Investors should construct their portfolios considering not only returns but also the risks  

-The US core consumer price index reported on July 12^th showed that annual inflation dropped further to 4.8% from 5.3% in June. The other potential good news was the unemployment rate which came down to 3.6%. This was a bit higher than expected, but was still under the 3.7% reported in June. There were also some signs of softening in the US economy as some economic indicators such as nonfarm payrolls, existing home sales and ISM manufacturing purchasing manager index (PMI) came out lower than June, but only marginally.

–As expected the FED decided to lift rates again in July, but didn’t really signal an end to the rate hikes given that inflation remained above its 2% target. FED chair Jeremy Powell reiterated their resolve to keep inflation in check and noted their goal to fine-tune efforts to further rein in inflation that’s been cooling for months. The hike, a unanimous decision, lifted the target range for the FED’s benchmark funding rate from 5.25% to 5.5%, the highest level since 2001. It marked the 11th increase since March 2022, when the rate was near zero. 

–The fight against inflation wasn’t isolated to the US. Both Bank of Canada and European Central Bank joined the FED in July and raised their benchmark rate by a quarter percent to 5% and 4.25% respectively. Despite the rate hikes, equity markets showed resilience and continued their upward trajectory, indicating that investors remained optimistic about corporate earnings and economic recovery. Cooling inflationary pressures in North America provided a boost to equity investor sentiment.

–While equities soared, in July the bond markets continued to dance to a different tune. This divergence suggested that investors had different expectations regarding economic growth and inflation. Earlier in July, the yields of 10 and 30-year US Treasuries dropped which propped up their prices (bond yields are inversely related to bond prices) in line with the positive sentiment in equities. However, in the last 10 days of the month, yields reversed and started climbing up (meaning bond prices went down), once again signaling a disconnect with the positive sentiment in stock markets. Bonds still expect the FED rates to remain elevated for some time.

–Negative volatility in Turkish stock market somewhat abated after the elections in May where Tayyip Erdogan was re-elected as President. As a result Turkish stocks had another sizeable monthly return in July with 22.7% in July in local currency terms (18.6% in US dollar basis) as of July 28th. This increased the market’s year to date return with 28.3% in local currency (-10.8% in US dollar basis). The continued negative return in US dollar basis was due to -30% loss in Turkish Lira against the greenback since the end of 2022.

–Similar to June in July crypto markets lost some steam due to strong performance in equities. As a result they gave back some of its earlier gains. As of July 28th Bitcoin and Ethereum were down by -4.3% and -2.5% on the month respectively. While the losses are not small compared to equity and bond markets, given the higher volatility in crypto currencies, the negative returns continued to make only a small dent in their year to date returns with Bitcoin still up 77% and Ethereum up 56% on the year.

–Crude oil experienced a strong month, influenced by cooling of inflation and dwindling recessionary worries. As of July 28th first month futures contract for US crude oil WTI was up by 14% effectively offsetting its entire year to date loss and bringing it back to the positive territory with 0.4%. Over the same time frame the first month futures contract for Gold was up by 3.7% on the month and added to its gains from earlier in the year delivering 9.5% return year to date.

–Market performance can be influenced by a multitude of factors, including economic indicators, investor sentiment as well as non-financial factors such as geopolitical developments and weather events. It is therefore crucial for investors to stay informed and consider a diversified approach to navigate the ever-changing landscape of global markets and adapt to potential market volatility in the coming months.

July brought a whirlwind of extreme weather patterns, wreaking havoc across the globe. Mother nature seemed intent on reminding us of her power, particularly through wildfires in eastern parts of US and Canada and extreme heatwaves across the northern hemisphere. For example, temperatures exceeded 50 Celsius, considered as “risky” for survival, on the 16^th of July in Death Valley in the US, southern Turkey as well as in Northwest China.

But amidst this chaos, the world of finance continued as per usual.

