticent
While goods prices may be rising, there is little sign that this is distressing US consumers.
Core retail sales rose by 0.5% in July (month-on-month, seasonally adjusted). The gain was not simply due to higher prices. Real (inflation-adjusted) retail sales rose by 0.3% in July. June’s figure was revised upwards, indicating consumers are buying more alongside paying (a bit) more.
In contrast to the robust US data, retail sales in China contracted in July – the third month out of the last four that this has occurred. Sales growth in the one positive month – May – was the result of government stimulus programmes, and the subsequent reversal illustrates the ongoing lacklustre demand and poor sentiment faced by the regime.
Small is beautiful
One can see the impact of the most recent earnings season and the latest tariff news on the performance of the main equity indices. Those coming out on top are technology (both in the US and in emerging markets), Japan, and certain small-cap indices. At the bottom are European equities, US value stocks, and non-tech emerging markets.
The drivers for technology stocks are well-known, but the outperformance of small-cap equities is less clear cut. In the US, they have chronically lagged the broad S&P 500, but this has been due to the strong returns of the tech parts of the index — almost no major market has outperformed the tech-heavy NASDAQ 100 index over the last several months.
However, compared to the rest of the S&P 500, which can be proxied by the Russell 1000 Value index, the Russell 2000 index of small-cap companies has outperformed by more than 9% after the post-‘Liberation Day’ lows in April (see Exhibit 3).
As said, US consumers have remained resilient in the face of tariffs on imported goods – the impact so far on pocketbooks of higher goods prices has anyway been small. Also, the unemployment rate has been low, and consumer confidence has been recovering.
Large-cap companies are likely paying a greater share of tariff costs (be it on finished goods or production inputs) than small caps. The administration’s higher-than-expected tariffs are leading to more investment in manufacturing capacity in the US, which should provide a boost to smaller companies.
The dynamic in Europe is somewhat different.
Large European companies face the challenges of high US import tariffs and a strong euro. Much of the anticipated boost for the region from higher defence and infrastructure spending has already been priced into large-cap equity prices, resulting in above-average price-earnings ratios: the z-score for the forward price/earnings ratio is currently 0.2.
By contrast, small-cap valuations are below average, with a z-score of -0.3. As in the US, consumer demand has remained strong, with retail sales rising faster than in the US and European consumers face no drag from tariffs.
