Issue 90: Retail Sales and the Fed

This Week’s Highlights

• May retail sales helps doves’ case
  Tuesday’s report of US retail sales in May saw little growth in spending last month, with April retail sales revised into the red: two more datapoints suggesting a moderation of the US economy’s growth in the second quarter, and more evidence to support a Fed shift to looser policy.
• European equities face choppy June
  It’s been a volatile month for European stocks, though French shares posted their best day since January last Thursday, bouncing back from losses on Macron’s surprise call for snap elections. UK stocks likewise rallied despite a BoE pause in cuts on hope for an August resumption of easing.
• Rayliant hosts live Japan webinar
  Last week’s webinar on Japan’s economy and red-hot stock market focused on what’s been driving Japanese equities higher, why this time may be much more than another false start, whether the market has already climbed too high (spoiler alert: we think not), and how investors might play it.

The CIO’s Take:

• While inflation is the focus of a “data-driven” Fed policy, it’s supply and demand that feed into price pressures, and May retail sales brought welcome data that the latter is softening. We’re happy to see such hopeful results accumulating, though nothing in Fedspeak indicates to us this will move the needle on a September cut.
• Our international allocation includes a measured exposure to European stocks—and active bets on UK shares have been a big contributor to outperformance in our developed markets model over the last year—though we expect volatility to continue as political risk spooks markets and concerns over sluggish growth remain on traders’ minds.
• We increased our models’ allocation to Japan earlier in Q2, which makes now a great time to do a deeper dive on the economic underpinnings of that tactical call. We see a very positive macro narrative continuing to play out in the BoJ’s Tankan survey, out early in July, which we expect to show solid sentiment and investment proceeding apace.

Retail Sales and the Fed

Downside surprise in retail sales
Among potential market-moving macro releases last week was May retail sales, posted by the Commerce Department on Tuesday, which grew just 0.1% month-over-month. That was a negative surprise to economists polled by Reuters, who had been expecting a 0.3% increase. April’s figure was also revised downward to a 0.2% decline. Although a big part of softening sales came from a tougher month for gas stations, the numbers still line up with other data—including April and May CPI—which seem to show the US economy cooling off in the second quarter.

Evidence mounts, but case isn’t closed
What does this mean for Fed policy? As we’ve emphasized before, the US central bank is walking a tightrope between easing too soon—and seeing inflation surge back, as threatened by CPI prints in the first quarter—and keeping rates high for too long, triggering a downturn. While May retail sales and other emerging signs of softening growth won’t likely be enough to sway the Fed to a definitively dovish posture, we see them contributing evidence that might give the Fed that elusive “comfort” things are trending positively to the point cuts are warranted.

Fed officials’ guidance still mixed
With the FOMC’s June decision to hold steady, the Fed’s benchmark rate has been locked at what seems like a cycle high for twelve months—just a little longer than the average length of Fed holds before cuts set in across five previous cycles since the mid-1990s (see below). While there is obviously considerable debate as to whether September or December might mark the start of easing, Fed officials’ comments yield some clues.

Speaking last Tuesday, Fed governor Adriana Kugler suggested she was encouraged by evidence from Q1 earnings that lower-income consumers were reining in spending. The St. Louis Fed’s new president, Alberto Musalem, likewise addressed the public on Tuesday, referencing May retail sales specifically as a sign of softening demand, suggesting he expects consumption to “moderate in coming quarters, without stalling”—though he also said it “could take months, and more likely quarters” before he felt ready to cut rates: a sign not everyone at the Fed is so dovish.

Effects of November election?
Finally, at the risk of confounding matters further, we note that growing excitement—or angst—around the US presidential election highlights a number of wildcards in terms of Fed policy. While Biden hasn’t been exactly friendly toward Beijing on the trade front, we expect a Trump victory would bring greater escalation in trade tension with China and others, creating inflationary pressure. More worrying to us is the impact on prices of a demand boost from massive deficit spending against a strong macro backdrop: something we expect to persist regardless of who wins in November.

Volatility in European Shares

Big swings for French stocks in June
Making our way across the Atlantic, we found international equity investors last week shifting their attention to a typically quiet market: France. Thursday turned out to be the best day for the popular CAC 40 Index since January, with French stocks rallying by 1.3% (see below). It wasn’t good news about the economy driving shares higher, but more of a bounce back from declines over preceding days that had been triggered by a concerning political outlook, after the country’s president, Emmanuel Macron, surprised traders by calling for a snap election.

