European equity markets are on track for their worst weekly performance in three weeks, as risk sentiment sours and interest rate bets get pushed back once again. Stronger than expected CPI in the UK, an increase in negotiated wage growth in the first quarter for the Eurozone, hawkish Fed minutes in the US and strong PMI data have all contributed to a ‘risk off’ tone to markets, even though Nvidia’s monster results suggest that the AI boom still has much further to go.

Recalibration of rate cut expectations for the UK and the US

Right now, the market expects the first rate cut from the Federal Reserve in December. By cutting interest rates at the end of the year, the US Presidential election will be out of the way and the Fed can avoid political scrutiny, but this also means that interest rates in the US will stay higher for longer. In the UK, the market is now expecting the first rate cut in November and they are only pricing in one full rate cut for this year. Sticky service price inflation at 5.9% is trumping concerns about the strength of the UK consumer, after retail sales excluding auto fuel fell at a 3% annual rate. The market is still expecting the ECB to cut rates in June, however, the pace of rate cuts after that has been scaled back, with just over two rate cuts expected for the Eurozone for the rest of the year. Not long ago the market was expecting three cuts.

The Dow and the FTSE 100 at risk as rate cut expectations get scaled back

The recalibration of interest rate expectations is having a big impact on financial markets. Stocks are broadly lower this week. The Eurostoxx 50 is down by nearly 1%, the FTSE 100 is lower by 1.4% and the Dow Jones is currently lower by 2% in the past 5 days. The S&P 500 is lower by 0.5% in the past 5 days and the Nasdaq is eking out a gain, rising 0.2% in the past 5 days. It is no surprise that the Dow Jones and the FTSE 100 have been the worst performers in the past week. The financial sector and the consumer discretionary sector are two of the largest weightings in the Dow Jones, both of those could be impacted by the Fed keeping rates higher for longer. Firstly, the consumer could come under pressure as high interest rates deter spending. US credit card delinquency rates of 90 days or more are close to their highest level since Q1 2021, in the middle of the pandemic. Secondly, although rising interest rates are good for banks’ net interest income, if rates stay high for an extended period, consumers can be put off borrowing money and it could hurt future dealmaking. Added to this, the FTSE 100 has some cyclical qualities that leave it vulnerable to a change in risk sentiment.

Interestingly, the utilities sector is the weakest performer in the FSTE 100 so far on Friday. This comes as Severn Trent, the water utility company, reported stronger than expected earnings earlier this week. The stock rose to a 5-month high earlier this week, however, it has experienced a sharp selloff, as the market focuses once more on the challenges facing the water sector as it struggles to maintain clean rivers and waterways with the changing, wetter weather in the UK.

What the VIX can tell us  

The Vix index, Wall Street’s fear gauge, had fallen to its lowest level since 2019 at the end of last week. It has risen slightly this week but is still at low levels. The Vix does not stay low indefinitely, and the changing central bank narratives that have emerged this week could be the trigger that pushes volatility higher, even though at present levels it does not suggest that the market is particularly fearful of a deep stock market sell off.

UK vs US Q1 earnings score card 

There are reasons to be cheerful: it has been a strong Q1 earnings season for US stocks. In the US, of the companies that have reported so far (481 out of 500), they have reported a sales surprise of 1.03% and an earnings surprise of more than 8%, the growth rate for all securities on the S&P 500 has been 4.09% for sales and 7.71% for earnings, the latter has been driven higher by tech, consumer discretionary and communications. In contrast, the growth rate for the companies that have reported earnings in the FTSE 100 is much weaker than for the US. A smaller percentage of companies have reported in the UK, so it is not a like for like comparison, however, companies that have reported earnings have delivered negative earnings and sales growth for Q1, with earnings surprises a bright spot, rising by 7.91%, driven by healthcare and energy. Thus, the contrasting fortunes for the UK and the US during the Q1 earnings season is another reason for the US stock market’s out-performance compared to UK blue chip stocks. Encouragingly, the FTSE 250 has seen more positive earnings and sales growth than the blue-chip index, which is a trend worth watching in the UK as GDP rates get revised higher, which boosts the domestic stock index.

However, there is undoubtedly a shift going on when Nvidia rises by more than 9%, and the S&P 500 index posts a loss, as it did on Thursday. Times are changing, and the tech giants are no longer acting as a wave that lifts all before them.

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