From six to three…and now only one rate cut

The US Federal Reserve and its global audience thought 2024 would be a rate-cut bonanza but with inflation proving much stickier than most predicted, those expectations are unfortunately something of the past. Fed Chair, Jerome Powell confirmed in May, when he signalled that policymakers would wait longer than previously anticipated to cut rates following a series of surprisingly high inflation readings. Traders now see perhaps one or maybe two rate cuts happening this year. That is a big letdown from the six they anticipated at the start of the year and the three that Fed officials pencilled in as recently as March.

The message from the Fed was two-fold: not only are officials only anticipating one rate cut this year, but they also see the easing cycle bottoming out at a higher level than previously expected, underscoring the era of higher rates for longer.

The Fed’s move to signal fewer interest rate cuts this year deepens its divergence from peers who have already started to ease. The Bank of Canada lowered its benchmark overnight rate by 25 basis points to 4.75%. The European Central Bank (ECB) soon followed, lowering its key rate by 25 basis points to 3.75%. Central banks in Switzerland and Sweden also cut interest rates this year.

Global markets

Global financial markets had another good quarter largely driven by US indices that hit new all-time highs. The MSCI AC World Index gained 2.9% in Q2 and is now up 11.3% year-to-date. The US makes up approximately 66% of the MSCI AC World Index. The MSCI Emerging Markets Index returned 9.6% year-to-date, slightly behind developed markets.

In the bond markets, the yield on the US 10-year government bond weakened to 4.4% over the quarter due to ‘higher-for longer’ interest rates and surprise strength in the US labour market. The Bloomberg Barclays Global Aggregate Index fell 1.1% for the quarter and is down 3.2% this year. Bond yields remain significantly higher than was the case at the start of 2022, which can be attributed to several key factors – the US Fed’s policy response to inflation, the strength of the US economy, and an increasing supply of US Treasury securities coming to the market.

US – bigger shares bigger gains

The current bull market in the US has been impressive. Optimism over a resilient economy, AI mania and the potential start of rate cuts have pushed US equities to new record highs this year.

The S&P 500 Index was up 4.3% in Q2 and 15.3% YTD, and the Nadaq Composite gained 8.5% in Q2 and 18.6% YTD. Since the bull market kicked off in late 2022, the S&P 500’s gains have been driven by a handful of mega cap tech stocks, led by Nvidia which gained 37% in Q2. The ‘magnificent seven’ has been responsible for approximately 60% of the S&P 500 total return this year, according to S&P Dow Jones Indices.

Words from ‘A tale of two cities’ by 19th century author Charles Dickens, clearly resonate on Wall Street today. The average share within the S&P 500 is up only 4% this year, while the broad index is up 15.3%. That is the largest underperformance since at least 1990, according to Dow Jones Market Data.

There are two distinctive factors in the current environment driving the movement of shares:

1. Pushing shares up: demand for chips to drive AI is helping tech shares that hold a lot of cash and have low borrowing needs. Typically, large cap tech shares, as shown in graphic above.

2. Pushing shares down: concern about the general economy affected by changes to the interest rate environment hurting smaller companies that likely must borrow more to fund operations and business growth.

A narrow market with only a handful of shares pulling the market up clearly puts the rally at risk. How long can the market rally continue? A steady trickle of recent economic data continued to suggest the economy is cooling, but at a gradual pace and without any signs of serious deterioration. The S&P 500 is currently trading at 21 times its expected earnings over the next 12 months, above its 10-year average of 18 times. The earnings story remains a positive one and will be critical for the direction of the market – especially the big tech shares, with the ‘magnificent seven’ trading at an average of 37 times their expected earnings over the next 12 months, according to FactSet.

It is difficult to pinpoint what will apply a ‘brake’ on the bull market. Analysts note that unlike the last time the market was this concentrated in the early 2000s, the biggest companies today are profitable and have strong balance sheets. And compared with the years leading up to the 2008 financial crisis, companies and individuals now hold much less debt.

France has brought political risk back to European markets

The Stoxx Europe 600 has not matched the tech-driven rally of the S&P 500, but it has kept up while offering diversification in the form of pharmaceuticals and luxury goods. However, the decision by the French President, Macron shocked the world when he called for elections under no obligation to do so, sparking the extraordinarily high stakes vote that could bring France into political turmoil and leave his legacy in tatters.

The first round of voting is pointing to a hung Parliament – yes, another coalition government with the Eurosceptic party (far right) and/or a tax-loving leftist alliance (far left), joining the incumbent centralist and possibly making it far more difficult to pass new legislation and for any pending legislation to advance. The CAC 40 finished the quarter down 8%. Disaster is unlikely, but is giving global investors a reason – for the time – to avoid buying broad baskets of European equities.

Japanese stocks have been on a roll

Q2 has been a rollercoaster period with the Nikkei losing 1.8%, as investors were concerned about the weakening yen, which hit a fresh 38-year low against the US dollar in June. Yet, year-to-date the Nikkei 225 Index is up 19.3%, its highest level since 1990.

Multiple factors have driven the rally to date, including the return of inflation after decades of fighting deflation. Importantly, structural reforms to Japan’s corporate governance and the resulting improvement in corporate earnings have increased investors’ confidence in Japanese firms, driving foreign investors to increase their holdings in Japanese equities. According to the Japan Exchange Group, foreign investors own about 30% of Japanese stocks. Despite strong inflows YTD, global funds are still underweight Japanese stocks by 6.8% according to Goldman Sachs.

