Last week’s inflation report, which could find justification from both hawks and doves, is unlikely to significantly alter the Federal Reserve’s policy inclination. This was confirmed by a moderate rise in bond yields. The S&P 500 index and the Nasdaq Composite index fell for the second consecutive week, down 0.2% and 0.4%, respectively, with the most significant drops occurring on Friday (the largest single-day decline in three weeks). Prior to this, stock market sentiment had been relatively positive.
The strike by the UAW automotive union on Friday was the direct catalyst, marking the first time in its 88-year history that the union has simultaneously targeted the three major car manufacturers.
Furthermore, the Philadelphia Semiconductor Index fell by 3% on Friday. Reports suggest that TSMC will delay the delivery of equipment to its Arizona plant due to cautious demand outlook; Adobe, despite outperforming its earnings forecast, saw an unexpected sharp decline on Friday, causing investors to be more cautious towards tech stocks that day. After a 25% IPO surge on Thursday, Arm’s stock price fell 4.5% on Friday.
Rising oil prices intensified the pessimistic sentiment. Oil prices broke through $90 per barrel, setting a new high for the year, with WTI up 3.5% for the week and Brent up 3.8%.
Meanwhile, the rising U.S. Treasury yields continued to put pressure on the stock market, with the 10-year yield climbing to 4.32%.
For the week, utilities were up 3.5%, non-essential consumer goods +2%, and finance +1.7% leading the performance. In contrast, the industrial sector was down 1.1%, and information technology down 2%.
In the currency market, the U.S. dollar index rose for the ninth consecutive week, reaching its highest level since March. It touched 148 against the Japanese yen, the highest since last November. However, the yuan remained strong over the past week, with USDCNY dropping to 7.25, a new low since early August.
Other stock markets, such as Hong Kong, Japan (with JPN225 setting a new high since July after SoftBank Group’s Arm went public, attracting Japanese investors to tech stocks), and the UK (with UK100 setting a new high since June), performed strongly. The European Stoxx50 index also gained 0.6%, while China’s mainland Shanghai and Shenzhen 300 indices declined for the third consecutive week.
So far in 2023, we have not seen a 10% level correction, which usually occurs annually. Therefore, if there is a deeper pullback in September and October, historically weaker months, it wouldn’t be surprising (the stock market might also move sideways for a while instead of dropping directly). However, in the short term, we don’t see any significant economic or financial risks, so any significant declines can be seen as a good buying opportunity for long-term investment.
In the cryptocurrency sector, there was a big drop at the start of the week, mainly because of the ongoing fallout from FTX’s $3.4 billion crypto asset liquidation. However, when it was confirmed on Thursday, the market did not drop significantly. We analyzed this in our Thursday morning Muse meeting.
Key Financial Events
European Central Bank raises interest rates by 25 basis points, but hints rates may have peaked.
The ECB raised its benchmark interest rate by 0.25 percentage points to 4% on Thursday, the tenth consecutive rate hike since the bank started rapidly increasing rates from below zero last year. Christine Lagarde, the president of the ECB, hinted that this might be the last rate hike in this cycle, leading to a sharp drop in the euro and pushing the U.S. dollar index above 105.3, a high since the March crisis. However, Lagarde also mentioned that they can’t currently decide if interest rates have peaked and didn’t mention whether they’d hike in November. She emphasized that the ECB has not discussed rate cuts and is data-driven. Given the weak data, the market believes it’s unlikely the ECB will hike again.
TSMC reportedly asks suppliers to delay equipment delivery amid slowing demand
Media reports on Friday suggested that due to economic conditions and softening end-market demand, Taiwan’s TSMC asked its primary suppliers to postpone the delivery of high-end chip manufacturing equipment. Affected companies include ASML, which manufactures lithography equipment. On Friday, semiconductor stocks in Europe and the U.S. fell across the board. ASML, BE Semiconductor Industries, and ASMI, suppliers to TSMC from the Netherlands, dropped 3.5%, 4.8%, and 6.6%, respectively. The Philadelphia Semiconductor Index in the U.S. was down approximately 3%, underperforming the broader market. Nvidia fell about 3.7%, and TSMC’s U.S. stocks fell 2.4%, hitting a four-month low.
