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Investment Weekly: The last mile of disinflation

18 Mar 2024

Key takeaways

  • Historically, Asian exports tend to be a leading indicator of EM corporate earnings. So, it’s promising that year-on-year growth in exports out of Korea, Taiwan and Vietnam has reached double-digits in recent months.
  • Earnings growth in US markets over the past 12 months has been driven by a few sectors doing much of the heavy lifting. So far, that looks like it will continue in 2024.
  • Could Japan finally be emerging from its 25-year fight with deflation? There is growing evidence that a wage-price inflationary pickup is underway – helped by what could be a bumper Shunto pay round this year – and hopes of a recovery in domestic demand.

Chart of the week – The last mile of disinflation

Let’s start with the good news! Markets took February’s higher-than-expected core CPI number – the third in a row – in their stride. The S&P 500 had its best day in nearly three weeks on the day of the release, suggesting the market narrative of ongoing disinflation remains intact. The details of recent data releases support this view with the ‘sticky’ elements of core inflation improving in February, and several indicators suggesting the labour market is cooling more quickly than headline payrolls numbers would suggest.

Now for the bad news. The last mile of disinflation may not be straightforward; data can be volatile – see February’s unexpected pickup in producer price inflation – and several risks remain in play. In 2021, investors and the Fed initially brushed off major upside inflation surprises, reassured by the narrative of ‘transitory inflation’. But when the upside surprises persisted in 2022, the Fed changed its tune and there was a significant drawdown in risk assets.

Moreover, even in the absence of bad inflation news, history shows us that the gradual cooling of the labour market (that now looks to be well underway) can mutate into a rapid cooling. Even if neither of these risks materialise, the consensus US forecast is for the softest of soft landings, so even a modest disappointment on growth could pose a headwind to the stock market.

Market Spotlight

Picking winners in PE

Rising rates and volatile markets have proved to be a major headache for private equity investing recently.

After a post-Covid deal bonanza in 2021, the asset class faced a barrage of challenges. Rising rates hiked borrowing costs, compressed valuations, and deterred trade buyers. And with equity prices falling, the route to sell investments via the stock market – through IPOs – was also closed off. As such, the number of ‘exits’ from private equity investments fell substantially.

But with markets pricing in rate cuts from this summer, and momentum building in equities, there are signs that deal flow could soon pick up – with IPOs potentially becoming viable once again.

In the meantime, PE managers are likely to have to work harder to generate returns, which could widen the gap between winning and losing funds – a trend which has been evident recently. Industry data suggests there is wide dispersion between the top and bottom quartile private equity returns. While median returns remain relatively attractive, selecting winners can have a meaningful impact on investment outcomes.

The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested. Past performance does not predict future returns. The level of yield is not guaranteed and may rise or fall in the future.

Source: HSBC Asset Management. Macrobond, Bloomberg. Data as at 11am UK time 15 March 2024.

Lens on…

Export-led growth in Asia

Historically, Asian exports tend to be a leading indicator of EM corporate earnings. So, it’s promising that year-on-year growth in exports out of Korea, Taiwan and Vietnam has reached double-digits in recent months.

But while the early signs are encouraging, the underlying details are uneven. Technology sector shipments – which have been boosted by a recovery in demand for semiconductors – account for the lion’s share of exports out of Korea and Taiwan. In addition, base effects are flattering the numbers because early 2023 was a very weak phase for global trade. More broadly, an uptick in export activity still risks being hampered by potential economic slowdowns in the west, as well as the drag of continuing weakness in mainland China.

But while there are reasons to be cautious, and more evidence is needed that this is a durable upswing. Signs of a turnaround in the global trade cycle are welcome news.

Will profits deliver?

Earnings growth in US markets over the past 12 months has been driven by a few sectors doing much of the heavy lifting. So far, that looks like it will continue in 2024, with nearly half of the market’s 9.8% expected earnings growth coming from its two largest sectors: Communication Services and Information Technology.  

While growth in tech-related sectors could continue to be a major contributor to US profits growth overall, valuations are high and vulnerable to disappointment. The US Information Technology sector trades on a forward price-earnings ratio of 28x (versus a 10-year sector average of 18x).

Likewise, more cyclical sectors like discretionary, industrials and financials, could be vulnerable if current expectations of a soft landing fail to materialise. And the performance of classic ‘bond proxy’ sectors – consumer staples and utilities – could also disappoint in the new paradigm of higher rates. With the market already punishing previously high-flying shares that miss earnings expectations, it remains important to be selective in stock-picking.

Japan’s NIRP dilemma

Could Japan finally be emerging from its 25-year fight with deflation?

There is growing evidence that a wage-price inflationary pickup is underway – helped by what could be a bumper Shunto pay round this year – and hopes of a recovery in domestic demand. So much so that the Bank of Japan (BoJ) could soon do away with its ultra easy monetary stance – the Negative Interest Rates Policy.

But for investors, there could be bumps ahead. Japanese equities have risen by nearly 23% over the past 12 months, but meaningful upward pressure on the yen from any policy shift could hurt stocks, given the current negative correlation between the two.

If the central bank doesn’t normalise – with risks that deflationary pressures may not have been fully eliminated – it could point to weak structural demand and put a question mark over corporate earnings strength, again hurting stock prices. Policy surprises could spark volatility and need to be closely monitored.

Past performance does not predict future returns. The level of yield is not guaranteed and may rise or fall in the future.

Source: HSBC Asset Management. Macrobond, Bloomberg. Data as at 11am UK time 15 March 2024.

Key Events and Data Releases

Last week

The week ahead

Source: HSBC Asset Management. Data as at 11am UK time 15 March 2024.

Market review

Risk markets held firm in a week that saw an upward surprise in US core CPI. Core government bonds weakened ahead of the key FOMC meeting amid rising doubts of a June Fed easing. The US dollar DXY index strengthened. In the US, the S&P 500 and Nasdaq moved sideways but fared better than the interest rate-sensitive Russell 2000. The Euro Stoxx 50 posted modest gains, driven by strong Q4 earnings, but the Japanese Nikkei weakened on heightened expectations that the BoJ would remove its negative interest rate policy at March’s meeting. In EM, China’s Shanghai Composite Index softened amid the uncertain economic outlook, and India’s Sensex index was also on the defensive. Oil prices rose to a four-month high on rising geopolitical tensions and lower US crude oil inventories. Gold took a breather from its recent strong run, while bitcoin reached new highs.

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