Financial Update from Brewin Dolphin - 21 July 2023

July 2023

The Weekly Round-up

Friday 21 July 2023

In his latest weekly round-up, Guy Foster, our Chief Strategist, analyses the start of the technology earnings season, better-than-expected UK inflation, and China’s property sector.

So, this looks to be another positive week for equities, but I am slightly wary about making that judgement while the US market remains open; particularly as this week has some very obviousdrivers of volatility. As we discussed previously, we are entering the summer months when liquidity deserts the markets during a critical earnings season with a lot of uncertainty around margins, inventories and guidance. Central banks are generally data dependent, creating some uncertainty about the direction of interest rates. An additional factor is derivatives usage. The explosion in retail options usage has been a big driver of markets at various points over the last few years.

A great deal is written about this with frustratingly few conclusions reached (until after the event). I will shamelessly add to this by acknowledging that $2.4trn of notional options exposure expires today. What should we expect? The trite observation that is habitually made at these times is that it may lead to unusual swings in price. On this occasion, it coincides with an unscheduled reshuffle of the NASDAQ index in order toreduce concentration of technology mega-caps (which was impairing funds’ ability to track the index). Apple, Microsoft, Alphabet, Nvidia, Amazon, Tesla and Meta will all be trimmed with their cumulative haircuts reallocated across smaller stocks on a pro rata basis.

Technology earnings season begins

The rebalance will come ahead of a step up in technology company earnings. However, this week saw the beginning of that wave. Netflix disappointed the market with low guidance as their crackdown on password sharing and advertising-funded streaming have not delivered the growth that was hoped for. Tesla disappointed investors with promises to continue discounting, although that disappointment should be seen in the context of shares that have doubled so far in 2023.

Away from the US, TSMC, the world’s largest contract chipmaker with a dominant position in the foundry industry, issued guidance that indicated that any secular trend towards greater AI adoption would not offset a cyclical slump in chips production. Related stocks slumped, demonstrating the benefits of understanding the cycles as a means of choosing entry and exit points.

Most banks have now reported earnings, and the overall message has been reassuring in terms of both their own activities and the resilience of the US economy.

The economic data was a bit more mixed. The NAHB house builders’ sentiment index increased for a seventh straight month, with the traffic of the prospective buyers’ index, a gauge of demand, rising to its highest in a year. There was however a decline in new housing starts (and building permits). US retail sales were weak, reflecting ongoing price disinflation in core goods markets. Other data showed an increase in loan refusals for car loans.

Financial conditions tightening

The tightening of credit conditions seems to be gathering pace and might argue for a further pause in interest rate increases when the Federal Reserve decides rates next week. The quite strong consensus expectation is that it will raise rates a further quarter of a percent, but there is some room for doubt. A surprise reduction in initial jobless claims reported yesterday might encourage Fed hawks, but the labour market does seem likely to weaken over the coming months based upon an increase in WARNs (worker adjustment and retraining notifications), which must be issued to some staff ahead of large layoffs.

Increasing evidence of layoffs and rising credit card delinquencies may sound grim, but at the moment in the US, they are really returning to normal levels from the very depressed levels reached whilst pandemic support measures were in place. This makes it difficult for the Fed to judge whether conditions are overtightened already, or not. However, the luxury it has is the ongoing goods disinflation and lagged declines in the shelter component of CPI, which should mean inflation continues to fall over the coming months.

UK inflation much less worse than usual

That has been a luxury the Bank of England has been craving after a few months of historically high inflation numbers. This month, it finally had some good news. Consumer prices rose far less than anticipated in June. Weighing inflation down were transport costs and an absence of the unusual price spikes seen in previous months (concert tickets, air fares and utilities bills, for example). After two months of upside surprises, this latest reading of CPI inflation is in line with the forecast the Bank published in the May Monetary Policy Report (MPR).

Inflation remains too high in the UK and considerably less comfort can be drawn from a single, surprisingly low inflation number but, replicating some of the approaches used in the US to identify underlying inflationary trends, the median inflation category slowed to a sedate pace during June. Moreover, many investors were assuming a continuation of the trend of upside inflation surprises. We therefore saw a sharp reaction in the gilt market, which rallied firmly, and in the currency market, where sterling fell sharply. The peak level of anticipated UK interest rates has fallen from 6.5% in June to 5.8% today. That peak is expected to be reached in February.

Reviving the Chinese consumer

China outlined a series of measures to increase car purchases, particularly for new-energy vehicles, as a way of improving environmental conditions and boosting growth. The National Development and Reform Commission announced a series of policies including lowering costs for electric vehicle charging and extending tax breaks for the purchase of electric vehicles.

As well as boosting consumer demand, the Communist Party and government also issued a joint pledge to revive animal spirits amongst private businesses. Heavy-handed central guidance prompted boom and bust cycles in many raw materials markets and more recently Xi Jinping has focused regulation on troubled sectors.

Last year saw a major clamp down on the real estate sector. The sector has, over the years, been instrumental in delivering government objectives but is now facing challenges from funding to consumer demand and oversupply.

Last Saturday, Chinese property prices were released, and we discussed how they were basically unchanged on the month before. On a seasonally adjusted basis, that implies a big loss of momentum. The concern is that property is a big driver of wealth in China, and if it falls, that could intensify the consumer retrenchment. The top quintile of Chinese households have an average of two properties each. The home ownership rate is high, and many investment properties are held unlet, assuming that they will benefit from rising prices.

The Chinese authorities are therefore considering easing home buying restrictions in some major cities. Currently, homebuyers with a mortgage record who don’t own a property would be subject to the higher down-payment and more restrictive borrowing limits applied to those buying a second home, but this restriction may be relaxed.

China’s technology outcasts

Developing the rural consumer through e-commerce was a big focus of the government from 2014 onwards, but more recently it turned hostile to the e-commerce sector in a wave of regulation. This has been a thinly veiled move to show the Communist Party’s ultimate authority and stewardship over the delivery of common prosperity.

A further $3.5bn of fines were handed out to a handful of companies this month for a variety of alleged offenses.

Against that, background efforts were made to try and restore confidence to the private sector. This week, a joint statement from the party’s central committee and the state council vowed to treat private companies the same as state-owned enterprises. Various state entities will be encouraged to invite business leaders for consultation before drafting policies.

The yuan is higher after China supported the currency with a stronger-than-expected reference rate and a change to its capital curbs to lure inflows.

The People’s Bank of China set its daily fixing at just under 7.15 per dollar, the largest upward surprise since November. It also adjusted some rules to allow companies to borrow more from overseas, opening the door for more foreign capital inflows.