FED IS BACK ON TRACK

As our readers may remember, the U.S. Federal Reserve (FED) had paused its rate hikes in June to take a breather. The idea was to observe the effects of the rate hikes on inflation and overall economy before taking any further action. The July annual inflation indeed signalled a visible slow-down, but that came at the cost of softer economic data. The US core consumer price index reported on July 12^th showed that annual inflation dropped further to 4.8% from 5.3% in June. The other potential good news was the unemployment rate which came down to 3.6%. This was a bit higher than expected, but was still under the 3.7% reported in June. There were also some signs of softening in the US economy as some economic indicators such as nonfarm payrolls, existing home sales and ISM manufacturing purchasing manager index (PMI) came out lower than June, but only marginally.

As expected the FED decided to lift rates again in July, but didn’t really signal an end to the rate hikes given that inflation remained above its 2% target. FED chair Jeremy Powell reiterated their resolve to keep inflation in check and noted their goal to fine-tune efforts to further rein in inflation that’s been cooling for months. The hike, a unanimous decision, lifted the target range for the FED’s benchmark funding rate from 5.25% to 5.5%, the highest level since 2001. It marked the 11th increase since March 2022, when the rate was near zero.

The fight against inflation wasn’t isolated to the US. Both Bank of Canada and European Central Bank joined the FED in July and raised their benchmark rate by a quarter percent to 5% and 4.25% respectively.

INFLATION COOLS AND EQUITY BULLS REJOICE

Despite the rate hikes, equity markets showed resilience and continued their upward trajectory, indicating that investors remained optimistic about corporate earnings and economic recovery. Cooling inflationary pressures in North America provided a boost to equity investor sentiment. The main driver is the expectation that central bank tightening measures will fade alongside cooling inflation.

Case in point, as of July 28^th the US equity index S&P 500 posted another sizeable gain of 3% for the month of July, bringing its year to date returns to 19.4%. The global equity markets benefitted from the rally in the US as well as the optimistic outlook by investors. The global equity indicator MSCI All Country World Index (ACWI) and the emerging market index MSCI EEM were both up 16.9% and 10.6% on the year respectively.

European markets had a similarly good month, as the Euro Stoxx 50 index went up by 1.5% in July bringing its year to date gain to 17.8%.

DISCONNECT BETWEEN EQUITIES AND BONDS PERSISTED

While equities soared, in July the bond markets continued to dance to a different tune. This divergence suggested that investors had different expectations regarding economic growth and inflation.

Earlier in July, the yields of 10 and 30-year US Treasuries dropped which propped up their prices (bond yields are inversely related to bond prices) in line with the positive sentiment in equities. However, in the last 10 days of the month, yields reversed and started climbing up (meaning bond prices went down), once again signaling a disconnect with the positive sentiment in stock markets.

What does all of this mean? This means that similar to earlier in the year, bonds still expect the FED rates to remain elevated for some time. What has changed is the fact that bond markets instead of a gradual drop, they expect the inflation to either remain the same or go up (yes up!) but very very slowly.

To get a better sense of how the market sentiment changed in rates once again let’s take a look at how the bond markets’ 5 and 10 year inflation expectations moved since late 2021 as illustrated in the chart below. As our readers may remember from our previous issues, the data points below are calculated using the US yield curve which represent the nominal rates and the US Treasury Inflation-Protected Securities (“TIPS”) which represent the real rates. Taking the difference between the two (i.e. nominal interest rates – real interest rates = expected inflation) then gives the implied (or breakeven) inflation that is expected by the markets.

Source: Bloomberg, EKR Total Portfolio Advisory

The first takeaway from the above chart is that in the long run, i.e., over 5 and 10 years, inflation is expected to remain below 2.5% (the purple line). This is where most of the headline news focus. It is however not the key highlight and falls short in providing the big picture which is where investors should be focused on. That brings us to the second takeaway… and that is the fact that markets’ expectations of 5 and 10 year inflation have gone up visibly not just since the end of 2021 (blue line) but also the end of 2022 (green line). In other words, bond markets increasingly think inflation in the long run will remain elevated vs. previously. The last and an equally important takeaway is that the markets don’t expect the inflation to go down, but they expect it to slightly increase in the long run. This is another way of saying that the bond markets are still not convinced that FED’s monetary policy will be successful, at least not as much as equities do.

