Page 27 | CC&L Financial Group Ltd.

The most important issue in the global economic outlook is the meaning of Chinese monetary weakness.

Six-month rates of change of narrow / broad money, bank lending and total social financing (on both new and old definitions*) reached record lows in June / July – see chart 1.

Chart 1

Monetary weakness has been entirely focused on the corporate sector: M2 deposits of non-financial enterprises plunged 6.6% (13.6% annualised) in the six months to July (own seasonal adjustment) – chart 2.

Chart 2

Recent regulatory changes appear to account for only a small portion of the corporate broad money decline.

A clampdown on banks paying interest above regulatory ceilings has resulted in a shift out of demand deposits but money has largely stayed in the banking system – available data suggest modest inflows to wealth management products and other non-monetary assets.

The clampdown has also discouraged the practice of “fund idling” (round-tripping in UK monetary parlance), whereby banks offered loans to corporate borrowers to meet official lending targets, with borrowers incentivised to hold the funds on deposit.

If an unwinding of such activity accounted for the decline in corporate money, however, short-term bank lending to corporations would be expected to show equivalent weakness. Such lending has continued to grow, albeit at a slower pace recently, as have longer-term loans.

A trend decline in the ratio of corporate M2 deposits to bank borrowing, therefore, has accelerated – chart 3.

Chart 3

Household money holdings, by contrast, have been growing solidly – chart 2. An alternative explanation for the corporate money decline is simply that households are still hunkering down as the property crisis deepens, with weakening demand for consumer goods / services and housing transferring income and liquidity from the corporate sector.

The latest PBoC and NBS consumer surveys confirm rock-bottom sentiment – chart 4. If this explanation is correct, corporate money weakness may presage a collapse in profits – chart 5.

Chart 4

Chart 5

Why hasn’t the PBoC hit the panic button? Policy easing has been constrained by currency weakness: the most comprehensive measure of f/x intervention (h/t Brad Setser) reached $58 billion in July, the highest since 2016 – chart 6. The recent yen rally has offered some relief, reflected in a narrower offshore forward discount, but the authorities may be concerned that this will prove temporary.

Chart 6

The strange policy of trying to push longer-term yields higher against a recessionary / deflationary backdrop may represent an attempt to support the currency, rather than being motivated primarily by concern about financial risks. To the extent that the policy results in banks selling bonds, however, the result will be to exacerbate monetary weakness and economic woes.

*The previous definition excludes government bonds so is a measure of credit expansion to the “real economy”.

Can the Japanese bubble of the 80s serve as a warning for the US real estate and stock markets today?

The mid to late-80s were the years of Japan’s “bubble economy”. A time when the country was at its economic peak. A time when everything was made in Japan and Japanese companies would conquer the world. A time when the US put tariffs on Japanese goods and engineered a currency accord that meant a rapid appreciation of the yen.

Consider a few historical economic facts about Japan around that time.

At the end of 1989, the Nikkei 225 stock market reached 39,000, a historic high it would only see again in 2024.
The Japanese property market was worth four times more than the US property market. It was rumoured (although not for sale) that the land on which the Japanese emperor’s imperial palace sits was worth more than the entire state of California.
By 1989, the market capitalization as a percentage of GDP was 151%, while it was 62% in the US.
Over the same time period, Japan represented 42% of global equity markets. This was almost 18% of the global economy, or approximately 71% of that of the United States.

Those were the heydays for Japan. And then came the decline.

So, what caused the crash of both real estate and stock market? There are several reasons, but two stand out:

First was the Bank of Japan (“BOJ”) was too slow in tightening, creating an asset bubble. One reason given for the reluctance of the BOJ was the US stock market crash in October 1987 (aka Black Monday).
Second was the rapid appreciation of the yen following the Plaza Accord of September 1985 when most major economies agreed to depreciate the US dollar.

US dollar / Japanese yen exchange rate
Source: Bank of Japan

Now, let’s look at the US in the 2020s.

The relentless rise and outperformance of the US stock market(s) over the last few years has led many to believe it is entirely justified and pointless to diversify beyond the US market – but that narrow perspective comes at a cost.

