US: Inflation slowdown and generative A.I. combine to improve investor sentiment

Concerns over US regional bank failures that had dented investor confidence in March appeared to abate during the quarter, despite the failure of US regional bank First Republic in early May. Some positive corporate results boosted market sentiment, particularly in the technology sector which also benefited from growing interest in Generative Artificial Intelligence (AI).

A bipartisan deal to increase US government borrowing was made just before the deadline that would have triggered a government debt default. Democrats and Republics agreed to increase government borrowing limits and set caps on spending through to 2025.

Annual inflation fell to 4.9% in April, with energy prices down and food prices rising at a slower rate. A greater-than-expected fall to 4.0% in May was supported by continuing lower energy prices. This heightened expectations that the Fed would pause its path of interest rate rises.

Higher interest rates contributed to the slowdown in economic growth. Annualised GDP growth shrank to 2.0% in the first three months of 2023 compared with 2.6% in the last quarter of 2022, albeit the latest economic growth rate was above market expectations. A reminder of the resilience of the US consumer despite the past 15 months of interest rate hikes, consumer spending picked up during the quarter, with a rise in monthly retail sales in April. A slight, but better-than-forecast, rise in retail sales in May signalled still-constructive consumer confidence.

Labour markets appeared to soften a little during Q2 as the number of initial claims for unemployment benefits largely rose versus Q1 2023. More people out of work, with a modestly higher unemployment rate of 3.7% in May, the highest since October last year, is likely to ease pressure on employers to raise wages and reduce the risk of wage-driven inflation. That said, while US aggregate job vacancy numbers have fallen back from last year’s highs, they are still some way above pre-pandemic levels, indicating that the US labour market is continuing to prove resilient.

In May, the Fed indicated it might be nearer to halting its policy tightening after increasing interest rates by 0.25% to 5.25%. This was the highest level since September 2007 and the tenth successive hike, but Fed Chairman Jerome Powell didn’t rule out further interest rate rises.

However, a change of monetary strategy came in June, when the Fed left the target for its funds rate unchanged at 5.25%. But Powell maintained the central bank’s stance that interest rates may need to go higher to bring inflation back to its target of 2.0%. At the end of June, he told Congress that “nearly all Federal Open Market Committee participants expect that it will be appropriate to raise interest rates somewhat further by the end of the year”.

In international developments, Treasury Secretary Janet Yellen warned of the dangers of decoupling the US economy from China. Secretary of State Antony Blinken visited Beijing in an attempt to strengthen relations between the two countries. The diplomatic effort followed growing political tensions over China’s longer-term unification plans for Taiwan and a Chinese spy balloon shot down over the US earlier this year.

In company news, significant in Q2 was the very strong results and Guidance from US semi-conductor company Nvidia. With its blow-out results propelled by soaring demand for the company’s designed semi-conductors used in Generative AI applications, Nvidia’s news in May also catalysed widespread market enthusiasm for technology shares in general.

Brooks Macdonald’s view

We have a neutral outlook for US equities. Corporate results in aggregate continued to reflect a still-resilient US consumer, with mentions of ‘recession’ in US company management post-result transcripts falling sequentially for three calendar quarters in a row. Further, while analysts’ earnings growth expectations for calendar year 2023 remain muted, there is a significant assumed up-tick to close to double-digit year-on-year growth in 2024. Markets have responded to the still-constructive picture by lifting valuation multiples, continuing their recovery following last year’s compression. Given the size of the US economy and its markets, the US continues to have an important role in providing growth investment-style exposures within the context of our current equity barbell balanced approach to asset allocation. Our US equity weights help to support our standalone and longer-term investment themes of technology, healthcare and, to a lesser extent, sustainability which the US has exposure to at an aggregate equity index level.