Despite Thursday’s pop, the country’s benchmark index was still down over 4% percent month-to-date, with continued volatility attributable to uncertainty around upcoming parliamentary elections. According to a recent Bank of America survey, France is currently the least favored European market among money managers—though we still see value in French shares for active stock pickers, with added turbulence creating some interesting opportunities.

UK stocks rallying year-to-date
A similarly unexpected call for snap elections to be held on July 4th by British PM Rishi Sunak apparently can’t keep UK stocks down, as the chart above shows. That could be because FTSE 100 companies do a big part of their sales abroad, making them less exposed to domestic political problems. Thursday also witnessed the Bank of England (BoE) leave its policy rate unchanged, though markets seemed to appreciate signaling that hinted at a likely August cut, after UK inflation in May finally made it back to the bank’s 2% target for the first time since July 2021.

Flagging euro area PMI a risk
In our last Perspectives, we covered a rebound in Asian countries’ Purchasing Managers Index (PMI) readings. Unfortunately, the news wasn’t quite as cheerful in June flash PMI reports from Europe, out last week. UK composite PMI declined to 51.7, short of the 53 economists expected. The euro area looked worse, with PMI sliding to 50.8—still in expansion, but far short of the consensus estimate at 52.5. We see slowing growth as a risk here, coming against a backdrop of sticky inflation and expectations for only one more quarter-point cut from the ECB in 2024.

Japan Webinar Recap

Rayliant and SMDAM talk Japan
Last Thursday, Jason Hsu, PhD and Phillip Wool, PhD of Rayliant had a chance to connect with Alex Hart from Sumitomo DS Asset Management (SMDAM) for a live webinar on the subject of Japan’s economy and markets. The conversation covered a wide range of topics and the Rayliant team will be posting clips of some of the highlights in coming days. In the meantime, we thought it might be useful to review some of the key points as they relate to investments in Japanese stocks—one of the world’s hottest major markets over the last year.

Has the market climbed too high?
Indeed, one of the first questions posed was whether Japanese stocks’ impressive run in the last two years has pushed prices too high for investors to benefit by allocating now. Sure, stocks in the TOPIX Index are up over 50% since the start of 2023. But, as Jason pointed out, things look a bit different from the perspective of a foreign investor who has also witnessed the yen weaken by almost 18% over the same period. With the yen at a three-decade low against the dollar—and the TOPIX just reaching levels of the late 1980s, there could be ample upside, especially if FX becomes a tailwind.

Macro drivers of a secular rally
And what are the key factors behind climbing stock prices? Alex framed the question in terms of Japan’s decades of deflation: a rarity among major economies. As a result of deflating prices, we haven’t seen Japan’s GDP grow much in thirty years, but corporate earnings have expanded on the back of cost cutting, almost as much as those of US firms over the last decade. Now, after a pandemic-era inflationary shock, Alex sees a burgeoning wage-price spiral—good news in an economy characterized by decades of deflation—giving way to a secular bull market in Japan.

What makes this time different?
Of course, Japan’s economy has given us some ‘head fakes’ in the past, so what makes this time different? Phillip cited investor psychology as a key contributor to past false starts: because deflation expectations have been so deeply ingrained in the minds of consumers, there’s no interest in doing anything but saving, and without visibility into demand, companies haven’t wanted to invest—a vicious cycle that’s made deflation a self-fulfilling prophecy. With recent inflation and wages rising, consumers might have finally been shocked out of their deflationary mindset.

Corporate reforms another change
Another interesting difference this time around, Phillip suggested, are corporate reforms geared toward improving companies’ capital allocation, including more investment and return of capital to shareholders, for example. Over the last year, the Tokyo Stock Exchange has been one source of change, motivating the large number of Japanese companies with exceptionally low valuations (see below) to shape up. Those reforms have been so successful other countries, from China to South Korea, have recently been trying to copy them and boost their own markets’ valuations.

Growth a better bet than value
So, how might investors approach Japanese stocks? Interestingly, Alex explained that the apparent preponderance of cheap companies in Japan—fewer than 4% of S&P 500 firms with positive book value trade below it today, versus nearly 40% of Nikkei 225 stocks—has brought so many value investors into Japan’s market that it’s created a bit of crowding in the shares of firms likely to benefit from reforms. Instead, all three participants in the webinar suggested a better focus was growth: especially an active approach focusing on quality growth and harnessing local insights.