by Jurrien Timmer, Director of Global Macro, Fidelity Investments
The Broadening Broadens Abroad
Week of September 30, 2024
Following the bullish broadening impulse to the start of the Fed’s long anticipating easing cycle, China launched a reflation bazooka of its own last week. As a result, what was at first a US broadening trade has potentially become the kind of global reflation trade that we were used to seeing in the aftermath of the financial crisis. I will leave the policy details to my AART colleagues, but suffice it to say that the market reaction was swift.
Below in red is the Shanghai Composite, which remains way at the bottom of the leaderboard, measured from the October 2022 bear market low. But it is quickly making up ground.
Here is the MSCI emerging markets index, with and without China. After being all but forgotten and deemed un-investable, China is having a moment. Whether it lasts is another question, but for now the action is fierce and is a nice extension of the “everything else” trade. Per the orange chart below (showing the industrial commodity cycle), the global economic cycle may be due for a rebound.
Part of this newfound reflation sentiment is a US dollar teetering at support. Any further weakness would suggest a larger move lower, which could add fuel to a global reflation trade.
China’s sharp rally has rocketed the MSCI China index to the top of the leaderboard (which measures rolling three-month returns). It hasn’t been there since 2019.
Another dimension of a broader reflation trade is commodities, especially if the dollar also weakens further. So far, very little has been happening on the commodities front, with both the Bloomberg Commodity Spot index and commodity sensitive stock index stuck in a range. The bullish read here is that the whole structure is forming a large base.
Ultimately, if the outperformance by China and emerging markets in general is to continue, we will need to see the earnings fundamentals back it up. We know that China is cheap at 9 times earnings (especially compared to India at 24x), but cheap valuations will only get you so far if they’re not backed up by earnings.
China has a long way to go to catch up earnings-wise, but the estimate drift is oversold and starting to head in the right direction. The chart below shows earnings squiggles by calendar year (top), the drift in estimates (middle), and the estimate progression relative to the US (bottom). Clearly, the relative performance of China follows relative earnings, so relative earnings will have to improve for this trade to grow legs. If they don’t, the China bazooka story may be a nice trade but perhaps nothing more.
Back in the Hood
In the US equity market, the broadening trade continued last week, with both the cap-weighted and equal-weighted S&P 500 indices making new highs. Absolute breadth remains robust, and relative breadth has improved as well.
The cap-weighted S&P 500 index remains in a well-defined bull market with 82% of stocks above their 200-day moving average.
And the equal-weighed index is making consistent new highs as well, with 84% of stocks above their 50 day moving average. Momentum.
The Mag 7 aside, the bottom 490 stocks in the S&P 500 remain in a well-defined uptrend, characterized by higher highs and higher lows.
While the annual seasonal pattern remains challenging for another few weeks (until mid-October), the Presidential election cycle has clearly dominated and remains bullish until year-end.
Normalization
With the Fed having jumpstarted the easing cycle, speculation is now growing about whether another jumbo cut lies in store for the November FOMC meeting. That’s still many weeks away, so it’s a moot point for now. What is clear is that with inflation at 2.7-3.2% (core-PCE & core-CPI), the Fed has room to cut as it normalizes policy back towards neutral.
The Labor Pendulum
With inflation seemingly at bay for now, the primary focus has turned to labor. With the pandemic-related excess demand for labor all but gone (orange line), the economic cycle and Fed are in the sweet spot right now. The question is whether it will continue. A labor market in balance plus inflation closer to target equals a neutral Fed, which is what the forward curve is pricing in.
The labor question is a tough one though. Looking at the demand for labor (using data from Empirical and Stifel), the chart below shows just how imbalanced the labor market was back in 2022 when the economy was back on track but the labor supply wasn’t there to feed it. You have to go back to World War II to get a cycle in which the demand for labor was so out of balance with the supply.
An analog of all drawdowns in labor demand illustrates the elevated starting point for this cycle. It seems like this is why the drawdown in labor demand hasn’t yet created a recession.
It’s also unusual that the Fed was tightening during this substantial drawdown in vacancies. Typically, the Fed starts to ease almost immediately. The only other time it tightened into a labor slowdown was during the late 1970’s. Both then and the recent tightening cycle were periods of stubborn inflation.
The question is whether the pendulum keeps swinging. Even following the robust starting point in 1945 during WWII, the pendulum did eventually swing all the way to a recession (in n1949). But it took four years to get there. Indeed, it seems that a recession usually follows once labor demand starts to wane.
So, we are left asking that dangerous question of whether this time is different. It seems that the pandemic and the policy response that it unleashed has made almost everything different this time, so perhaps the labor dynamic is part of that. Certainly, the market seems to be thinking so, with its celebration of a soft landing.
Recession or not, there is no simple market playbook for labor market slowdowns, other than to maintain a diversified portfolio. There are never any easy answers in the market, even when we know where the fundamentals are heading.
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