Powell reassures on inflation, focus returns to growths

A positive week closed in financial markets with global equity indices back testing all-time highs. The bond world also contributed positively to portfolio performance with spreads in credit now at their lowest in 15 years and government bonds supported by falling rates, especially in America.

The week was characterized by some important macro data, especially on the inflation front. In particular, we saw inflation on the production side a bit higher than expected and show 0.5% growth on a monthly basis compared to the expected 0.3%.

But Powell's words that followed reassured markets that inflation is on the way back despite a more sticky rental component that will take some more time.

Retail sales and CPI data, on the other hand, were quite weak and such as to bring investors back on the rate-cutting bandwagon. The CPI for April came out at 3.4% in line with expectations and down from 3.5% in the previous month. The Core figure also came out lower than the previous survey and in line with expectations at 3.6 percent. Surprising the markets, however, was the change on a monthly basis, showing inflation at 0.3% lower than expectations of 0.4%.

Even more interestingly, both primary and core data, excluding housing, rose 2.2% and 2.1%, suggesting that inflation is on track to come down to the Fed's 2.0% target by the end of this year and helping to explain the good market reaction that took the 10-year treasury to 4.35%. Positive news for the government bond world also comes on the side of new issuance, with the U.S. treasury receiving applications for 3 times the amount in issue in a 1-year t-bill auction this week, again a sign of a market that sees short-term rates as an opportunity to be seized now because it reasonably will not last much longer. There seems to be a sense that bonds are now less scary for the market, which would look more at growth. In fact, the volatility of the bond world as measured by the move index is coming back being a good omen for the descent of 10-year rates.

The Citi Economic Surprise Index, an index that measures economic surprises is also disappointing; in fact, since May 2 it has returned to negative territory, and this is happening for the first time since early 2023.

The chart now deserves our attention because it signals a weaker U.S. economy even as consensus opinion has pushed markets upward embracing the belief that the Federal Reserve will cut rates in 2024 and a recession will be avoided. There are no more positive economic surprises, and economic indicators, while still good, are slowing contributing to the decline in the yield on 10-year U.S. Treasury bonds from its recent peak of 4.71 percent on April 25 to 4.35 percent today. 

We are back in a phase where good news is read as good news and bad news also becomes good news for markets because it makes a rate cut more likely. Overall the news is that inflation is moderating and the economy is still growing, with The Atlanta FED model showing GDP growth for the second quarter of 3.6 percent, a scenario that would be ideal for markets but about which we have some doubts.

In fact, we monitor very carefully any signal that might give us indications on the trend of growth and consumption, and from this point of view the reporting season of two American biggies, Walmart and Home Depot (to all intents and purposes two market benchmarks), is interesting. Walmart reported excellent numbers beating analysts' estimates, but this was due to sales of private label products and the so-called “trading down” by the consumer, who in a context of high inflation and economic difficulties decides to shift their purchases to lower cost non-brand products. Looking at Home Depot, sales were down 2.8 percent, with the number of transactions down 1.5 percent, but the most significant finding is that the number of orders over ,000 dropped 6.5 percent indicating again a deterioration in consumer dynamics that could soon translate into declines in expected economic growth.

Earnings season remains good with 93% of companies reporting a 78% earnings surprise and led analysts to revise 2Q2024 earnings estimates slightly upward and to maintain expected growth for 2024 at +11%.

Looking at the first quarter alone, at the beginning of the year the analysts' consensus estimate for the S&P 500 EPS implied an increase of just 1.2%, the actual result was an increase of 6.3%.

Also very favorable and positive is the outlook for corporate buybacks, expected in America for 2024 at more than .9 trillion, rising to .08 trillion by 2025. Even in Europe we are at three-quarters of the companies that have reported showing dynamics very similar to those in the U.S. and overall good reporting.

With markets at highs we are not surprised to begin to perceive some signs of exaggerated optimism, such as the newfound euphoria on meme stocks, but in truth we are still far from worrying situations. This situation of optimism but not yet excessive euphoria is confirmed by the fund management survey, a monthly survey that Bank of America submits to all managers and which shows, for example, a level of cash held by the institutional world of 4 percent, which is low, but not yet on the lows that are reached in periods of euphoria.

We can make the same argument by analyzing sentiment levels, which are on the high side since 2021, but far from the extremes.

One of the key lessons learned in our many years of management is that investor psychology drives markets. Therefore, we can expect markets to continue to rise as long as bullish sentiment remains intact. But human psychology is fragile, and catalysts for an eventual change in investor sentiment may soon be created.

There fortunately remain many areas of undervaluation in the markets, which geographically we continue to see in Europe, UK, in U.S. small caps, but especially in China.

Despite the recent outperformance of defensive sectors and utilities in particular, we continue to see in the defensive sector possibilities for further recoveries from the large underperformance accumulated over the past two years.

Finally, undervaluation continues to highlight duration government bonds, which at these levels appear to be a very attractive asset to hold in the portfolio, both as a source of coupon flow and potential appreciation if rates fall.