Earnings and growth warnings hit market sentiment

It is hard to see how the rally in markets can continue for now after several weaker than expected earnings reports including Tesla, LVMH and the US postal service, have led to concerns that stocks will fail to deliver the boost to earnings that would spur the next leg of the rally. The S&P 500 is set to open lower on Wednesday, although it is only 100 points down from its all-time high reached last week. However, the slip in corporate earnings from the likes of Tesla and Google, which failed to set the market alight with its AI investments, suggests that the fundamental basis for a rally is slipping away as we reach the peak summer months.

The focus on Wednesday also moved to economic growth at the start of Q3. The news wasn’t great, particularly for Europe. The manufacturing PMI slipped deeper into negative territory at 45.6, weaker than the 45.8 from June and defying analyst estimates of a recovery. The service sector also weakened to 51.9 for the currency bloc this month, and the composite index is only just above expansion territory at 50.1. There was a divergence in the reports across individual countries. The German manufacturing sector PMI report for July fell to 42.6, the weakest reading for several months, and lower than June’s 43.5 reading. Since its 2021 peak, Germany’s manufacturing sentiment report has been on a sharp downward trajectory, and it does not show any signs of bouncing back.

What Germany and LVMH have in common

The problems that Germany’s manufacturing sector are facing are the same as the problems faced by LVMH, the French luxury goods giant. Its share price is down nearly 5% on Wednesday after it posted organic sales growth of 1% last quarter, less than half what was expected, due to reduced Chinese spending. Its first half revenue declined by 1% to $41.68bn, lower than the $42.22bn expected. This may not seem like a bug difference, but the market is sensitive to Chinese demand, especially for the luxury houses who have traditionally relied on the luxury conscious Chinese consumer to fuel revenue and profit growth.

Interestingly, the sales declines at LVMH were broad-based and sales growth and margins were lower than expected across most of its sales divisions. It was also hit by forex losses, most notably weakness in Asian currencies in recent months, however, the company remained upbeat. It forecasts that there will be a rise in the number of Chinese consumers traveling to Japan to buy their goods due to the weak Japanese exchange rate. However, until there is a recovery in LVMH’s revenue and sales growth, most notably in China, it is hard to get bullish on the stock, although LVMH could remain more resilient than other stocks in the luxury sector.

China woes and fears of US trade barriers weighing on German manufacturers

Germany’s manufacturing sector is essentially suffering from the same malady as LVMH: the failure of the Chinese economy to return to pre-covid growth levels. Germany is weighing on Eurozone growth, with the economy having barely moved in July. This was led by the manufacturing sector, which counteracted a decent performance in the service sector. Sentiment in Germany’s manufacturing sector is weakening as China’s growth remains sluggish and the prospect of trade barriers from the US if Trump wins the presidency, are another threat to contend with.

Germany: Mid cap stocks lagging the blue-chip index, bucking global trend

There had been hopes that Germany’s growth rate would pick up in the second half of this year, however, July’s PMI report suggests that there is still a lot more work to do. Added to this, while other countries like the US and the UK have seen their mid-cap stock market indices bounce back recently, that has not happened in Germany, as you can see below. The performance gap between the Dax and the Mdax widened in recent weeks, with the blue-chip index outperforming the mid cap index. This is bucking the trend in the US, where the Russel 2000 has been outperforming the Magnificent 7 and the broader blue-chip indices in recent weeks. We believe that until the mid-cap index can catch up with the blue-chip index, Germany’s economy will struggle to recover.

Chart 1: Germany’s Dax and MDax, normalized to show how they move together over the past year.

Source: XTB and Bloomberg                                               

G10 FX space favouring safe havens

Elsewhere, the UK’s July PMIs remained in positive territory, however, this has not stopped the pound from slipping as the FX market has been favouring safe havens this week. The yen is the top performer in the G10 FX space as its bounce back versus the dollar continues, and the Swiss franc is also making gains. GBP/USD has dipped below $1.29; however, we expect this to be a temporary pullback as we remain bullish on sterling.

The next few days will be pivotal for markets, as the only hope of spurring another leg in the stock market rally is further signs that the US Federal Reserve will cut rates in the coming weeks. Thursday’s US GDP and core PCE report could add to evidence that a rate cut is coming, which may boost market sentiment.