LD Macro Weekly Report (2023/07/04): Risk assets collectively rise, ignoring the continued increase in interest rates.

Summary

The global market continued to rise this week, and the correlation between cryptocurrency and the stock market also returned to positive territory. Despite concerns about further monetary tightening. This week, we have seen more hot economic data, quarterly position adjustments by funds, gradually entering the Stretch level, and the breakdown of the historical correlation between interest rates and stocks.

Chart: Price trends of major stock indices and commodities last week

Source: Tradingview, TrendResearch

With the end of June, the S&P 500 index has held up against concerns of economic recession and the US banking crisis, rising by 15.9% in the first half of the year. The Nasdaq Composite Index rose by 31.7%, marking the largest first-half gain in 40 years.

Last week, macroeconomic data from the US continued to paint a picture of economic resilience — housing, consumer confidence, and durable goods all exceeded expectations. Coupled with hawkish comments from the Federal Reserve, the possibility of rising interest rates seems increasingly likely. The market now expects a probability of 84% for a rate hike in July, 29% in September, and expects rates to stay above 4% throughout 2024. This expectation has already triggered a large-scale rotation from growth stocks to value stocks, and combined with the solid health proof obtained by banks in the latest stress tests, major financial institutions have increased dividends and resumed buybacks, leading to a significant rebound in financial stocks.

Chart: Federal Fund Rate Futures priced higher last week

Source: Bloomberg, TrendResearch

Image: KBE Bank Industry Index, IVE Value Stock Index, IVW Growth Stock Index performance last week

Source: Tradingview, TrendResearch

Image: Cyclical Stocks vs Defensive Stocks

Source: GS, TrendResearch

Although the rise in long-term interest rates should bring risks, the stock market is still performing well, and there are generally three understandings in the market:

1. Optimistic attitude towards economic soft landing

2. Belief that the improvement in production efficiency brought by AI and other technological innovations can offset the rise in interest rates (↑profit growth expectations)

3. Many funds still do not believe that the Fed's policy will be as strict as expected (↓interest rate expectations)

Chart: S&P 500 12-Month Forward PE

Source: GS, TrendResearch

In history, the long-term bond yields have mostly moved opposite to the stock market. When long-term yields peak, the stock market tends to bottom out. However, in the current environment, the stock market has sustained its rebound due to the aforementioned optimistic expectations. It now seems that only a very serious hawkish impact or external growth shock (similar to COVID-19) could cause significant damage to risk assets and lead the market to retest the bottom.

U.S. Stock Market Surprises Approach Year-High, Europe Diverts

On the data front, U.S. GDP in the second quarter exceeded expectations once again (+2% compared to an expected +1.4%), pushing the U.S. economic surprise index close to a year-high. However, there are also indications of loosening prospects in the data, with the U.S. consumer market slowing down (for example, May PCE only rose by 0.1 percentage points compared to the previous value of 0.4%, a significant slowdown) and multiple warning signals in the industrial sector (falling factory prices, declining output).

The divergence between Europe and the United States is worth noting. Funds have entered into short positions in the U.S. market, which has triggered a rebound and is still ongoing with continuous accumulation. Various position indicators are gradually getting "crowded" but have not reached excessive levels, as markets usually reverse once they become excessive. However, hedge funds' net exposure to Europe is close to a five-year high, while their net exposure to U.S. stocks is at a five-year low. This situation may create downward pressure on European stocks.

Chart: The contrasting trend of economic surprise indices between Europe (purple) and the U.S. (green) over the past month

Source: Citi, MacroMicro, TrendResearch

The market breadth is extremely low, based on historical experience...

In the past two weeks, there has been a slight improvement in stock market breadth. However, it is important to note that the market breadth is still low. Some see this as a bullish signal and believe that a rebound is possible, while others see it as a concentration of gains and a potential vulnerability. When the earnings of market leaders are weaker than expected, the upward trend of the overall market will halt.

Chart: Market breadth of S&P 500 constituents, as measured by Goldman Sachs, currently below 1 standard deviation from historical average

Source: GS, TrendResearch

Narrow width, which means concentrated rise, is consistent with the current environmental logic. In the case of slow economic growth and widespread concerns about recession, investors seek the highest quality and steady growth. Generally, safety is proportional to the market size and market value of a company. Large and high-quality growth companies are rare. Therefore, although the breadth narrows, the market rises.

Historically, the sharp decline in market breadth often occurs at non-peaks or bottoms. Some obvious low points can be seen in the chart, including 1984, 1990, 2016, and 2020, when the market reached bottoms. The decline in breadth in 2000 and 2007, on the other hand, marked market tops. So whether you are an optimist or a pessimist, you can find your own logic and historical evidence. However, in the long run, the classic saying still holds true: pessimists are right, optimists make money.

Q2 Earnings Season Begins

In the short term, the biggest challenge for the US stock market to sustain its upward momentum is the Q2 earnings season (which starts this week and continues until August). Previously, artificial intelligenceThe smart boom has sparked a new bull market in technology stocks, but Wall Street currently expects the overall profit of S&P 500 companies to decrease by 5.7% compared to the same period last year. The expected price-to-earnings ratio for the S&P 500 index is 19.4 times, which is higher than the historical average of 15.8 times, indicating that it is not cheap.

