US equities: Fundamentals remain soft, don’t chase cyclicals
Some data points over recent weeks fuelled hopes that the US economy could be stabilizing with inflation gradually converging towards the Fed’s target – a goldilocks scenario for equities. We would caution against this view though. Relevant macro indicators continue to weaken and the unprecedented pace of monetary tightening this year has yet to fully feed through the system.
The US manufacturing ISM is the most relevant and most timely cyclical indicator for the US equity market. After touching a 2-year low in July, regional Fed surveys are indicating another drop in August. The implied reading of 49.2 would mark the first sub-50 reading since May 2020 and move US macro momentum further into negative territory.
This does not come out of the blue. Fed policy affects the US cycle through various channels. In the current cycle, one of those channels certainly is the US dollar, which on a trade-weighted basis, has risen to a 20-year high, partly driven by the surging spread between US yields and the rest of the world. Typically, a sharp rise in the US dollar precedes a downturn in the cycle, with the 10% USD appreciation over the past year continuing to act as a drag on the US economy.
Another key channel for monetary policy is the US housing market, which accounts for roughly 25% of US households’ gross assets. While the rise in the US dollar has a more immediate impact on the cycle, the housing market moves more slowly and should remain a headwind for the US cycle for months to come. A reflection of the additional burden for homeowners or prospective homeowners is the rise in mortgage payments. “Monthly principal and interest” on a typical home has risen to more than 25% of US median household income. This is not only the highest level in more than 30 years, but when the last two times it was reached, a recession also followed within two years. This point is reinforced by the correlation with the ISM, which typically follows changes in mortgage payments with a lag of 12 months, suggesting more weakness in the cycle.
Where does this leave us with regard to equities? Most notable in the recent rebound was the outperformance of cyclical sectors (industrials, materials, consumer discretionary) over defensive sectors (staples, utilities, health care). To us, this looks much more like a rebound from oversold levels – after the sharpest 12-month drawdown since 2009 – than a sustained recovery built on fundamentals. Given our view that macro momentum is unlikely to turn positive in the near-term future, defensives should resume their outperformance over cyclicals from a tactical point of view.
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