Surpassing NVIDIA, Tesla’s Supercomputer?
Tesla’s stock surge is partly attributed to Wall Street’s major banks adjusting their target prices upwards. On Monday, Morgan Stanley raised its target price for Tesla from the previous $250 to $400, emphasizing the potential of Tesla’s Dojo supercomputer project. Dojo is a supercomputer network that can integrate data from millions of Tesla vehicles, aimed at training AI systems to perform complex tasks, such as assisting Tesla’s Autopilot driver-assist system and advancing “Full Self-Driving” capabilities. As of July this year, Tesla has sold nearly 4.53 million cars, each sending back data to Tesla to develop autonomous driving features.
With this backend supercomputer, specifically designed to learn from real data, combining a massive network of mobile sensors and cameras with powerful edge computing capabilities, Tesla transcends the realm of mere automakers.
Morgan Stanley believes that theoretically, Dojo could bring the company a long-term value of up to $500 billion. By 2030, Morgan Stanley anticipates that Tesla will receive a recurring monthly income of $2,160 from car owners, derived from services provided by Dojo, automotive subscription software for autonomous driving systems, vehicle charging, maintenance, software updates, and future content development.
China’s August RMB New Loans and Social Financing Increase Significantly
In August, RMB loans increased by 1.36 trillion yuan, and the social financing scale increased by 3.12 trillion yuan. The overall social financing scale increased by 9% YoY, and the broad money supply (M2) increased by 10.6% YoY. Compared to previous values and the same period last year, new loans and social financing in August increased significantly. This was mainly due to the introduction of regulatory measures to stabilize the economy, stock market, and property market, which boosted market confidence, and financial support for the real economy continued to increase.
Weight Loss Drugs are the New AI
The market for weight loss drugs is booming. As Novo Nordisk and Eli Lilly, two major weight loss drug producers, see their market values soar, the financial blog ZeroHedge proclaims “Weight loss drugs are the new AI.” According to JP Morgan’s latest forecast, by 2030, under the duopoly of Novo Nordisk and Eli Lilly, annual sales of GLP-1 class drugs will exceed $100 billion.
US Inflation Persists, August CPI YoY Rebounds to 3.7%, Core CPI MoM Accelerates for the First Time in Six Months
Soaring oil prices further accelerated US inflation in August, potentially requiring the Federal Reserve to maintain higher interest rates for a longer duration. The overall CPI YoY growth rate rebounded for the second consecutive month, exceeding the expected 3.6% with July’s value being 3.2%. The MoM CPI growth rate accelerated from 0.2% in July to 0.6% in August, matching expectations and marking the largest MoM increase in 14 months. The core CPI, which the Federal Reserve pays more attention to, saw its YoY growth rate fall from 4.7% to 4.3%, meeting expectations and marking the smallest growth in nearly two years. However, its MoM growth rate slightly increased from 0.2% in July to 0.3% in August, exceeding the expected 0.2%.
US August PPI Exceeds Expectations, YoY Increases by 1.6%, MoM Marks the Largest Growth in Over a Year
Affected by rising energy prices, the US August PPI continued to rise beyond expectations. The YoY growth was 1.6%, higher than the expected 1.3%, marking the second consecutive month of exceeding expectations. The MoM growth rate for PPI was 0.7%, the highest since June of the previous year, with the growth rate for July being revised to 0.4%. August’s core PPI increased by 2.2% YoY and 0.2% MoM, both slowing down compared to July, meeting expectations.
Gasoline Prices Strongly Support US August Retail Sales, MoM Increase of 0.6%, Far Exceeding Expectations
US retail sales in August increased by 0.6% MoM, exceeding the revised previous value of 0.5% and greatly surpassing the market’s expectation of 0.1%. This marked the fifth consecutive month of growth. The overall resilience of retail sales in August was mainly due to the surge in gasoline prices, with inflationary pressures beginning to manifest elsewhere.