Let’s review a few facts, keeping in mind our description of Japan’s bubble economy:

The US stock market is now 65% of the MSCI ACWI (All Country World Index), while the US economy is only 25% of the global economy.
By sharp contrast, the second largest country in MSCI ACWI is Japan, with a weight of 5%. Its economy is about 4.5% of the global economy.
The weight of China, the second largest economy with 18% of global GDP, is only 2.6% of the MSCI ACWI. That is less than the market cap of Alphabet (Google). Indeed, the individual market cap of Apple, Microsoft and Nvidia are all higher than any single stock market in the world, except Japan.

So, is the US market in a bubble at the moment?

A favourite bubble indicator used by Warren Buffet, is the ratio of the US total market cap over GDP. As seen in the following chart, that ratio is currently around 190% (and helps explain Warren’s approximate $300B cash pile).

US ratio of total market cap over GDP
Source: public

As a comparison, the same market-to-GDP metric applied to China is 61%, 48% for Germany, and 71% for the UK.

Japanese vs US stock market: 1975-2024

Source: Dallas Federal Reserve

Moving to real estate, US housing prices are at an all-time high, and housing affordability has hit the lowest level on record this month.

US vs Japanese housing prices: 1975-2024

Source: Dallas Federal Reserve

This commentary is not meant to signal an imminent crash of US house prices or stock market. Rather, it is just meant to show how we are in uncharted territory, and how looking at what happened to the Japanese economy could help navigate the present US economy.

Consider some events from the past few years:

Did the decision to raise rates come too late, potentially lead to an inflated asset bubble?
Has the US dollar shown signs of strengthening against other currencies?
Is the fiscal deficit in the US inflationary?
Is the US resorting to tariffs?

Arguably, the answers to all the above would be “Yes”. This begs the question – should we consider the similar historical context of both economies?

Given what I’ve said earlier on the narrow perspective of investors flooding the US market in the last year, there are many troubling signs on the horizon, while there is continued growth in the US market, it would be prudent to consider diversification – now more than ever.

And as a conclusion, here is a graph of the S&P 500 in a past period.

S&P 500 Index: 1928-1949

Source: public

A sharp fall in the global manufacturing PMI new orders index in July confirms renewed industrial weakness. The companion services survey, however, reported an uptick in the new business component, which is close to its post-GFC average. Will services resilience sustain respectable overall growth?

The understanding here is that economic fluctuations originate in the goods sector, reflecting cycles in three components of investment – stockbuilding, business fixed capex and housing. Multiplier effects transmit these fluctuations to the services sector – there is no independent services cycle.

The manufacturing new orders and services new business indices have been strongly correlated historically, with Granger-causality tests indicating that the former leads the latter but not vice versa*.

Several considerations suggest that the recent divergence will be resolved by the services new business index moving lower:

1. The services future output index correlates with new business and fell to an eight-month low in July – see chart 1.

Chart 1

2. Recent new business readings have been inflated by strength in financial services – chart 2. Financial services new business correlates with stock market movements, suggesting weakness ahead.

Chart 2

3. Consumer services new business correlates with the manufacturing consumer goods new orders index, which fell below 50 in July – chart 3.

Chart 3

Output price indices for consumer goods and services support the optimism here about inflation prospects through mid-2025. A weighted average has fallen back to its October 2009-December 2019 average, a period in which G7 annual CPI inflation excluding food / energy averaged 1.5% – chart 4.

Chart 4

*Contemporaneous correlation coefficient since 1998 = +0.84. Granger-causality tests included six lags. Manufacturing terms were significant in the services equation but not vice versa.

The strategy focuses on investing in frontier and emerging market companies that our team expects will benefit from demographic trends, changing consumer behavior, policy and regulatory reform, and technological advancements.

Below, we explore several key factors influencing returns and share observations on the portfolio and the markets.

Retail Portfolio

The strategy saw healthy returns during the period from the ASEAN retail portfolio, led by Philippines Seven Corp. (the master franchisee of 7-11 stores in the Philippines) and Mr. DIY Group (the multi-price point value retailer in Malaysia).

Our investment in Philippines Seven Corp. (SEVN) is premised on its first-mover advantage in convenience store (CVS) retailing in the country. As of the end of March 2024, SEVN has a network of 3,829 stores, ~9x that of its closest competitor. The magnitude of SEVN’s scale advantage is perhaps best captured by the fact that its annual store openings nearly match the entire store network of its closest competitor. Scale and location are key success factors in convenience retail, especially in an archipelago where an efficient and agile supply chain requires significant capital and operating investment.

