The strength in the US July employment report will further focus the market’s attention on the Fed’s taper decision ahead.
The US labour market gained 943,000 jobs in the month of July, exceeding market expectations. The number of jobs added in June was also revised substantially upwards by an additional 119,000. Taken together, the number of jobs lost in the US economy since the pandemic now stands at 5.4 million, compared to an estimated 6.8 million last month and 9.8 million at the start of the year. There was an increase of ~1 million in employment amongst households, and the overall unemployment rate fell by a solid 0.5 percentage point to 5.4%.
Wages continue to rise as well – weekly earnings for private workers rose ~4.6% year-on-year, compared to 4.3% last month. Jobs and wage increases in the leisure and hospitality, services and retail sectors were robust and reflect the effects of summer re-opening.
The reaction of the market to the strong employment data was expectedly positive last Friday – the S&P500 gained 0.2%, while the Dow rose by 0.4%. Against the picture of an improving economy, the nominal US 10-year Treasury yield rose 7bps to 1.288%, while the 10-year real yield edged up slightly by 5bps to -1.05%. Gold on the other hand reacted negatively, falling to USD1,762 (-2.1%) from Thursday’s close of USD1,800.
While the Fed’s taper announcement could come as early as the next FOMC meeting in September, we believe that the Fed could possibly wait until as late as December.
The path ahead will depend on the economic data in August. A strong set of employment and inflation figures will fuel the hawkish members of the Fed to push for an early decision in the tapering of its quantitative easing program, and importantly sway even neutral and dovish members of the committee.
This was evident last week when Richard Clarida, US Federal Reserve Vice Chairman and a senior member of the FOMC, who is widely thought to be amongst the more dovish voting members together with Chairman Jerome Powell, expressed a comparatively hawkish view of the US economy and outlined some of the most concrete parameters for monetary policy decisions.
During his speech at the Peterson Institute for International Economics, he noted that should core PCE inflation – the Fed’s inflation policy target measure – come in at 3% this year, he would consider that to be “much more than a ‘moderate’ overshoot of our 2% longer-run inflation objective”. He also believed that the risks to his inflation outlook “are to the upside”.
If inflation and employment track his projections (which are similar to the Fed’s in the summary of economic projections), the “necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022”. Nonetheless, the Fed’s base case remains for the ongoing uptick in inflation to be transitory.
While the announcement could trigger some degree of volatility, we do expect the Fed to gradually build up market expectations through its communications to avoid a surprise and a reprise of the 2013 taper tantrum. Moreover, we expect only a gradual reduction in the monthly pace of asset purchases which should continue to be largely supportive of risk asset prices.
The broadly constructive outlook for risk assets would be anchored by the fact that the Fed would be tapering against a background of a broad economic recovery with corporate earnings slated to rebound further from Covid-19 lows.
Today, we are near the end of the 2Q earnings reporting season in US and Europe, with 80% of companies having reported their earnings. Despite the strong expectations coming into this season due to the low base effects from last year’s pandemic-induced slump, most of the companies exceeded expectations.
In the US, 86% of the S&P500 companies that have reported their earnings beat expectations, with earnings per share (EPS) growing by 93% compared to 2Q last year, surprising positively by 17%. It is a similar picture in Europe, where 65% of the Stoxx600 companies that have reported beat expectations; EPS growth is currently running at 74%, 22% higher than expectations.
Sales growth also surprised positively in both the US and Europe. Best-performing sectors were discretionary and financials in the US, and energy and industrials in Europe.
Notwithstanding a positive long-term outlook for risk assets, we see the scope for short-term volatility due to continued uncertainties over Delta variant of the Covid-19 virus.
This risk is particularly stark if we examine the situation in China, which has been “first-in and first out” of the Covid-19 pandemic and is now struggling with the spread of the Delta variant and re-imposing restrictions in some cities.
Covid-19 cases in China continue to rise with 452 local cases being confirmed last week, compared to 193 the week prior. The government has proceeded swiftly with partial lockdowns (national and provincial highways are closed in Yangzhou, the latest hotspot) and tighter border controls with the halting of issuance of entry and exit permits for non-essential and non-emergency exit.
The good news is that Chinese policymakers have signaled that they are sensitive to the trajectory of its economic recovery and are starting to loosen its monetary policy stance.
Under the cloud of the rise of the Delta variant in China and the cautious assessment of the economic outlook coming out of the July Politburo meeting, the Chinese government is expected to step up policy support.
The surprise 50bp RRR cut in early July is a strong signal that fiscal and credit tightening in the first half of this year has ended. Policy support is likely to be tilted towards fiscal measures in the coming months as outlined in the Politburo meeting. The government only utilised one-third of the bond issuance quota in the first half of the year and it will likely utilise the existing fiscal headroom to step up fiscal spending this year and into early next year.
We should expect more monetary and fiscal support from the Chinese government if required, and they have significant dry powder in store. Given that Chinese risk assets have historically demonstrated a strong correlation with credit growth in the Chinese monetary system, this should serve to buttress valuations over the long term.
In our view, we remain overall overweight in equities through an overweight position in US equities.
We are neutral on Asia equities given that we expect China’s regulatory overhang to weigh on investor sentiment over the near to medium term.
Within the Chinese equity universe, we have a relative preference for the onshore A-shares market, which yields less exposure to the sectors receiving regulatory scrutiny.
As for the Chinese technology sector, we believe its long-term prospects remain sound, but it is premature to call a bottom for the sector considering the latest move by the government to set up a special task force to regulate the internet sector and the risk of further earnings uncertainty.
In contrast, we favor sectors that are key to Beijing’s long term strategic goals as highlighted in its 14th Five-Year Plan, such as semiconductors, telecom, AI, 5G, renewables, infrastructure, new energy vehicles, and the domestic consumer sector as these are slated to receive increased government support.
In fixed income, we remain overweight in Emerging Market High Yield bonds, where valuations still look relatively attractive and should offer a buffer against the adverse impact of rising rates compared to other fixed income segments.
We stay underweight in both Developed Market and Emerging Market Investment Grade bonds, where historically rich valuations leave little buffer against rising rates.Disclaimer applicable to recommendation
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Version: July 2020