The weekender: Pause till the dust settles

Markets

The US bellwether S&P 500 notched its 4th consecutive weekly gain while hitting the highest level since August as the new kid in town, "Generative AI," has quickly achieved herd immunity to the prospects of higher interest rates. Still, some old kids on the block are playing catch-up now. 

The S&P 500 has returned 13% YTD, but the rally has masked muted returns for most stocks. The equal-weighted S&P 500 has returned just 3% YTD. The five largest S&P 500 firms (AAPL, MSFT, AMZN, GOOGL, NVDA have rallied by 47% YTD and now comprise 24% of the S&P 500 market cap. Excluding those five, the remaining 495 stocks have returned just 5%. However, breadth has widened slightly since the start of June as the Russell 2000 has outperformed the S&P 500 by 5 pp (+8% vs. +3%) as investors shed recession fears.

The week was characterized by a pro-cyclical rally (Consumer Discretionary, Industrials, and Financials have all outperformed) -- likely fueled by increasing confidence that the US economy is on a sustainable growth pace and unlikely to slip into recession as so many have been concerned about since the Fed began raising rates in early 2022.

Catalysts for the better growth outlook: the resolution of the debt ceiling last week and increased confidence that the drag from March's Regional Banks turmoil is unlikely to be a significant GDP snag.

In addition to the subtle increase in 10-year Treasury yields last week and the pro-cyclical rotation fading mega-cap Tech a bit and dipping toes into stocks more explicitly tied to economic activity is helping the ticker tape. The VIX slipped back to 13 this week -- its lowest level since March 2020 -- before the full impact of the pandemic was realized, drawing systematic strategies.

But in this game, we are constantly waiting for the next shoe to drop, so what risks are markets pricing today?

The FOMC meets next Tuesday and Wednesday, and since it's generally a good idea to follow the leadership, it's virtually a lock the Fed will not raise rates at next week's meeting, favouring an approach of waiting to see how significant an impact the Regional Bank turmoil has on growth via tighter lending standards and how significant an impact a year of raising rates has on growth and inflation, both of which are showing sides of gradually subsiding). However, investors will watch the Fed dot plot for signs of a preference to raise rates later this year, most likely in July, as growth and inflation remain stubbornly buoyant. 

There are a lot of peeling-back onions on the AI front. Still, from a layman’s view, I look back at the productivity boost disruptive technology has created in the past, and using a straight-line analysis, you could make a case that the S&P 500 is 10 % undervalued at its current price.  

Forex market

Our slightly bearish view on the Euro from our last "Weekender" was challenged early in the week, and we acknowledged that struggle on Tuesday, before the RBA and BoC, that selling the EURO will be tricky into a likely FED pause for no other reason other central banks have turned price maker.

Trading FX has never been a complicated story; hence for the Dollar to go down, EUR and CNY have to go up—which requires better capital return prospects.

We are very bearish in CNY until proven wrong but increasing less bearish in the EURO with oil prices falling. 

But issues selling the Dollar remain the same; US growth has been holding up well; hence the Fed could bolster their outlook given the firmer activity picture while progress on cooling inflation has continued to fall short of expectations.

USDJPY has been trading in a 139-140 range, and speculation has risen, once again, of potential FX intervention and an imminent BoJ policy shift in response

Intervention is unlikely based on the previous BoJ line in the sand, where rate checks last September and subsequent interventions were 143 levels. However, the new BoJ guidance allows YCC to be adjusted flexibly on factors such as the excessively weak yen and stronger-than-expected inflation. With USD/JPY currently moving close to 140, notably up from close to 134 before the April MPM, Governor Ueda's comments on this factor are likely to garner attention.

Japan has a legacy of zero negative inflation, plus premature policy tightenings that have choked off nascent recoveries. Still, over-weighting context brings risks too. Almost all of G10 had a persistent (albeit modest) inflation undershoot in the years headed into covid - might that have conditioned central banks and forecasters to dismiss inflation as 'transitory' when it emerged in 2021/22? That view hasn't aged well.

Oil market

Oil futures prompt contracts fell more than 1% on Friday, with all petroleum contracts registering weekly losses despite a surprise production cut of 1 million bpd unveiled by Saudi Arabia earlier this week and an extension of 3.6 million bpd curbs to OPEC+ cumulative output.

Manufacturing industries in China, the United States and the Western European Union accounting for a large chunk of global oil demand fell into a funk late last year and have shown few signs of shaking that malaise. 

Further adding to the bearish sentiment, news outlets have reported that the US and Iran may be nearing a temporary nuclear deal that could un-sanction Iran's oil exports, adding ample crude supplies to the global market when visible supply is still high.

Iran could quickly restore about 1 million bpd of crude oil production and return to " full capacity" of about 3.7 million bpd by next year.

The fundamentals for an eventual turnaround in crude oil prices remain intact: declining supply, rising demand and relatively low global inventories. However, one cannot ignore the possibility that prices may continue to fold until it's clear that the OECD economies can avoid a hard landing and, in tandem, that China's post-pandemic recovery starts to fill the 2 million bpd demand gap that is needed to pull Brent Oil out of its current downswing.

Conversely, what's become increasingly apparent is that last year's price boom, when Russia's invasion of Ukraine caused the biggest price shock in 50 years, was likely a temporary phenomenon. With OPEC+ now forced to scale back production rapidly, Russia's supply still shy high, it feels like a bit of a mug's game unfolding in the oil complex.

Perhaps the more significant long-term issue for oil market participants revolves around 'peak oil demand' as more countries inevitably fast-forward the electrification process.