Spotlight: Concerns about Yield Curve Inversion
Many investors believe that the current rise in real yields is different from the past, as they continue to climb even though the central bank’s tightening cycle is nearing its end. The market increasingly expects that compared to the pre-pandemic decade, the new equilibrium real interest rate level will be higher, due to larger fiscal deficits and productivity growth. The larger fiscal deficits mean more government bond supply, and recent technological innovations have brought about higher productivity, in stark contrast to the prolonged stagnation after the 2008 financial crisis.
Today’s real yields and real GDP growth in the US look similar to those before 2008. In mid-2006, 10-year treasury bonds priced real yields at around 2.5%. The previous year, the US economy grew at a real rate of 3.0%, and the Federal Reserve raised its policy rate target to 5.25%.
Now, 10-year bonds offer close to a 2.0% real yield, while the real economy recently grew by 2.5%. Even today’s target federal funds rate range of 5.25%-5.50% is similar to that of 2006. This market pricing is almost indistinguishable from the situation before the 2008 global financial crisis.
The most noticeable and most discussed difference is that, compared to 2006, the yield curve is much flatter today, both nominally and in real terms. In mid-2006, the nominal yield of a 2-year treasury bond was the same as that of a 10-year treasury bond. Today, the 2-year yield is 70–100 basis points higher than the 10-year yield. Many believe that the severity of the yield curve inversion in 2022 indicates a recession in 2023.
Apart from the previously mentioned market distortions caused by expectation differentials, the size of the central bank balance sheet also affects the yield curve’s shape. The large volume of treasury bonds on the central bank’s balance sheet makes the current yield curve more sensitive to changes in the short-end rate than in the past. This can cause a more rapid flattening or inversion than in previous cycles.
Today’s yield curve is a complex subject, influenced by various factors. The spotlight on the yield curve inversion brings with it concerns of potential economic repercussions and impacts on market stability.
Pessimistic View from CICC, September 17th:
Since the Federal Reserve began monetary tightening in March 2022, the large-scale and continuous fiscal expansion has made credit tightening notably sluggish. A prime example of this is the fiscal expansion after the SVB incident in March. However, delay does not mean absence. The start of credit tightening will serve as the “gravity” constraining growth. Since March, the exposure of risks in small and medium-sized banks has facilitated the expansion of government credit, but it also hastened the tightening of private credit. This is especially evident in indirect financing related more to small and medium-sized banks:
Banking credit standards have significantly tightened. This is particularly evident in commercial real estate, large and medium enterprises, and small business loans. The proportion of banks tightening standards has risen rapidly, approaching the peak seen at the start of the pandemic. Credit card and housing loan standards have also contracted.
The absolute scale of commercial loans has declined markedly, with a YoY growth rate nearing zero. Consumer loan and housing loan growth rates have also fallen from high levels.
Looking forward, key moments for the U.S. economic cycle include: the Fed’s nearing the end of rate hikes by the end of this year, while tight credit continues; excess savings will be mostly depleted by early next year, which will gradually suppress consumption. Inventory reduction is also expected to last until around the second quarter of next year. Thus, the U.S. economy might continue its downward trend from the end of this year to next year, but not too deeply, as household balance sheets remain healthy. Therefore, market expectations suggest that the Federal Reserve might start a rate-cutting cycle in the second half of next year, which would stabilize and reignite the credit cycle, possibly leading to an economic recovery.
Optimistic View from Deutsche Bank, September 14th:
The report from Deutsche Bank on September 14th believes that the U.S. economy is still in a resilient growth phase with no apparent signs of recession. This is mainly based on several positive factors:
Corporates and households are in good financial health with strong balance sheets. Corporate leverage is low, and household savings are ample, which is different from past recession cycles.
The job market remains tight, with unemployment nearing historical lows. Companies are reluctant to lay off workers. Employment figures are still below the pre-pandemic trend. (To date, total employment remains slightly below the level it would have achieved had it continued growing at the 2015–2019 rate of 1.6%)
Households accumulated a significant amount of additional savings during the pandemic. Even with optimistic assumptions, these savings should support consumption at least until the second half of 2023.