From a top-down perspective, the Philippines’ large and young population (+100 million people with a median age of 25), expanding cities, and growing tourism sector should provide a long growth runway for CVS retail, resulting in a narrowing of the penetration gap (measured in CVS stores per capita) with neighboring countries like Malaysia and Thailand.

In addition to scale, location, and market opportunity, SEVN’s management team has proven over the years to be formidable operators and good stewards of shareholder capital.

Our team turned more bullish on SEVN at the end of last year, encouraged by evidence of an inflection point in store productivity, resilient operating margins, and an acceleration in store openings. Unusually, the stock was trading at all-time low multiples despite the company reporting three consecutive quarters of strong results. The team also identified a catalyst for the shares in the form of an expectation that SEVN will resume paying dividends after a three-year hiatus due to an SEC (the Philippines Capital Markets Regulatory Agency) mandated technicality. This technicality resulted from the implementation of IFRS 16 accounting standards in the Philippines in 2019. For SEVN, the capitalization of leases mandated by IFRS 16 standards created a large, deferred tax asset which, according to SEC rules, is deducted from the retained earnings base from which the company can pay dividends. On a recent earnings call, management estimated that the company is sitting on twice the amount of cash it needs to run and grow the business due to its inability to pay out excess cash. As SEVN’s operations accumulated cash (reaching ~20% of its market capitalization), retained earnings finally exceeded the regulatory hurdle above which dividends can be paid, and management was able to recommend a dividend to its board. Furthermore, management announced it is in the process of crafting a dividend policy that will entail distributing excess cash on an annual basis, a positive step.

Mr. DIY Group’s (MDIY) shares benefited from the anticipation of a recovery in demand from the B40 group of Malaysian households (B40 refers to the bottom 40% income group). This optimism stemmed from the restructuring of the Employee Provident Fund (EPF), which created a new “flexible” sleeve that allows for early withdrawals from beneficiaries below the age of 55 (previously, early withdrawals were only possible for critical needs like healthcare, housing, and education). The expectation is that this new feature (effective from May 11, 2024) will support disposable incomes and lead to a boost in spending among the B40 group.

MDIY is well-positioned to benefit from this given it is over-indexed to shoppers from the B40 group. For context, the company operates 1,283 stores in Malaysia (as of the end of March 2024) and has been expanding stores at a net rate of ~150 per year since 2017. This rapid expansion in stores has been internally funded by a highly cash-generative business model characterized by fast breakeven periods on new stores (2-3 years), reflected in industry-leading returns.

This profitability is supported by a virtuous cycle of supply chain optimization and store-level operating efficiency that enables the company to invest in price and offer shoppers value-for-money across the +10k SKUs it carries on its shelves. Low prices and new store expansion drive demand and larger volumes, which the company uses to negotiate with suppliers and unlock further discounts. Overlaying that cycle is a highly scientific approach to SKU management, which ensures optimized inventory turnover and minimizes drags on operations and the shopping experience. MDIY has also become more progressive with dividends in the last twelve months, with a quarterly payout policy of 50-65% of earnings, an appropriate level that balances the company’s strong cash position and growth requirements.

Internet and Technology Portfolio

Investments that the team made and wrote about in previous letters, including Vietnam’s FPT Corporation (FPT) and Turkey’s Logo Yazilim Sanayi (LOGO), performed well in the quarter.

We are especially pleased to see that FPT’s early foray into the AI space through global partnerships and acquisitions is helping it sustain a robust growth profile in global IT services. This was evident in the first half 2024 results, wherein global IT services revenue grew at ~30% in the first half of 2024 and is showing no signs of slowing down. FPT’s global IT services business exceeded $1bn in revenue in 2023, and recent underlying trends are positive with a larger proportion of higher-value digital transformation projects in the mix (47%), a diversified and growing geographical revenue stream across APAC, US, and Europe, and an increase in the number of contract wins in excess of $5m. FPT is also reinforcing its human resource advantage by adding AI and other technology modules to its university curriculum, which will help its own workforce and supply future skilled workers for other technology companies in Asia and around the world. For example, FPT University is expected to admit 1,000 students for the first batch of its semiconductor major, specializing in integrated circuit design.

