Market Update: Embracing the Rebalance

The challenging period for global stocks continues, particularly impacting US mega-caps. While smaller caps show promise, these gains are overshadowed by large-cap losses. The “Magnificent 7” (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, Tesla) have collectively declined by more than 11% since early July. Despite this, we believe the overall market rebalance is beneficial.

Tesla faced the steepest decline last week, with a 12% drop in share price due to disappointing Q2 profits. The electric carmaker is struggling with negative sentiment towards tech stocks and a global downturn in the automotive market. Chinese overproduction has diminished carmakers’ pricing power, a scenario echoed in the microchip industry, putting manufacturers under significant pressure.

Fortunately, this weakness has not yet spread to the services sector, historically a precursor to broader economic issues. The current problem is on the supply side, with demand holding up reasonably well. For now, manufacturing weakness appears to benefit consumers by lowering prices and increasing disposable income for services. However, this could change if manufacturers start cutting jobs, a situation we will monitor closely.

We welcome the shift from large to small caps, although the losses among the Magnificent 7 could still impact the broader market due to their significant influence. This capital redistribution is advantageous for smaller caps and will be further supported by the Federal Reserve’s upcoming rate cuts. The outlook for global growth remains strong, with the UK, in particular, showing positive signs due to improved relations with Europe.

While the recent market volatility, particularly among US mega-caps, may continue, this rotation should ideally reallocate capital to areas with greater growth potential. Investors should not fear this rebalance.

Sahm Rule: A Cause for Concern?

The “Sahm rule,” a US recession indicator based on rising unemployment, is nearing its trigger point. The rule suggests a recession begins when the three-month average unemployment rate is 0.5 percentage points above its lowest level in the previous 12 months. With US unemployment reaching 4.1% in June, the gap is now 0.43 percentage points.

Although we are unlikely to hit the 0.5 threshold soon due to technical reasons (the previous low will drop out of the monitoring period next month), a similar measure by former New York Fed president Bill Dudley (three-month average unemployment 0.3 percentage points above the cycle low) has already been breached. Recession indicators are not infallible, and Claudia Sahm, the rule’s namesake, noted that her rule might not hold during this post-pandemic cycle.

The critical question is whether unemployment will stabilize or if job losses will escalate. Fed officials expect stabilization, as current unemployment is close to their estimate of the ‘neutral’ rate. This is supported by the ‘Beveridge curve,’ which shows a balance between unemployment and job vacancies. June’s unemployment rate suggests a neutral point, which could be interpreted either as stability or as a potential tipping point.

While the US economy has shown resilience in the past, the depletion of pandemic-era savings could pose a challenge. Upcoming rate cuts will help, but businesses may soon start cutting jobs. The US economy appears more fragile than it did a few months ago.

Shipping Costs and Inflation: China’s Impact

The cost of shipping freight out of Shanghai has surged, historically an indicator of downstream inflation affecting Chinese goods producers and US consumers. However, we believe this time is different, and inflation is unlikely to rise from this source.

The increase in shipping costs is driven by a surge in US demand for Chinese goods, likely due to fears of new tariffs if Donald Trump is re-elected. With Trump promising tariffs of 60% or higher, Chinese exporters and US importers are rushing to trade, despite high freight costs.

This situation is unlikely to lead to long-term inflation because Chinese firms are unable to raise prices. China’s domestic economy is weak, and the government’s exacerbation of overproduction problems has led to international dumping, particularly of electric vehicles, driving prices down. Currently, China is exporting disinflation.

Chinese producers will likely absorb the increased freight costs due to their limited options. Regardless of the election outcome, this rush in China-US shipping is expected to end by 2025, meaning current freight costs are less inflationary than in the past.

Important

This article is for information purposes only – should not be perceived as financial advice. We recommend you should always speak to a financial adviser before making any investment decisions.

Please note, past performance is not a reliable indicator to future returns. Your investment may fall as well as rise, and you may not get back what you put in.