Bedrock’s Newsletter for Friday 28th April 2023

Friday 28th April 2023

Two competing impulses have fought to set the tone for markets in the last week or so. On the one hand, renewed fears about fragility in parts of the US banking sector have dragged on sentiment and stocks. But gaining the upper hand as this week progressed has been a more buoyant push, centred on Big Tech. Having rallied appreciably in March, the S&P 500 largely held its ground in the first weeks of April, pushing only gently higher: scepticism was widespread about the quality and breadth of March’s rally but no downward catalyst presented itself to crystallise those doubts and both realised and implied volatility sagged (the VIX index, a measure of the latter, fell to its lowest levels since late 2021). However, one seemed to come along this week, as banking sector turbulence again reared its head. Under-pressure Californian lender First Republic Bank – its share price already down -86% since March – reported on Monday and promptly saw its stock hammered another -50%. The heart of the problem is much the same as with its recently deceased neighbour at the other end of San Francisco Bay, Silicon Valley Bank: light regulation and poor risk management allowing a yawning asset-liability maturity mismatch to open up, imperilling the balance sheet and near-term liquidity and feeding into a lightning-fast, digitally enabled run on deposits. First Republic lost $72bn of the latter in Q1. It has spent recent weeks trying – and so far failing – to woo buyers for some of its assets, while keeping its head above water with (expensive) emergency funding from the Fed’s discount window and its new Bank Term Funding Programme. Nervous regulators have been working with the bank behind the scenes to find a solution but are yet to make their move. Market participants were similarly nervous, fearing First Republic’s travails were confirmation of the near-inevitability that something would have to crack under the strain of rapid rate rises and throttled credit. Equity indices retreated on both sides of the Atlantic, including a -1.6% fall for the S&P 500 on Tuesday.

Come Wednesday, though, this negative impulse was losing the tussle for markets’ attention as a string of encouraging reports from Big Tech saw stocks advance, including +2.0% and +2.4% gains yesterday for the S&P 500 and tech-focused Nasdaq, respectively. Microsoft and Alphabet reported resilient revenues and profits in Q1, setting the foundations for a rally that gained strength on the back of Facebook parent Meta’s results. The company – its share price mauled -76% from 2021 peak to 2022 trough – announced a return to sales growth in its first positive quarter in four. Its stock is now up +98% YTD. Yesterday’s rally broadened appreciably, with 88% of S&P 500 constituents and all sectors advancing. Indeed, though earnings season is far from over, the positive results have so far not been limited to tech names, with big banks and the likes of Coca Cola beating estimates. Nonetheless, this year’s rally remains remarkably narrow and highly dependent on the FAANG+ stocks. Seven mega-cap tech names (Alphabet, Apple, Meta, Nvidia, Amazon, Microsoft, and Tesla) have collectively added over $2.1tn of market capitalisation this year, contributing almost 90% of the S&P 500’s YTD gains. Microsoft and Apple now represent 13.4% of the S&P 500, a record weight for the top two stocks in the blue chip index. Speculative retail participation is high. While the latest moves are not at the frothiest, FOMO-driven extremes, they do not project a stable base for judging the near-term market outlook – and are driven by the inherently backward looking indicator of quarterly results and beats against low forecasts. Ultimately, how much can the reports of a few (admittedly large) tech companies and a narrow market rally really tell us about the state of the US economy?

