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Key developments:

1. China’s challenge: Industrial profits slump. The focus on hi-tech manufacturing is facing critical challenges already. As profitability slumps, it’s more challenging to sustain manufacturing activity in a market economy. However, the push to continue investment into manufacturing could see mis-allocation of capital, which is a long term negative.
2. Tech earnings: Mixed results but investor reaction is rational, not bubble-like. Microsoft and Alphabet did well, but Meta shares fell as it announced large investment into AI. Tesla profit miss didn’t hamper its stock price, although it is important to note that its share price has tanked 40% since the start of this year. Announcement about cheaper cars propelled the stock higher but the trend remains bearish.
3. US economy: Q1 GDP growth is lower than expected. Gross domestic product increased at a 1.6% annualised rate last quarter. Economists polled by Reuters had forecast GDP rising at a 2.4% rate after growing at a 3.4% rate in the fourth quarter. But this is the first estimate. High chance that it will be revised higher. But PCE price index remains elevated, pushing up the “higher for longer” factor. A key risk is that rates may actually go up if inflation remains persistent.
4. US bond yields are heading higher: Inflationary pressures and a less dovish FED is pushing bond yields up. Will it start to hurt the real economy? Need to watch homebuilders closely as mortgage rates hit a new high. If homebuilding stocks turns bearish, the risk of a consumer pull back is higher. Right now, homebuilders are in neutral, the long term trend is bullish (above 200dMA) but at risk (below 50dMA).

Markets reacted to the events in the Middle East, where Israel responded to Iran’s barrage of missiles and drones. A surgical strike without major damage reported by Iran and a lack of follow up by Iran would have settled any concerns of escalations in the oil producing region.

Nonetheless, equity markets continued to fall, driven by (1) profit taking after a three month rally which resulted in a overbought market, (2) bank earnings that were a little disappointing, (3) inflation reports that suggest the rate cuts could be off the table in 2024.

On point (2), although some banks reported less than stellar earnings, the overall trend of bank stocks appear to be healthy for the large banks (KRW), and cautious for the smaller regional banks (KBW). Banks are unlikely to be the key driver of the market weakness.

More likely, a combination of an overbought market and three consecutive months of sticky inflation reports led to the sell off in equity and bond markets. FED funds probabilities of no rate cuts for 2024 have risen from 0% to 17%, pressuring stock valuation and bond yields.

Conclusion: We are still of the view that this is just a correction, and not the beginning of a bear market. Economic growth is intact, and corporate profits are growing. This week will see the Tech giants report earnings and give an insight into AI driven demand. Technically, we are looking at the S&P 500 settling at the 200-day moving average before starting another rally before the US elections heat up.

• Oil and gold prices heading higher. Is it a cause for concern? Two key commodities that are influenced by geopolitics have surged in recent weeks. West Texas crude is approaching $90/bbl while gold is hitting $2350. It should be noted that during this period, the US dollar index did not decline, indicating true strength in the oil and gold rally. The potential for Israel-Iran conflict should be seen as a trigger for supply disruption while the pick up in manufacturing could see demand going up in the next few quarters. The all important question is if this would translate to higher inflation.

• US manufacturing is back! No landing in the US. Capital spending defies higher interest rates. After a year of aggressive rate hikes, US capital spending shows no signs of slowing down. Made in America is helping to keep investment humming for now. Manufacturing PMI poised for recovery. Recession risk continues to be low for now.

• No rate cuts this year? FED speakers tame rate cuts expectations. The strength of the economy, couple with sticky inflation, is seen as a reason for the FED to hold back on cutting rates. The June rate cut odds have fallen, from 57% a month ago, to the current 46%. The odds for keeping rates unchanged has risen to 51% from 26%. Risk free bonds are likely to underperform in this environment.

• Weakness in stock market spotted! Volatility rising. Time for a correction. Thursday’s bearish engulfing candle shows investors are skittish about the rally. Equal weight Tech and Discretionary ETFs are starting to roll over. Markets are overbought, so a correction is inevitable but the underlying tailwinds (economic growth to propel earnings) remain intact. Traders to take profits while investors can buy the dip.

After a better showing in the manufacturing PMI, some have pointed to the “still weak” back log index as a sign that there is something wrong with US industry. We disagree. The performance of Trucking stocks suggests that the recovery is ongoing and sustainable.

Fitch Ratings came up with a report, “Global Contagion Risk Growing from Rising CRE Losses, Led by Office”. By percentage of assets and capital, small U.S. banks have significantly higher CRE concentrations than banks with over $100 billion in assets. This could result in the failure of a moderate number of predominantly smaller banks. Naturally, people begin to worry that the US banking system will be vulnerable.

So far, there has been no bank failure, according to the FDIC.

The performance of regional banks, community banks remain stable. No signs of systematic failure.

There is no need to worry for now. Just monitor, as any prudent investor should.

Positive reading from US and China ISM surveys. Manufacturing recovering.

US consumer spending continues unabated.

US 2023 Q4 economic growth revised to 3.4%, supported by consumer spending.

US stock market outlook is positive, supported by strong market participation. More stocks and sectors are rallying. No longer a Mag-7 or Fab-4 driven bull market. Stay invested, pull backs are opportunities to invest!

Summary of Main Events:

• FED Chair pushes back on March rate cuts, but rates have peaked.
• US jobs report was stellar! Payrolls: 353K vs 185K.
• US Q4 economic performance outperformed expectations (3.3% vs 2%).
• Mid-east escalation: US servicemen killed, US strikes back but oil prices steady.
• Taiwan exports point to new electronics cycle

Things to consider: Is the current FED funds rate too restrictive? Are financial conditions too tight that will trigger a recession?