Real estate, being the most interest-rate-sensitive part of the economy, represents only 2.8% of the GDP. Moreover, there are recent signs of stabilization in real estate sales.
Companies’ internal cash flows can cover dividends and capital expenditures, reducing the need for additional debt financing.
Even though various leading indicators suggest that the economy should enter a recession, the actual growth rate has only slightly decelerated. The report believes the economy may continue its slow growth rather than entering a recession. The Federal Reserve’s interest rate hike cycle is almost over, and significant tightening is improbable. However, the report also anticipates that the Federal Reserve is unlikely to significantly cut rates to stimulate the economy in the future.
Liquidity, stock buybacks, issuance, and position changes historically account for most of the variation in stock market returns. In a mild, short-term recession, positions are expected to show modest declines, with minor capital outflows offset by stock buybacks. A balance between supply and demand should maintain the S&P 500 index around 4500 points by the year’s end.
Capital and Position
Overall stock positions rose slightly last week, with discretionary investors adding to their holdings. Equity funds witnessed their largest net inflow in 18 months, while bond fund inflows slightly increased, and money market fund inflows remained strong.
From a market perspective, we are in a typical correction phase. The overall stock position increased marginally this week, slightly above neutral level (61% historical percentile), mainly propelled by an uptick in discretionary investors’ holdings:
Discretionary investor positions jumped from the 49th percentile to 53rd, while systematic strategy investors climbed from the 71st percentile to 72nd.
In general, the rebound driven by extreme bearish positions, which peaked in August, is no longer the main force supporting the stock market. At this stage, fundamental drivers, such as better-than-expected economic data and improvements in corporate profits, are needed to re-establish bullish positions in the market.
Deutsche Bank believes that expectations for economic data surprises remain low. A series of growth figures surpassing expectations has bolstered the economic surprise index. However, the prevailing sentiment is that the economy will slow down, which might support the next round of data surprises. Notably, discretionary investor position changes are highly correlated with the economic surprise index.
Moreover, discretionary investor positions have been highly negatively correlated with interest rate volatility (a correlation of -89% since 2021) as they continue to monitor the lagging effects of monetary policy tightening. Current interest rate volatility has plummeted to an 18-month low.
Last week, equity funds (ETFs and mutual funds) recorded their largest single-week net inflow in 18 months ($253 billion), primarily from the US ($264 billion). Emerging market funds saw a net outflow of $12 billion for the second week, and European funds extended their 27-week net outflow streak, losing $14 billion.
Bond fund inflows ($48 billion) were slightly higher than last week. Corporate bond inflows at the investment grade accelerated ($20 billion), but high-yield bonds (-$10 billion) and emerging market bonds (-$11 billion) continued their outflow. Government bond inflows remained strong at $30 billion.
Money market fund inflows slowed down a bit from the previous week to $289 billion, but remained robust, mainly in the US ($232 billion).
By sector, the tech sector ($13 billion) turned to inflows after last week’s net outflow. The energy sector also experienced a modest inflow ($2 billion). Healthcare (-$8 billion), non-essential consumer goods (-$6 billion), telecoms (-$4 billion), raw materials (-$3 billion), and finance (-$2 billion) sectors all witnessed net outflows, while other sectors remained relatively stable.
In the futures market, US equity futures remained largely stable. The net long positions for S&P 500 futures surged to their highest level since last February, while Nasdaq 100 net longs decreased.
The net short position of the US dollar decreased for the fourth consecutive week, now at its lowest since last October, mainly driven by major asset management reducing their net short positions.
In the commodities section, net long positions for crude oil reached their highest since last October. However, net long positions for gold decreased. Copper positions flipped from net long to net short.
In the realm of cryptocurrency, centralized exchanges witnessed a modest net inflow of $57 million in stablecoins over the past 7 days, totaling $13.86 billion. On-chain stablecoin net outflows amounted to $92 million, bringing the total to $124.3 billion. The outflows were mainly driven by BUSD, USDT, and TUSD, while inflows were primarily from DAI and USDC.
