Bedrock’s Newsletter for Friday 26th May 2023

Friday 26th May 2023

Much has happened in the last two weeks – even if a quick scan of the market screens may suggest otherwise. In truth, it has been more a case of developments of things to come, remaining somewhat subterranean and not erupting into the open as fully formed outcomes – yet. We entered the fortnight on the back of several weeks of rather becalmed markets, as discussed in our last notes. This has largely held, with the last two weeks continuing an extended period of broadly sideways, range-bound trading. Indeed, since the start of April the S&P 500 has remained within a narrow 142-point range and as of yesterday’s close the net effect was a rise of just 27 points (or +0.65%) over the period. This has kept the VIX measure of S&P 500 volatility suppressed; only twice in the last 8 weeks has it poked a whisker briefly above 20, the rest of the time remaining mostly around the 16-17 mark. Fixed income markets measured by the Bloomberg Global Aggregate Index have charted a similarly narrow course, though here the trajectory has become more markedly negative, especially this week (the index is now down -1.3% since the start of May). Currency markets, too, have been rather muted this week, even as the US dollar continued to regain some strength to bring it back just above flat YTD. But this is not to say the last two weeks have seen no striking daily moves within these otherwise narrow bounds – including an appreciable sell-off on Tuesday as a flare-up in fears around the US fiscal outlook saw the S&P 500 drop -1.1%.

But perhaps most memorable – and telling – was yesterday’s trading. The S&P 500 changed direction after 4 days of declines to rise +0.9%, while the Nasdaq gained +1.7%. Firmly at the centre of events was chipmaker Nvidia, which specialises in the Graphics Processing Units that have become the pivotal hardware behind the dramatic advances in Artificial Intelligence that have attracted so much attention this year. All that attention is paying off handsomely: on Wednesday, Nvidia announced $11bn of expected sales in Q2, well beyond forecasts, as demand for its chips soars amidst the accelerating AI arms race. The firm’s stock leapt +24.4% on the day yesterday – also helping AI-leading big-tech stocks Microsoft and Alphabet to strong daily gains (+3.8% and +2.2%, respectively), while major semiconductor names elsewhere also benefited (ASML rose +3.8% and SK Hynix +5.9%). Nvidia added $184bn to its market capitalisation – that is one whole Hungarian economy in a day – and is now racing towards the $1tn club (its market cap currently stands between a Switzerland and a Turkey, for those who like to measure their stocks this way). While this was all spectacular and enough to push the aggregate stock market measures into positive territory, really it just underscored the story of this year’s rally, discussed in previous letters: it is incredibly narrow – and, if anything, narrowing. Just 40% of S&P 500 constituents finished the day positive yesterday. For the year so far, despite representing only 30% of the index’s capitalisation, the S&P 500’s top 20 stocks have generated 94% of its returns. Almost all of the 20 are tech-related (Exxon Mobil and Visa the only real exceptions) and AI has been the most substantive tailwind whipping them along. Beyond some defensive names, little else amongst US stocks is delivering this year. Strikingly, even as yesterday’s bell took the S&P 500 to +8.1% in 2023 so far, the equal-weighted version of the index is actually down -1.0%. The Russell 2000 tells a similar tale: the US small-cap index is down -0.4% this year. As we have highlighted previously, this is not a healthily advancing stock market – and speaks rather of a sort of ‘flight to safety’ to the biggest growth stocks amidst a very uncertain macroeconomic outlook.

