Will investors continue to have the appetite for risk in 2H?

This is one of the biggest questions that is on investors’ minds right now. Can the stock market continue to perform as strong as it has in the past 6 months, in the next six months? Added to this, why is the dollar reacting to higher interest rate expectations, but stocks seem immune? And what comes next for the AI boom. If you can unlock the answers to these questions, then your portfolio could perform extremely well in the next 6 months. To put this year into context so far through the prism of the S&P 500: the US blue chip index is up 11.38% YTD, it is up more than 5% in the past month and it registered a 3.26% gain last week. This is a strong momentum rally, it was the third straight weekly rally for the S&P 500 last week, and the sixth straight rally for the Nasdaq.

The persistence of the AI trade

One of the worries for investors is that this rally does not have breadth, and pessimists are correct. More than half of the S&P 500 is in the red so far this year, including some big names in the finance sector including Wells Fargo and Morgan Stanley as well as Whirlpool, and Exxon Mobil. Banks, consumer durable companies and oil majors have seen their share prices decline so far this year. Instead, there are four standout top performers, including Nvidia, Meta, AMD, and Royal Caribbean Cruises, which are all up 169%, 126%, 81% and 74% respectively. Royal Caribbean Cruises looks like an outlier for this group; however, US economic growth has mostly been driven by the service sector and consumers’ willingness to continue to spend on services. Since the cruise industry is the epitome of the service industry, and the fact that it had a cheap price to earnings ratio, is the chief reason why it has surged in line with these tech giants. While some argue that Nvidia is now overpriced and looks like it is in bubble territory, there are signs that the AI industry that Nvidia’s chips service, is a non-cyclical trend and that its growth expectations may become embedded, in which case there could be further for this stock to run. Added to this, while NVidia looks enormously over-valued on a regular price to earnings ratio, its P/E ratio is currently over 200, its forecast P/E ratio for next year is a more reasonable 64, while its PEG ratio, Price-to-earnings-to-growth ratio is 2.81. The PEG ratio is the one to watch, in our view. Nvidia predicted a huge surge in growth, which is capping the PEG ratio for now. If these forecasts are right, then great, if they are wrong then we could see the Nvidia share price fall, however, we will have to wait until Q2 earnings season to hear from Nvidia and see if they remain as upbeat about future growth. Overall, yes, the stock market rally is narrow, however, the Russell 3000, which includes a broader base of US companies is also up more than 10% so far this year, so perhaps the optimism will spread.

Why Opec may not be able to boost the oil price

Oil stocks are some of the best performing stocks at the start of the week, after Opec+ announced that they would cut production by 1mn barrels a day. This has sent the oil price higher, and Brent crude had risen by 1.5% earlier on Monday, however, it has given back some gains this afternoon, after a weaker than expected ISM services sector survey in the US. This index came in at 50.3 for May, just about in expansion territory, but there could be trouble ahead because the new orders component of the ISM service sector survey was well below expectations, coming in at 52.9 vs. 56.5 expected. Added to this, the employment component of the ISM service sector report also tanked, which is a keen reminder that the NFP report is not the only labour market indicator to watch. We continue to believe that the oil price could remain range bound, even with the Opec production cut, with Brent crude likely to struggle to break above $78, the top of the recent range. The reasons why oil is likely to struggle in our view is due to fears about China’s growth and any concerns about the US economy if the Fed continues to hike interest rates.

The unravelling of the China rebound story

China’s economy is taking on more attributes of the Western world. It’s latest Caixin activity surveys showed the service sector rising to 57.1, one of its highest levels since 2020, however, the manufacturing sector survey is far weaker at 50.9, although it managed to bounce back into expansion territory last month. We expect the manufacturing sector to continue to lag, as credit issues within the Chinese economy constrain economic growth. Thus, as we progress through 2023, the China re-opening strategy is unravelling, which is a theme that could persist in the coming months. Not even the prospect of a Beijing stimulus package has helped the Chinese stock indices pick up pace, and the main Chinese index is down 3.5% in the past month. The targeted stimulus package was considered a quick way to try to prop up China’s struggling real estate developers, which left the market sceptical that this would in fact relieve the underlying issues in the Chinese economy.

China vs Japan

The continuing issues surrounding the Chinese economy is primarily reflected in China’s stock market under performance compared with elsewhere in Asia, notably Japan. The Japanese Nikkei has surged another 2% on Monday and is up nearly 25% so far this year. The Japanese stock market is also a play on relative interest rates, with rates in Japan expected to remain far below interest rates in the West. However, at some point western central banks will stop raising interest rates and we could be close to this point, thus if you have not got exposure to Japanese equities already then the ship may have sailed.

Cracks appearing in US labour market report

Elsewhere, the market is focussed on the Fed meeting, and even after the mega payrolls number, the market is still pricing in a 75% chance of the Fed remaining on hold when they meet next week. Perhaps the bond market wasn’t put off by the strong payrolls number since the details included within the report were not so edifying. For example, employee hours worked fell sharply last month, and employers tend to cut back on hours before they cut back on employees.

To conclude…

To finish, we think that a pause from the Fed along with the continued strength of the AI trade could prop up US stocks in the medium term. China’s economic outlook remains murky; however, Japanese stocks may have come too far too fast. The oil price may continue to struggle, and the dollar recovery in 2023 will depend on what the Fed says next week.