US stock markets have been flying high over the last month on the back of encouraging US inflation news and expectations for a more dovish policy from the US Federal Reserve. Europe, by contrast, is seeing stubbornly high inflation and a muted economic recovery, causing equity market performance there to lag. China is facing challenges, too.
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The latest rally in US growth stocks kicked off in June when US core inflation for May came in at just 2% (month-on-month annualised). This was a sharp drop from the 3.5%-4.5% rate at the beginning of the year.
It was such a surprising decline that it seemed prudent for investors to wait and see if inflation remained at its new – cooler – level or would jump back up again. Confirmation was needed before concluding that the inflation worries were indeed behind us.
The latest pleasant surprise for US equity markets was that June’s number was even lower than May’s at just 0.8% (see Exhibit 1). Examining the details, goods inflation was negative, as was services inflation excluding shelter. Even the rate of shelter inflation was less than half the rate at the beginning of the year.
Growth stocks again jumped on the news and the odds of the Fed cutting rates in September rose.
Investor enthusiasm waned slightly, however, with the start of the latest US earnings reporting season and the first reports from the large banks. Some results showed a decline in net income, which disappointed the market.
Expectations for the remaining companies are nonetheless positive and we would anticipate another quarter of better-than-expected results.
Europe still struggles with inflation
In contrast to the inflation slowdown in the US, the eurozone is struggling with persistently higher inflation. On a month-on-month basis, core inflation has been at 4% or higher for the last three months, leading to an increase in the year-on-year rate (see Exhibit 1). Whether the ECB can continue to cut policy rates will depend on whether this trend changes.
There is an additional worry for the ECB. While the economic recovery in the region continues, it is losing momentum.
Services sector purchasing managers’ indices (PMIs) for the largest economies were mostly above 50 (indicating expansion), but they were at a lower level than in May. The manufacturing sector was far weaker, with three out of four countries posting PMIs below 50 (indicating contraction). For most countries, these PMI were below the levels seen in May (see Exhibit 2).
The performance of European equity markets has reflected this murky outlook: the MSCI Europe index has risen by just 1% since the end of May through 12 July (total return in local currency), compared to a 7% gain in the S&P 500.
China looking for new sources of growth
China is also facing challenges. The latest data showed the economy expanding in real terms at just 2.8% quarter-on-quarter at a seasonally adjusted annual rate (see Exhibit 3). This is well below Beijing’s 5% target for this year.
Growth – such as it is – is coming from exports rather than domestic demand. Retail sales have disappointed, the troubled property market is still dragging on investment, and the ‘credit impulse’ has been negative for two quarters in a row.
Whether exports can continue to drive growth by as much as it is currently is questionable. With trade barriers rising not just in the US, but also in Europe and some emerging markets, China will need to find other sources of growth.
With the country’s third plenum policymaking meeting beginning, investors are anticipating further stimulus measures.
Our view is that these are likely to fall short of the kind of ‘big bang’ measures that would be needed to return China’s GDP growth to the rates seen before the pandemic.