The prime exemplar of a situation where there has been movement over the last fortnight but as yet no final fruition (at time of writing, at least) is the impasse on the US debt ceiling. Since the mid-1990s and especially since 2011 and the first Obama administration, leading a battle over deficit spending and the Federal debt ceiling has been a Republican ritual whenever they are locked out of the White House. (Famously the GOP loses all such qualms when they have the keys to the Oval Office; the Reagan and Bush Senior administrations were allowed to juice the deficit by Democrat and bi-partisan Congresses while Bush Junior and Trump were similarly able to ramp the ceiling up without Capitol Hill psychodrama.) This time it has been no different. Indeed, needing to buttress his weak authority after a protracted struggle to secure the speakership, Republican Speaker of the House Kevin McCarthy has had particular motivation to put on a show for the troops. But for all this, the risks are very real. As Treasury Secretary Yellen has repeatedly warned, if Congress fails to lift the ceiling, the Federal Government will likely run out of money at the start of June (next week!) and a default on the US’ supposedly risk-free debt looms. The full implications for a US-centric, USD-denominated global financial system are hard to fathom – but there is no doubt volatility would surge. Against the backdrop of rapidly tightening financial conditions, the timing would be terrible. Unsurprisingly, then, the fragments of news coming out of the negotiations between McCarthy and Biden’s White House have been major drivers of market sentiment in the past two weeks. This included improving signals across last week before the Republicans walked out of talks on Friday, sparking a risk-off turn that carried into this week.  Over the last few days, though, the mood music has again become encouraging. By Thursday, statements from both sides suggested a deal was coming into view, expected to cover spending for the next two years. But with just 16% of the Federal budget being non-military discretionary spending – and thus considered ‘in play’ – there is very little room for manoeuvre; a key sticking point is reportedly a Republican push to cut the budget of the Internal Revenue Service, hampering its ability to gather tax receipts and thus eroding the US fiscal position in the years to come. Our expectation is that a deal is forthcoming – but as it would then be subject to voting in the House where McCarthy has limited control of his thin majority, the risk of turbulence remains.

All this adds another crosswind to markets still struggling to grapple with a macroeconomic picture than continues to trouble and befuddle. Signs of softening in the US economy are there – survey data point to sagging consumer confidence while corporate earnings showed a shift away from discretionary spending. With outstanding credit card debts  having returned almost to pre-pandemic levels – but at significantly higher interest rates – this is not surprising. But again the latest hard data prints point to ongoing macroeconomic resilience and stubborn inflation. This week initial jobless claims came in down and below expectations; USD GDP growth in Q1 was revised up to +1.3% annualised; and today April’s Core PCE index (the Fed’s favoured inflation measure) rose to +4.7%. This has served to drive another shift in interest rates expectations. Whereas another hike at the Fed’s June meeting was all but priced out as a possibility at the time of our last letter, the probability has now risen above 50% for the first time since March, while the chance of another rise by July is up to 97%.

Meanwhile, another area where there has been much activity but as yet no outcome since we last wrote is geopolitics. Ukraine’s armed forces remain poised for a long-expected but high risk counterattack against a Russian invader that has now dug in along the battlelines. It seems Russia’s forces, led by the convict-mercenary army of the Wagner Group, have finally taken control of the town of Bakhmut – at staggering cost but little discernible strategic gain. Otherwise, developments on the battlefield have been minimal. Instead, last week it was all about diplomatic action as Japan hosted the G7 summit and President Zelenskyy unexpectedly attended in person. With a stop-off in Saudi Arabia on the way and the leaders of Brazil, India, and Indonesia in attendance at the summit, Zelenskyy had an opportunity to make the case for resisting Russia’s invasion directly to leading powers of the Global South who have avoided condemning Moscow’s actions. Brazilian President Lula dodged a one-on-one meeting but a bilateral between Zelenskyy and Prime Minister Modi of India saw the Indian leader make some of his most supportive comments yet. The Communiqué from the industrial democracies gathered in the G7 was strikingly sweeping in its scope and ambition – but the event was nonetheless another reminder of the changed balance of global power and the divergent views between many of the emergent powers and the incumbents (an impression underscored by news that South Africa has allegedly been sending weapons to Russia, and the departure for Europe of China’s special envoy on the Russia-Ukraine war).

All in all, it is difficult to draw a single narrative from the last weeks – beyond a still uncertain picture marked above all by divergence and dissonance across markets, macroeconomics and geopolitics. China’s recovery is sputtering, Germany is in technical recession, the UK’s cost of borrowing is again surging, while Japan’s stock market is on a roll. Heightened geopolitical risk looms over this, as does the menace and possibility of AI’s technological advances. From an asset allocation perspective, this is a promising environment for global macro trading – while we also continue to advocate for gold and caution with taking on excess credit risk.

______________________________________