LOGO shares performed well in the period as investor confidence in Turkey’s outlook strengthens. The government seems intent on pursuing macroeconomic policy orthodoxy that started a year ago. This policy goodwill is reflecting itself in Turkish assets, with the BIST 30 index up ~30% in the first half of 2024, and Moody’s upgrading its credit rating of the country by two notches from B3 to B1 in July. While it is early days and inflation remains stubbornly high (a staggering 75% in May 2024), Moody’s forecasts that inflation will begin to moderate from elevated levels and exit the year with a print of 45%.

If the economy does indeed turn a corner and business confidence grows, this will reflect positively on LOGO, which has so far underperformed the broader market (on a twelve-month basis) due to margin pressure from wage inflation and headcount investments, softness in its core SME segment in Turkey, and drag from its EUR-denominated low-margin business in Romania. Nevertheless, we remain confident in LOGO’s position as the leading enterprise resource planning (ERP) provider for Turkey’s large SME corporate market and are constructive on management’s initiatives to improve product flexibility through Software-as-a-Service (SaaS), and expand the product suite to new segments of the market (large retail customers, micro SMEs, e-government services, and HR). This should drive the penetration of ERP software in the country and position the company for strong earnings growth as business confidence returns.

Outlook

We continue to be constructive on the opportunity set for the strategy for the second half of the year. We believe we positioned the portfolio to be considerate of changes in the interest rate cycle, political environment, and portfolio company valuations. As always, the ultimate objective of our decision-making process is to express our best research opinions through a diversified portfolio of high-quality businesses that we believe will help us deliver on the strategy’s return promise to investors.

We look forward to continuing to update you on the strategy over the rest of the year.

MENA equity markets had a weak second quarter of 2024 with returns of -4.2% (for the S&P Pan Arabian Index Total Return), trailing the MSCI Emerging Markets Index which was up 5% in the same period. For the first half of 2024, MENA equity markets are up 3.0% compared to 7.5% for the MSCI EM index.

The performance drag in the quarter can be partly attributed to a surge in equity capital market activity that led investors to sell existing positions to fund a long list of initial public offerings and secondary sales. Top of the list was the $12bn secondary share sale of Saudi Aramco, which drew strong demand from foreign and local investors and was reportedly multiple times oversubscribed. For context, the Saudi Aramco equity raise is equivalent to 5.5x the average daily traded value for the entire Saudi market in the second quarter of 2024 and resulted in an increase of ~3% in the market’s aggregate free float market capitalisation. (Note: much more money was actually drained out of the market given oversubscription levels).

In November 2019, when Saudi Aramco first listed, foreign investors were demonstrably absent from the deal, as many viewed both the company and the country as non-core and even un-investable. Less than five years later, foreign investors are reported to have accounted for over 60% of the $12bn Aramco share placement. This is a strong vote of confidence in the Saudi market, and an indication of the credibility that it has deservedly earned with foreign investors in a short period of time. Excluding Aramco, seven other transactions concluded in Saudi and the UAE in the second quarter, with an aggregate amount raised of $3.4bn. While this pace of capital raising is typically associated with a rich valuation environment (i.e., a low cost of equity and high multiples), we believe it serves the strategy well as it strengthens our long-term thesis on capital market development in the region.

As discussed in previous letters, we believe the region’s share of global market capitalisation will steadily increase over time and we have expressed that theme through an investment in Saudi Tadawul Group, the country’s stock exchange holding company. Moreover, the combination of new listings and higher free floats is deepening the strategy’s investable universe and opening opportunities for the strategy to invest in strong businesses in healthcare, technology, and infrastructure, sectors that have not been well represented in MENA public markets historically.

Two key, related events in the quarter were the dissolution of the Kuwaiti National Assembly and the suspension of certain articles in the Constitution related to legislative powers in the country. This surprise announcement was made in a televised speech on Friday May 10th by Kuwait’s Emir Sheikh Meshal Al Ahmad Al Sabbah. The Emir came to power in December 2023 after the passing of his predecessor. His televised speech demonstrated clear intentions to break the cycle of policy paralysis and deadlock that has plagued the country due to the hostile and volatile relationship between parliament and government.