Last week’s AAII survey showed that the percentage of neutral views rose to 36%, bullish views dropped to 34%, and bearish views remained unchanged. The CNN Fear & Greed Index remained steady around the neutral 51 mark. Goldman Sachs’ institutional position sentiment index saw a significant jump to 1.2, landing in the stretched zone.
This Week’s Focus
It’s a super week for central banks with the US (unchanged), UK (+25bp expected), Switzerland (+25bp expected), and Japan (unchanged) all set to make appearances. The main focus will be Wednesday’s Federal Open Market Committee (FOMC) meeting. After the Fed’s interest rate hike in July, the market widely expects the rate to remain unchanged. However, the communication and projections might emphasize further tightening is still possible this year. This week’s data, mainly focused on housing, is unlikely to have a significant impact on the messages from the Fed meeting.
The meeting’s statement might indicate mixed progress on the conditions required to halt further rate hikes. This includes moderate economic growth, signs of inflation improvement, but a still tight labor market.
Economic Forecast Summary and Market Insight
The economic forecast summary may show an upward revision of growth, especially for 2023, but a slight downgrade in inflation forecasts, considering the PCE figures have already touched the June expectation of 3.2%. As for interest rates, the Fed’s SEP in June indicated a peak federal funds rate of 5.6% in 2023, predicted to decrease to 4.6% in 2024, and to 3.4% in 2025, with long-term rates at 2.5%. Given the data progress over the past three months, the 5.6% forecast for 2023 might either remain unchanged or slightly decrease, while the median rates for 2024 and 2025 may either remain constant or show a mild increase.
While the post-June meeting maintained a long-term rate at 2.5%, the core trend shifted from the 2.4%-2.6% range to the 2.5%-2.8% range. This suggests that the Fed might perceive the neutral rate (neither stimulating nor restricting economic activity) to be higher than previously anticipated, with a 2% inflation target implying a real rate of 0.5%.
From the bond market perspective, the 30-year treasury yields hover around 4.2%. Subtracting the Fed’s 2% inflation target gives a real rate of 2.2%, significantly higher than the Fed’s expectations. Consequently, the bond market appears aggressively priced. The equity market’s declining earnings yield juxtaposed with an increasing P/E ratio indicates that it remains skeptical about the Fed’s assertion that rates must remain restrictive for some time.
Looking at the interest rate derivatives market, the short-term path aligns almost precisely with the Fed, predicting a maximum policy rate of 5.45%, falling to around 4.6% by the end of 2024 — consistent with the SEP’s June predictions.
Yet, the long-term path is starkly different. Contrary to the intuitive “L” shape, the futures market predicts a “U” shaped interest rate trajectory. It expects nominal rates to rebound quickly to 4.7% after hitting the bottom in 2026, consistently rising afterward. This suggests a vast discrepancy, over 100bp, between the Fed’s 3.4% forecast for 2025 and the traders’ bets, with longer-term expectations differing by more than 200bp.
Who would you trust? Those believing the Fed is mistaken might short risk assets, whereas those siding with futures traders could go long.
In the upcoming press conference, Powell will undoubtedly emphasize policy data-dependence, remain cautious about declaring victory on inflation, but might highlight some preliminary progress concerning the labor market’s equilibrium. He’s unlikely to provide clear indications on the timing of further rate hikes.
Why the continued prudence from officials? The inflation’s second round of surge has always been a concern for older officials. Those who haven’t lived through the 70s might not relate. This historical backdrop will limit any potential rate cuts.
Predicting the future, even just a month ahead, is inherently challenging, let alone two to three years down the line. However, the divergence between equity and bond market expectations concerning future interest rate trajectories is evident. The equity market seems to be betting on several rate cuts by the Fed in the future, contrary to the bond market’s expectations. As the Fed updates its information next week, the primary point of interest will be any changes in the expected significant rate cuts for the subsequent years. The crux is which market gets realigned — whether the bond market gets pulled in line with the stock market or vice versa.