Risk assets have cheered the end of the US debt ceiling drama, turning their focus to seemingly resilient Developed Market growth and hopes of new policy stimulus in China. The S&P500 index, after several false bear market rallies, has broken above key resistance. Are we in for a sustained bull market?
While the narrow Artificial Intelligence (AI)-related technology sector ‘mania’ – seen in the outperformance of the market-weighted vs. the equal-weighted S&P500 index – could last longer (how does one estimate how long a ‘mania’ will last!), Standard Chartered market view by Rajat Bhattacharya said the bank remains sceptical about the sustainability of the broader market rally, given leading indicators are still pointing towards a US recession. If anything, the past week’s weaker-than-expected ISM Services PMI data suggests the main driver of the ongoing US expansion is deteriorating. The unexpected jump in the US jobless rate to 3.7% in May adds another potential red flag to our US recession checklist. Meanwhile, US markets are likely to see a USD 1-1.5trn liquidity squeeze in the coming months as the government replenishes its coffers post the debt ceiling suspension. Also, data this week showed the Euro area entered a technical recession in Q1. Against this weak backdrop, SC assesses three potential drivers for a risk rally and explains why we do not expect them to last over the next 12 months:
Immaculate disinflation: There is a very narrow window for this scenario to play out. It involves a rapid decline in DM inflation towards central bank targets this year, without a sharp rise in jobless rates. Elevated core inflation across DMs amid still-tight job markets suggests inflation is unlikely to fall to target without a much weaker job market. Leading indicators of the US job market, including the falling rate at which workers are quitting and the rise in permanent job losers, are pointing to a deteriorating US job market.
Central banks easing up on their inflation fight: Any sign that central banks are tolerating above-target inflation would be bullish for stocks and negative for bonds. As of now, we see no such signals from the central banks. If anything, recent weeks have seen the reverse playing out: US rate cut expectations have been pared back since March, with markets now pricing in another 25bps rate hike by July. The ECB is signalling higher rates to fight inflation, even as economic activity deteriorates (SC expects the Fed and ECB to reiterate higher-for-longer rates next week). The RBA and BoC surprised markets this week with rate hikes, with talk of more to come, amid resilient core inflation and labour markets. While the Bank’s base case is that of a pause in Fed rates until Q4, there is a rising risk of higher rates if US and Euro area recession expectations are pushed back into 2024. Higher DM rates would challenge the rally in risk assets.
AI-driven, capex-led expansion: This is the new narrative for bulls, reminiscent of the internet “mania” of the late 1990s. The hope is that the so-called AI revolution will trigger large-scale corporate spending on technology, transforming productivity. This in turn is expected to prolong the economic cycle. Like the internet revolution, the transformative potential of AI cannot be ignored. However, like the internet, it is likely to take years for firms to monetise AI’s benefits. Meanwhile, the narrow AI-led equity rally (driven mainly by a few tech-sector leaders) faces stretched valuations and positioning. The lessons from the dot-com bubble also suggest it is hard to pick the winners in any “Mania”. Several supposed internet leaders collapsed once the internet bubble burst. Hence, prudence dictates position-sizing any exposure to this sector according to one’s risk appetite.
Investment implications: The AI mania could well last for a while. However, the challenging fundamental backdrop means we remain reluctant to chase the narrowly supported frenzy in some risk assets and instead rebalance into more defensive assets such as DM government bonds, within a diversified foundation allocation. Asia USD bonds and Japanese stocks are among other top picks.
By Rajat Bhattacharya for SC Insights