• Junk bonds have held up despite the disappointment. No fear of recession in high yield bond prices.

• Market breadth is still positive. More stocks rising than falling as risk appetite remains good.

The results are out and pro-independence Lai Ching-te, the DPP candidate, is the newly elected president of Taiwan. Naturally, this raises concerns that cross strait tension will increase. In my opinion, the level of tension is unlikely to increase. They will however, remain high.

DPP won 40% of the vote (This is lower than the 57% they won at the last election). Beijing friendly KMT candidate gathered 33% while former Taipei mayor received 26%. Voter turnout rate is estimated to be 69%, lower than the previous 75%. If Taiwanese are voting based solely on the China issue, we do not have a majority siding for independence, since the Taipei mayor presented himself as a balanced candidate.

The legislative election outcome is unlikely to lead to greater tension. The DPP lost 10 seats, while the KMT gained 14 seats. It is hard to make a case that the Taiwanese people is moving towards pro-independence.

The outcome is also expected by the Chinese, as we did not see any mass military exercise around the island. It also helps that US president, when asked for his reaction, said that the US does not support an independent Taiwan. All these point towards an unchanged environment for cross straits relation.

It is likely that the US presidential election may matter more, especially if a Republican, who tend to take a more aggressive posture with China, wins.

Financial markets reaction is fairly muted thus far, with Asian equities, gold, FX trading in a tight range. The election result is not expected to have any impact on financial markets.

As we approach the latter half of 2023, the prevailing theme in the financial landscape is undoubtedly resilience. Despite the Federal Reserve’s assertive rate hikes, occurrences of bank failures, and tightening financial conditions, the US economy has demonstrated remarkable strength, managing to avert a recession. While equity markets have shown positive performance, not all stocks have participated in the gains, except those associated with artificial intelligence. Nonetheless, there are indications that the market could be heading for a downturn as concerns about an inevitable recession surface in the latter half of the year. It is, however, crucial for investors to consider the possibility that the US may continue to avoid a recession this year, which could have significant implications for risk assets.

The US economy has displayed unexpected resilience, with Q1 GDP revisions indicating an annualized growth rate of 2%, surpassing the earlier estimate of 1.3%. Strong consumer spending and robust exports have been pivotal in supporting this growth. Furthermore, the outlook for Q2 remains positive, with the Atlanta Federal Reserve’s GDPNow estimate projecting a growth rate of 1.8%. The US economy’s ability to withstand higher interest rates highlights its capacity to endure adverse monetary conditions.

While inflation has peaked and is now slowing, it remains above the Federal Reserve’s target rate of 2%. Although the CPI declined to 4% in May from the peak of 9.1% in June 2022, the core CPI (excluding food and energy) remains elevated at 5.3%. However, there are encouraging signs, such as the slowdown in housing inflation, which may contribute to a further decline in inflation in the coming months.

The Federal Reserve remains resolute in its commitment to combat inflation, maintaining a hawkish bias and projecting two more rate hikes for 2023. This stance has resulted in an inverted yield curve, contributing to concerns about an impending recession.

A notable factor contributing to the US economy’s resilience amid higher interest rates is the strength of the labor market. The unemployment rate has consistently remained below 4% since 2022, standing at 3.7% currently. The decline in ongoing jobless claims indicates that those affected by layoffs have been able to find new employment opportunities swiftly.

While the US regional banking sector experienced some turbulence, the situation seems to have stabilized, with deposits at small banks steadying after the Silicon Valley Bank’s failure. However, banks are facing challenges related to profitability and balance sheet protection, which may affect their lending activities and subsequently impact the economy.

Looking ahead, the US economy’s outlook is subject to various factors. If inflation continues to decline, and the Federal Reserve adopts a prudent approach to monetary policy, the start date of a forecasted recession may be postponed. The recovery in the housing sector and its potential to offset weaknesses in manufacturing could contribute to avoiding a recession.

In the US stock market, while large-cap technology stocks have performed well, other sectors have lagged behind, and small caps are facing challenges due to recession concerns. The market’s sustainability largely depends on whether the rally broadens to include non-large cap technology stocks, indicating broad-based confidence in the US economic outlook.

The European economy faced headwinds, falling into a technical recession in Q1 2023 due to various factors, including the Ukraine war, energy price surge, and slowdown in global trade. However, current consumer sentiment indicators suggest a mild recovery may be underway.

In China, growth momentum may be slowing, with some data indicating a slowdown in industrial activity. Restoring consumer confidence and stimulating the economy are critical to its recovery, especially amid global tensions and challenges.

In the bond market, an inverted yield curve remains a concern for investors, with potential scenarios ranging from a recession-driven rate cut to a more cautious Fed policy. Corporate bonds are facing challenges, and defaults are expected to rise, requiring close monitoring.

Commodities such as oil and copper reflect global economic conditions. While oil prices have been under pressure due to weak global industrial activity and higher interest rates, signs of stability in commodities could indicate an upturn in industrial activity.

The US dollar has remained range-bound amid the Fed’s hawkish monetary policy, with emerging market currencies rallying against it. The stability or appreciation of currencies like the Brazilian real may attract American investors seeking higher yields.

In conclusion, the second half of 2023 presents a mixed outlook for financial markets. While recession concerns persist, positive economic data and potential broadening of the stock market rally offer reasons for optimism. Monitoring inflation trends and the Federal Reserve’s response will be crucial in shaping market dynamics. As financial advisors, it is essential to carefully assess these factors to make well-informed decisions and navigate the evolving economic landscape for the benefit of your valued clients.