Kuwait has had four elections in the last five years and its economy has suffered from very low economic growth, a bloated public sector, rising levels of corruption, and crumbling infrastructure (most recently on display in late June when the country announced power cuts due to peak seasonal demand in the summer). The decision by the Emir to strip parliament of nearly all its powers and transfer control to the government will likely mean that stalled and much-needed economic policy legislations like the debt and mortgage laws, approval of national development plans, and fiscal reforms will now see the light of day.

This is a significant development for Kuwait that we expect will unlock a capex cycle that will have to catch up on nearly twenty years of significant under-investment. To position for this, the strategy invested in National Bank of Kuwait (NBK), the country’s largest corporate bank with over 30% share of system loans. We believe NBK’s strong deposit franchise and market leadership puts it in a strong position to benefit from a multi-year loan growth cycle that we expect will commence in the second half of 2025.

Our team spent some time in Morocco this quarter meeting with portfolio and prospective companies. The primary objective of this trip was to validate the strategy’s investment in Aktidal Group (AKT), a leading healthcare provider in the country with ~15% of the private bed capacity in the country. (Note: the private sector accounts for ~30% of total bed capacity). AKT operates 2,532 beds in 23 sites spread across 11 cities. The clinics managed by AKT are reputed for their quality of care and are known for the strength of their oncology department (~30% of consolidated revenue). The Moroccan healthcare market is severely under-served, with bed and physician per 1,000 persons below regional averages and well below WHO recommended levels. (A WHO study ranks Morocco 79th of 115 countries in doctors per capita). To address this shortage, the Moroccan government embarked on a series of reforms including the rolling out of a universal healthcare scheme and the removal of a restriction that allowed only doctors to invest in the sector. AKT is at the forefront of the growth in the sector, as has been validated in its 2023 results which showed revenue and operating profit growth of 84% and 86% respectively. Site visits and meetings with Moroccan doctors and competitors of AKT during our trip validated the company’s brand and reputation in the market, and highlighted the growth opportunity that lies ahead for the company.

We look forward to continuing to update you on the strategy in the next letter.

A post in June suggested that a recovery in the OECD’s US composite leading indicator was ending. A calculation based on the latest input data confirms a reversal lower.

The historical performance of the OECD indicator compares favourably with the Conference Board leading index. The OECD indicator recovered from early 2023, signalling that recession risk was (temporarily?) receding, while the Conference Board measure continued to weaken.

The latest published data point, for June, was released in early July. The next update is due on 5 September and will provide July / August numbers.

Chart 1 shows the published series (black), a replica series calculated here based on data available in early July (blue) and an updated replica incorporating an additional month of input data (gold). The updated series has fallen sharply from an April peak.

Chart 1

The decline reflects weakness in four components: consumer sentiment, durable goods orders, the manufacturing PMI and housing starts. The two financial components – stock prices and the 10-year Treasury yield / fed funds rate spread – were still marginally positive in July but levels so far in August imply a turn lower.

The price relative of MSCI World cyclical sectors, excluding tech, versus defensive sectors has mirrored movements in the OECD US leading indicator historically – chart 2. Relative valuation is high versus history and has diverged from a weakening global manufacturing PMI – chart 3.

Chart 2

Chart 3

Manufacturing PMI results for July support the forecast of a global “double dip” into early 2025.

The global manufacturing PMI new orders index plunged by 1.9 points from June to 48.8, a seven-month low. The combination of a one-month fall of this magnitude or greater and a sub-50 reading occurred in only 14 months since 1998, highlighted by shading in chart 1.

Chart 1

In chronological order, those months were:

October 1998 (Asian / Russian / LTCM crises)
December 2000 / January 2001 (start of US / global recession)
September / October 2001 (911 terrorist attack)
March 2003 (Iraq invasion)
September through December 2008 (GFC climax)
November 2011 (Eurozone crisis / recession)
February through April 2020 (covid recession)

So the current signal suggests significant economic weakness and risk-off markets, at least until policy-makers respond.

The forecast that global economic momentum would weaken in H2 2024 was based on a fall in six-month real narrow money momentum into a low in September 2023 and an observation that the money-activity lag has recently extended to a year or more – chart 2.

Chart 2

The September 2023 real money momentum low suggests that PMI new orders will reach a low by January 2025. With money trends still weak, however, a recovery may be lacklustre.