Source: GS, TrendResearch

US Government Stepping on the Gas of Debt Issuance, But Financial Conditions Remain Loose

After the debt ceiling was lifted at the end of May, the US government immediately accelerated the pace of borrowing to replenish its fiscal accounts. The total debt increased by $850 billion to $32.32 trillion in June, continuously hitting new historical highs without any surprise:

Chart: US Government Total Debt

Source: fiscaldata.treasury.gov, TrendResearch

The balance of the Treasury Department's account rapidly replenished from a near bottom of $23 billion to $465 billion (blue line in the graph below). However, during the same period, the overnight reverse repurchase balance of the Federal Reserve also decreased by $120 billion. This can be understood as a transfer of funds from the short-term Fed investment account to the bond market, partially offsetting the market's absorbing effect of bond issuance. However, the extent of offsetting is limited when comparing the quantities:

Graph: Comparison of U.S. Treasury Department's Balance with Federal Reserve Overnight Reverse Repurchase Balance

Source: MacroMicro, TrendResearch

However, strangely enough, the financial market conditions index has become more loose (this index includes bond spreads, market volatility, bank lending conditions, etc.), indicating that the market has not really been "absorbed":

Image: Federal Reserve Bank of Chicago Financial Conditions Index

Source: chicagofed.org, TrendResearch

We suspect this is mainly due to the increased demand for U.S. bonds from international investors. The official data from the United States includes the changes in foreign holdings of government bonds, but this data is only available with a two-month lag, so this speculation is based on the recent international fund flow trends from EPFR. As of last week, U.S. bond funds have seen continuous inflows for 26 weeks.

Considering that the Treasury Department's balance is only expected to be replenished by $500 to $700 billion, the fastest phase of issuance is about to pass, so there is no expected tightening of issuance, and U.S. financial conditions may continue to be accommodative.

Global Fund Flow Data: European and American Stock Markets

According to EPFR data, for the week ending June 28, the inflows into mutual funds were relatively limited, with net inflows into stock and bond funds being relatively weak, at $1.5 billion (previously -$4.97 billion) and $400 million (previously + 50.4 billion).

Among them, global stocks saw a net inflow of 15 billion U.S. dollars, although the scale is small, it has greatly improved compared to the net outflow of 49.7 billion in the previous period, mainly due to the support of funds flowing into emerging markets. This week, it was + 39.8 billion U.S. dollars, compared to -0.32 billion U.S. dollars last week, mainly driven by China (+ 28.8 billion). However, Hong Kong stocks and A shares only recorded a slight increase last week.

Source: GS, TrendResearch

Developed market stocks saw a net outflow of $3.31 billion last week, with the U.S. experiencing a net outflow of $1.59 billion for the second consecutive week. Western Europe saw an outflow of $4.56 billion, marking the 16th consecutive week of outflows. Total divestments for this year have reached $27 billion. However, these outflows did not cause a decline in European and American stock markets, with European markets showing weaker momentum than the U.S.

Japanese stock funds saw an inflow of $1.4 billion last week, marking the largest inflow in the past four weeks, totaling $7.86 billion.

In terms of industries, the allocation proportion of technology stocks experienced a significant increase after only one week of decline, currently accounting for nearly 24% of all stock allocations:

Source: GS, TrendResearch

Global bond saw a small net inflow for the 14th consecutive week, totaling $460 million. There is a significant divergence between developed and emerging markets. Developed markets saw a net inflow of $1.79 billion, while emerging markets experienced a net outflow of $1.22 billion.

Source: GS, TrendResearch

Market Sentiment Indicators

The BofA Merrill Lynch Global Fund Manager Survey's sentiment indicator decreased slightly from 3.4 in the previous week to 3.2 and is currently in the neutral range:

Goldman Sachs' position sentiment index has been in the heavily long position range for three consecutive weeks, but has not yet reached the level of extreme heavy long position:

AAII investor sentiment survey, the bullish ratio has been declining for two consecutive weeks, but still remains at a high level since November 2021:

CNN Money's fear greed index returned to the extremely greedy range of 80 last week:

Cryptocurrency

Last week, the cryptocurrency market rose along with the traditional market, and the correlation finally returned to positive territory. The duration of this negative correlation was only 40 days, consistent with historical patterns (since 2018, there have been 15 instances of negative correlation lasting an average of 35.5 days, with a median of 39 days):

The balance of stablecoins on centralized exchanges remained relatively stable last week and did not continue to rise with the prices:

The total supply of on-chain stablecoins decreased slightly from 128.6 billion to 127.4 billion, basically giving back the growth in the second half of June:

Institutional Perspective

Goldman Sachs: 10% Rule

The stock market performance from the beginning of the year until now is a good reminder that usually only a small portion of stocks determines the index returns. The seven major tech stocks (AAPL, MSFT, GOOGL, AMZN, META, TSLA, NVDA) have achieved a return of 58% so far this year, while the remaining 493 S&P 500 stocks have only achieved a return of 5%.

Therefore, reality shows that identifying companies that can sustain income growth of more than 10% may provide returns for investors. We have refreshed our "10% Rule" screening and identified stocks that have achieved and are expected to achieve annual sales growth of more than 10% between 2021 and 2025. The stocks expected to grow fastest from 2022 to 2025 include ENPH, TSLA, SEDG, PANW, NOW. We also provide similar screening based on net income growth. There are 8 stocks that appear in both screenings: NOW, PAYC, FTNT, PODD, CMG, INTU, CDNS, APTV.

Low Macroeconomic Uncertainty Will Boost

Macro Risk Advisors analyst John Kolovos: The low implied volatility has fueled bullish sentiment. "Our concerns about the macro economy have disappeared," he said. "When macro uncertainty is very low, it is a huge driver for the stock market."

This Week's Focus

The US market will be closed on Tuesday (Independence Day) this week. Important data includes the non-farm payroll for June, the ISM manufacturing and non-manufacturing PMI for June, weekly unemployment claims, and the minutes of the June FOMC meeting.