A US default is off the cards, but is it bullish?

The Democrats and the Republicans in the US may be on track to avoid a US default; however, this has not set the markets alight at the start of the week. With markets in the UK and the US closed, trading was thin and is unlikely to give us a steer on market sentiment this week.  However, it is worth remembering that the debt-ceiling agreement, which would suspend the borrowing limit for 2 years and cut spending, still needs to pass votes in both chambers of Congress. There is a risk that progressives on the left and hardline Republicans could slow the bill’s passage through Congress, so there remains a chance that the US could default on its debt obligations on June 5th. However, both President Biden and Republican House Speaker Kevin McCarthy say they have enough bipartisan support to stop such a travesty for the global financial system from happening, thus even if the US was to “default”, the fact that there is an agreement in place to solve this debt ceiling issue for the next two years could be enough to placate financial markets.

US market breadth narrows further

With the US debt ceiling issue now mostly resolved, the markets will focus on three things as we move into June: inflation trends, what the Fed will do next and can the AI bubble that is driving US stock markets continue? Looking at the latter point, the gap between the performance of the largest stocks and the smallest stocks in the US is at its widest since 1997. The Russell 1000 index of large companies is up 9.2% this year, compared with a 0.7% gain for the Russell 2000. The performance of the Russell 1000 is largely driven by a handful of tech companies including Tesla, Meta, and chip maker NVidia. This compares with the small cap stocks, which have been weighed down by the collapse in share prices for regional US banks and the fall in the oil price, which is hurting some energy stocks. Interestingly, the FTSE 100 is performing more like the Russell 2000 and is also up a paltry amount in 2023 compared to the stunning performance of the US large cap indices. The question now is, can this gap continue to widen, and can tech continue to lead the way? Considering Apple and Microsoft now make up 13% of the Russell 1000 index, if one of these behemoths’ falters then the large cap rally could come to a halt. However, we don’t think that will happen. Firstly, the demand for chips and AI is likely to be a multi-year theme for markets. Secondly, mega cap stocks like Microsoft are considered recession-proof in the current economic environment. They can raise capital even in an environment where interest rates keep rising, and they have strong balance sheets. Therefore, investors keep pouring money into big cap US stocks: $2.6bn was invested into US stock markets on a net basis during the week that ended 19th May, which is the largest net inflow since October, according to analysis by Bank of America. About $2.2bn went into large cap stocks, while small cap stocks saw a net outflow of $42 million. In the current environment, it could pay to follow the money, especially if bets continue to rise that the Federal Reserve will raise interest rates in June.

US jobs report key for Fed decision

The market is now pricing in a 58% of a 25bp rate hike from the Federal Reserve when it meets next month, which would push US interest rates up to 5.25-5.5%. This compares with a 23% chance of another rate hike just one month ago. However, whether the Fed will hike rates on 14th June will depend on the outcome of this week’s NFP report. The market is expecting a decline in the pace of jobs growth in the US, with only 195k jobs expected to have been created in May. This would be the lowest pace of jobs growth since March, and one of the lowest in recent years. The unemployment rate is expected to rise to 3.5%, still close to a record low, while wage growth is expected to rise 0.3% monthly, down from 0.5% in April. If the pace of jobs growth falls below 200k, expect a rally for small cap stocks, and some dollar weakness, as it may reduce the chances of a rate hike from the Fed next month. However, the strong PCE report last week, is still giving us reason to think that the Fed would be wise to raise rates this month, and to consider pausing later in the summer instead.

The FX effect

The dollar index rose 1% last week and is up a touch at the start of the week. We expect the FX market to trade in a tight range up until Friday’s payroll report when we expect volatility to rise. The dollar index is making tough work of 105.00, and this level may not be broken unless we see a positive jobs growth surprise in the US, which makes a rate hike from the Fed next month even more likely.

Global economic data watch

Elsewhere, Eurozone inflation is expected to have fallen sharply in May, again leaving the UK as an outlier, which could weigh on the pound and on UK stocks. Global manufacturing data for May is also expected to remain in the doldrums in Europe, the US, the UK, and China, which is likely to add to fears about a global recession. US house prices for March are also expected to have tumbled sharply, with a 1.6% annualised decline expected.