Could PMI new orders break below the low of 46.5 reached in December 2022? The low in six-month real narrow momentum in September 2023 was beneath the preceding low in July 2022 – chart 2. Current weakness is more likely to spill over into labour markets, creating negative feedback loops.

“Surprise” economic deterioration is forecast to be accompanied by sharply weaker inflationary pressures, reflecting broad money stagnation in H2 2022 / H1 2023. The consumer goods PMI output price index fell back below its pre-pandemic average in July, following a plunge in the consumer services index the prior month – chart 3.

Chart 3

Will the Bank of Japan’s latest attempt to exit ZIRP prove any more successful than its previous two efforts, in 2000 and 2006?

The monetary backdrop is no more promising. The six-month rate of change of broad money M3 was 0.5% annualised in June compared with 1.3% and -1.1% respectively before the August 2000 and July 2006 rate hikes – see chart 1.

Chart 1

Chart 1 showing Japan Policy Rate Target & Broad Money (% 6m annualised)

Money growth, admittedly, has been depressed by recent record intervention to support the yen. The judgement here is that the authorities have marked out a major low in the currency – see previous post – so f/x sales are likely to slow / end.

A reduced intervention drag, however, will be offset by a contractionary monetary influence from QT. The announced phased reduction in monthly purchases implies that the BoJ’s JGB holdings will fall by about ¥8 trn during H2 2024, equivalent to an annualised 1.0% of M3.

Credit developments are superficially more supportive of policy tightening. The six-month rate of change of commercial banks’ loans and leases was 3.5% annualised in June compared with -1.9% and 2.8% before the 2000 / 2006 hikes.

Bank lending, however, is usually a lagging indicator of economic momentum, suggesting a slowdown ahead in response to recent activity weakness.

The BoJ “will … continue to raise the policy interest rate” if its outlook for economic activity and prices is realised. Headline and core CPI inflation are projected to be close to the 2% target in fiscal years 2025 and 2026 based on the output gap turning positive and a “virtuous cycle between prices and wages continuing to intensify”.

The “monetarist” forecast, by contrast, is that inflation is heading for a big undershoot. Six-month core CPI momentum was 1.5% annualised in June*, with lagged broad money growth suggesting a further decline into 2025 – chart 2.

Chart 2

Chart 2 showing Japan Consumer Prices & Broad Money (% 6m annualised)

Coming Japanese inflation experience will be another test of forecasting approaches. Simplistic monetarism has trounced new Keynesian orthodoxy so far this decade. Another win for monetarist simpletons will spell third time unlucky for the BoJ.

*Own estimate adjusting for policy effects and seasonals.

Global six-month real narrow money momentum – a key indicator in the forecasting process followed here – is estimated to have moved sideways for a third month in June, based on monetary data covering 85% of the aggregate.

Real money momentum has recovered from a September 2023 low but remains below both its long-run average and the average in the 10 years preceding the GFC, when short-term interest rates were closer to recent levels – see chart 1.

Chart 1

The expectation here has been that the fall into the September 2023 low would be reflected in a weakening of global industrial momentum into late 2024. DM flash PMI results for July support this forecast, implying a fall in global manufacturing PMI new orders from 50.8 in June to below 50, assuming unchanged readings for China / EM.

Chart 2

The stalling-out of real money momentum at a weak level suggests that economic expansion will remain sub-par in early 2025.

Global six-month industrial output growth, meanwhile, recovered in April / May, crossing back above real money momentum – chart 3. The implied negative shift in “excess” money conditions may partly explain recent market weakness / rotation.

Chart 3

Global six-month real narrow money momentum was held back in May / June by weakness in China and Japan, discussed in recent notes. A US slowdown is a risk going forward.

A note in February argued that expansionary deficit financing operations – “Treasury QE” – have more than offset the monetary drag from Fed QT. Specifically, the Treasury relied on running down its cash balance at the Fed and issuing Treasury bills to fund the deficit in H2 2022 and 2023. The former represents a direct monetary injection while bill issuance is likely to expand broad money because bills are mostly purchased by money funds and banks. (A recent paper from Hudson Bay Capital makes a similar point, referring to variations in the maturity profile of debt sales as “activist Treasury issuance”.)