Looking forward, the outlook of sustainable inflation, moderate valuations and promising earnings growth are all likely to provide tailwinds for Japanese equities.

Chinese market lagged global peers

China’s stock markets have faced significant volatility since the start of the year. Markets have recovered slightly from their long decline after the country’s first-quarter economic growth exceeded expectations. Yet, the benchmark Shanghai Composite Index, the CSI 300, continues to lag among other global indices and is flat year to date, up only 1%.

There are several reasons why the Chinese market has fallen ‘out of favour’ with investors. Increased regulatory oversight, entrenched deflation, geopolitical tensions between the US and China over Taiwan, as well as a real estate downturn all played a part. Global investors are returning, albeit slowly, but investor confidence remains fragile. The country’s State Council, China’s cabinet, unveiled a series of steps that call for shareholder enhancement, corporate governance and tighter rules against market manipulation. It has also encouraged the country’s state-linked companies to buy shares to boost equity markets.

In May, the Chinese authorities announced historic steps to stabilise its struggling property sector, whereby the central bank facilitated 1 trillion yuan – approximately $138 billion – in extra funding, as well as easing mortgage rules

Local Markets

JSE on fire as SA Inc shares surge

The JSE All Share Index had a slow start to the year but rallied 8.2% in Q2 as SA Inc shares spiked on optimism around the establishment of SA’s government of national unity (GNU), after the ANC lost its parliamentary majority for the first time in 30 years. The gains were driven by a very strong showing from the financial sector (+15.9%), and to a lessor extent from industrials (+4.8%) and resources (+3.6%).

Although the performance of SA’s equity market has been mostly disappointing in 2024 compared to developed markets, the JSE All Share Index gained 5.8% year to date. An improved political and economic policy outlook should encourage investors to revisit some of SA’s relatively ‘cheap’ equities. The rand’s performance more recently is a good reflection of improved investor confidence.

In Q2, banking shares FirstRand and Capitec were up 24.6% and 27.0% respectively, followed by Standard Bank, up 17.8%. Absa lagged following disappointing interim results but was still up 11.6%.

Diversified industrials such as Barloworld (+40.8%), Bidvest (+17.3%) and Grindrod (+18.8%) also contributed to the strong performance from SA Inc. shares. Together with some of the quality consumer services companies such as Mr Price (+18.5%), Clicks (+17.0%) and Shoprite (+14.8%).

Industrial shares, Naspers/Prosus gained 6.2% and 8.8% respectively, helping the industrial sector to ‘grind-out’ a positive return in Q2. Prosus reported strong full-year results, which show that it managed to swing its e-commerce business into its first-ever profit, together with their 25% shareholding in Tencent. Tencent nailed down an earlier-than-anticipated debut of one of the year’s most eagerly awaited mobile games, helping the local tech company.

Unfortunately, other big index and rand hedge shares such as Richemont, AB Inbev and British American Tobacco (BAT) dragged the sector and overall market down in Q2.

Canal+ to buy MultiChoice
French media group Canal+ made an all-cash mandatory offer to buy all the shares of MultiChoice that it does not already own. But the groups still have major regulatory hurdles to overcome. Canal+ will need to navigate the country’s stringent Black Economic ownership requirements and restrictions on foreign media ownership, which caps voting rights at 20%.

Drama…drama as Anglo rejects the BHP offer
There is never a dull moment in financial markets. The local mining industry has been overshadowed by the potential takeover of Anglo American PLC by BHP – the biggest mining deal in history – after BHP made a non-binding conditional all-share offer to take over Anglo American. Anglo American rejected the takeover offer and BHP never made a firm offer.

The attempt to take over Anglo American is all about copper. The world needs more copper and a lot more of it. The green transition and increased use of AI applications are feeding demand for copper, and because it is very difficult to develop new copper mines, mining producers look to buy rather build production growth. The copper price is up 11.7% year-to-date as global demand picks up and supplies tighten.

Anglo American’s share price increased 23.9% in Q2, allowing the resources sector to ‘squeeze out’ a small positive return, as most of the big mining companies produced negative returns in Q2, led by some of the Platinum Group Metals (PGMs) producers.

Other asset classes…property leads the way

The JSE All Property Index finished the quarter up 5.7% and 9.4% YTD, benefitting from improved investor sentiment following the election outcome. Sector heavyweights like Hyprop, Redefine and Growthpoint were amongst the bigger winners in June, rallying 14.8%, 12.0% and 10.8% respectively.

Despite the ongoing challenges, rental reversions are materially less negative for most property companies. Vacancies and domestic property valuations continue to improve and consequently, long-term value remains in the sector, that requires economic growth to unlock.

SA bonds also gained from the change in sentiment towards domestic assets. The SA 10-year bond yield fell 90 basis points to 11.4% in Q2. On the back of this, the All Bond Index gained 7.5%.

Local inflation was unchanged at 5.2% in May. Accordingly, and as expected, the SA Reserve Bank kept interest rates unchanged at 8.25%. The inflation rate has not been under 5% since August last year and is still higher than the 4.5% midpoint of the Reserve Bank’s target range of 3% to 6%. The reluctance of the US Federal Reserve to cut interest rates has also kept the domestic central bank away from cutting rates, as the rand remains vulnerable to interest rate differentials.

Money market assets, as measured by the STeFI Composite Index, delivered a respectable 2.1% for the quarter.