Judging by the latest data releases: not all that much. Yesterday’s first print for Q1 GDP growth came in at +1.1% (QoQ, annualised), well off the +1.9% average forecast and a clear step down from the previous quarter’s +2.6%. This abrupt deceleration suggests the Fed’s sharpest rate hiking in decades (nearly +500bps in just 12 months) is beginning to squeeze the brakes on the US economy. Consumer confidence in April sagged to a 9-month low and retail sales have fallen month-on-month since February. The labour market remains tight – but here, too, tentative signs of a slowdown are starting to appear. Having surged dramatically in January, monthly job creation (measured by non-farm payroll data) has been on a downward trend, falling to +236,000 new jobs in March. But the overall picture remains one of resilience, for now; the unemployment rate is only a little higher than record lows while the latest weekly initial jobless claims data measured a slight drop after rises since the start of April. The state of play on US inflation is similarly ambiguous, as discussed in our last note (headline CPI down in March thanks to falling energy prices but core inflation so far impervious to Fed rate hikes). The fight against inflation is clearly not yet won. Indeed, despite that softening GDP print, last week’s US PMI data have continued their upward march into expansionary territory (the composite struck 53.5, the highest since last July, while manufacturing and services PMIs rose to 50.4 and 53.7, respectively). The picture is not dissimilar on this side of the Atlantic, where today’s Eurozone GDP figure for Q1 was a below-expectations +0.1% (Germany particularly detracting), even as inflation in France and Spain rose again in April (the inflation picture for the Eurozone as a whole will follow next week). With this in mind, both the Fed and the European Central Bank are poised to add another +25bps to their target rates next week – indeed, a 50bp increment remains on the table in Frankfurt. Today’s slight decline in the US Core Personal Consumption Expenditures index (the Fed’s favoured inflation measure) from 4.7% to 4.6% in March strengthens the case for a hiking pause in the US beyond that, however. With a host of indicators pointing firmly downwards, from business and consumer confidence to financial conditions, via housing starts and jobless claims, the risk of a hard-landing recession is very real. Although the macro data dashboard is still mixed, with signs of ongoing resilience, the propensity for economic downturns to erupt in an unpredictable, non-linear fashion suggests the risks are skewed to the downside. The US banking sector is more solid than First Republic’s impasse implies – but it is nonetheless a clear sign that there is plenty of tinder about as credit conditions tighten.

The threat of a recession will be watched particularly closely in the White House, where Joe Biden this week finally launched his re-election campaign. No incumbent president has successfully won re-election against the backdrop of a recession in their last two years in office in over 120 years (2 have tried and failed). If a hard landing hits, Biden will face an uphill battle. Launching his campaign by asking for a mandate to ‘finish the job’, Biden nonetheless has a solid – if not unblemished – record to present to voters. A highly experienced Senator, President Biden has chalked up some sizeable legislative wins – most strikingly the CHIPS Act and the Inflation Reduction Act. These are the centrepieces of a Biden industrial policy that looks to be bearing fruit: companies have drawn on the subsidies packages to double their manufacturing investment commitments to $200bn in 2022. Signs of a nascent reindustrialisation will be an important draw for the kinds of disaffected rust-belt voters who in 2016 bought Donald Trump’s promise to ‘Make America Great Again’. More broadly, Biden’s identity as a highly experience relative moderate and authentic son of the American heartlands (rather than the remote coastal elites) will underscore his appeal amongst those small groups of swing voters that have the power to decide presidential elections.

But Biden’s decision to throw his hat in the ring is nonetheless a gamble – and his approval ratings are weak. Age is undoubtedly his greatest political vulnerability. At 80 he is the oldest ever occupant of the Oval Office. On election day he will be 82. He will reach 86 at the end of any second term. Holding down one of the most demanding jobs in the world is physically punishing and it is fair to say Biden is starting to look his age – raising real questions about his ability to keep up the pace for another six years. And the immutable laws of human mortality and the dictates of the presidential succession tie the question of Biden’s age to what is arguably his ticket’s next greatest weakness: his running mate Vice President Kamala Harris. A pathbreaking Veep – the first female presidential deputy and first African-American and Asian-American in the role – she has nonetheless had a bumpy time in office, at times being less than convincing under questioning, though she is a credible campaigner with appeal amongst important Democrat constituencies. Republican campaign teams will remorselessly amplify any missteps that suggest Biden’s faculties are failing or that Harris is not someone most Americans want a mere heartbeat from the presidency. Ultimately, though, much depends on the identity of Biden’s challenger at the top of the ticket. At present, Trump (no spring chicken, himself) looks most likely to secure the Republican nomination, even as legal jeopardy swirls around him. Polling indicates voters would again reject Trump in favour of the current president. But the same polling says Biden would lose to a generic, placeholder ‘A.N. Other’ Republican candidate. If the Grand Old Party can fill in those red outlines with a (perhaps younger) candidate with real appeal, Biden will have a fight on his hands. We are still a long way from election day and goodness knows a lot can happen between now and then. But the race is heating up – even as the economy starts to cool.

Just how far the economic temperature may plunge remains uncertain – but we see the risks skewed to the downside. We are moving to protect portfolios accordingly. Now is an appropriate moment to pare back both credit and equity risk, while we continue to favour allocations to gold and barbelled fixed income positioning.


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