The February article and an update in May, however, noted that Treasury financing estimates implied that the six-month running total of Treasury QE would slow sharply in Q2 and turn negative in Q3. With Fed QT continuing, albeit at a slower pace, the joint Treasury / Fed impact on broad money was on course to become significantly contractionary.

Treasury QE has fallen as expected and the joint contribution has become negative – charts 4 and 5. Six-month broad money momentum has yet to slow significantly, although three-month growth in June was the weakest since November. Money momentum lagged when the joint impact swung from negative to positive in late 2022 / early 2023.

Chart 4

Chart 5

The approach here places greater weight on narrow than broad money for short-term forecasting. A US broad money slowdown, in theory, could be accompanied by stable or stronger narrow money expansion, for example if rising confidence leads to an increase in broad money velocity, with an associated portfolio shift into demand deposits. Such a scenario, however, is less likely the longer the Fed delays significant rate cuts.

The slowdown in Treasury QE explains a reversal lower in US bank reserves since April – chart 6. The prior rise in reserves, despite ongoing Fed balance sheet contraction, occurred because money funds were moving funds out of the overnight reverse repo facility in order to buy newly-issued Treasury bills, with the Treasury reinjecting the cash via the deficit.

Chart 6

Japanese bank reserves are also on course to fall as the BoJ embarks on QT – chart 7. Market speculation is that the MPC will announce a reduction in gross JGB purchases to ¥3 trn per month at next week’s meeting, from an average ¥5.7 trn in H1. With redemptions averaging ¥6.5 trn over the last year, this suggests monthly QT of ¥3.5 trn ($23 bn), equivalent to 2.6% of broad money M3 at an annualised rate.

Chart 7

The reporting season of our international holdings gets underway in the weeks ahead. After a particularly strong Q1 reporting season, forward earnings per share estimates for the STOXX 600 have been flat since June. Some sectors, like in travel and leisure have observed an increase in their earnings revision while others, like in luxury or in construction and materials have obtained a lower-than-expected earnings revision. On the revenue side, we saw a weaker forward sales revision lately, a potential signal that the macroeconomic trends might remain complicated for the second half of 2024. On a sector basis, consumers and technology seems to be experiencing a soft patch. When not impacted by delay, new order intakes seem to be coming through but the cadence in manufacturing is progressing at a slow pace.

Political risk is back

Index performance rebased to 100 (USD)

Source: Bloomberg, MSCI.

Volatility spiked last month due to a political risk resurgence in Europe. The French election caught investors off guard and prompted many to de-risk and reallocate elsewhere. French bond yield has narrowed since the end of June, but equity hasn’t recovered much. French equities have suffered and have trailed other benchmarks since early June.

The left-wing alliance unexpectedly won the election, beating both the presidential and far-right party. Now, attention turns to the election of a new President of the National Assembly in July. The balance of power seems to have shifted towards the center-left alliance and this could be the best-case scenario for markets. The formation of a technocracy cannot be ruled out either.

The first real test for the new government will probably be to vote on the upcoming preliminary budget that needs to be submitted to the European Commission by mid-October. Last month the European Commission signaled that France should be put under excessive deficit procedure. If that proposition is adopted by the European Council, France will have to meet the requirement of the European Union’s (EU) fiscal rules. The incoming government will have little room to maneuver from a fiscal point of view. Considering that the last time France recorded a surplus was in 2001, the challenge is colossal.

Political uncertainty adversely affects the decision-making processes of companies. It will be interesting to track how companies intend to reallocate capital in the upcoming months.

Investors positioning

Fund flows are trending towards bonds and money market funds. US equity fund inflows remain high but have slowed, reflecting cautious investor sentiment. In Europe, equity funds are experiencing outflows, while Asia ex-Japan sees significant inflows, particularly in China and India. Technology remains the top sector, while materials and consumer sectors show muted interest. Shares of small caps in the US have recently surged, with the Russell 2000 Index hitting a 2024 high, fueled by optimism regarding the federal reserve’s advancements in combating inflation and the increased likelihood of interest rate cuts.

Fund Flows (last 4 weeks, % of assets)

Source: Deutsche Bank.

Cumulative equity flows (last 12m, weekly, $bn)

Source: Deutsche Bank.

Small caps is a key beneficiary of the expected lower rates, and given they continue to trade at a 20-year low valuation versus their larger counterparts, we believe now is an interesting time to own small caps.