The shift in investor sentiment in government bond markets was also reflected in the global bond index returns. As of July 28th Bloomberg Global Aggregate Bond Index was roughly flat on the month maintaining its return on the year at 3%. Bloomberg Global Corporate Bond and High Yield Bond Indexes were up on the month 0.5% and 1.5% respectively, bringing each index to 3.6% and 6.6% respectively.

TURKISH LIRA TAKES A TUMBLE, MARKETS UNIMPRESSED

Negative volatility in Turkish stock market somewhat abated after the elections in May where Tayyip Erdogan was re-elected as President. As a result Turkish stocks had another sizeable monthly return in July with 22.7% in July in local currency terms (18.6% in US dollar basis) as of July 28th. This increased the market’s year to date return with 28.3% in local currency (-10.8% in US dollar basis). The continued negative return in US dollar basis was due to -30% loss in Turkish Lira against the greenback since the end of 2022. This was partially due to increasing inflationary pressures and much lower than expected rate hike by the Turkish Central Bank. As the Lira struggled to find its footing, it left investors wondering if it could regain its balance.

CRYPTO MARKETS GAVE BACK SOME OF ITS GAINS

Similar to June in July crypto markets lost some steam due to strong performance in equities. As a result they gave back some of its earlier gains. As of July 28th Bitcoin and Ethereum were down by -4.3% and -2.5% on the month respectively. While the losses are not small compared to equity and bond markets, given the higher volatility in crypto currencies, the negative returns continued to make only a small dent in their year to date returns with Bitcoin still up 77% and Ethereum up 56% on the year.

GOLD AND CRUDE OIL HAD A GOOD MONTH

Crude oil experienced a strong month, influenced by cooling of inflation and dwindling recessionary worries. As of July 28th first month futures contract for US crude oil WTI was up by 14% effectively offsetting its entire year to date loss and bringing it back to the positive territory with 0.4%.

Gold also fared well but not as well as crude oil in July. Over the same time frame the first month futures contract for Gold was up by 3.7% on the month and added to its gains from earlier in the year delivering 9.5% return year to date. Gold prices have been partially buoyed by the strong global central bank demand for the precious metal since the higher rates put a dent in the US Treasury returns.

LOWER INFLATION MIGHT SPELL TROUBLE FOR EQUITIES

Softer core inflation in July in many of the developed countries has revived hopes for central bank rate cuts in 2024. This could possibly support a bull run across assets for some time.. until it potentially runs into the disconnect between fast-falling inflation and potential squeeze on corporate margins and pressure on stock prices. Inflation falling is good news for sure. However, when accompanied by higher nominal interest rates and tight labour markets such as now, it means higher cost of capital and thus a drop in corporate margins and consequently in equity prices. Also, dropping inflation means lower prices on goods and services which just exacerbates the squeeze on corporate margins.

INVESTORS SHOULD CONSTRUCT THEIR PORTFOLIO CONSIDERING THE RISKS

As we move forward, it is also essential to closely monitor the impact of extreme weather events on supply chains and inflationary pressures. Additionally, the divergence between stock and bond markets warrants careful attention as it may indicate shifting investor sentiment and risk appetite.

Therefore, let’s reiterate that market performance can be influenced by a multitude of factors, including economic indicators, investor sentiment as well as non-financial factors such as geopolitical developments and weather events. It is therefore crucial for investors to stay informed and consider a diversified approach to navigate the ever-changing landscape of global markets and adapt to potential market volatility in the coming months.

ELA KARAHASANOGLU, MBA, CFA, CAIA

International Finance Expert

karahasanoglu@turcomoney.com

ela.karahasanoglu@ekrportfolioadvisory.com

https://www.linkedin.com/in/elakarahasanoglu/