Chinese setback, AI woes, and ECB decision
By Peter Garnry, Head of Saxo Strats
- Chinese market and manufacturing struggles: The Chinese equity market experienced a significant decline, pulling down emerging market equities by 3%. This was exacerbated by disappointing PMI figures indicating contraction in the manufacturing sector, reflecting ongoing economic challenges in China.
- Health care sector performance: The health care sector underperformed, dropping by 2.1%, making it one of the worst-performing sectors of the week. Despite this setback, the sector is projected to have high expected returns driven by a strong real earnings growth rate of 3.7% annually over the next decade, only second to the energy sector.
- AI concerns: Earnings reports from Salesforce and Dell Technologies fell short of expectations, raising doubts about the immediate growth benefits of heavy investments in generative AI. This has sparked broader concerns about a potential bubble in AI-related enthusiasm, as highlighted by comments from industry leaders and Nobel laureate Paul Romer.
- ECB rate decision: The ECB is expected to cut its policy rate next week, with a 97% probability assigned by the market. Despite a rebound in the European economy and inflationary pressures, there are concerns that the rate cut might exacerbate inflation in the medium term. The bond market reflects this worry, with the German 10-year yield reaching its highest level since November 2023, suggesting scepticism about the ECB's approach to inflation management.
Chinese setbacks in manufacturing and negative health care sentiment
The past week has been negative for equity markets with especially the Chinese equity market tumbling pulling emerging market equities 3% lower reinforcing this part of the market as the weakest year-to-date up only 4.3% compared to 17.4% for Japanese equities. China continues to be the story of two steps forward and one step back. Today the PMI figures on the manufacturing and services sectors showed a negative surprise with the manufacturing PMI for May even dipping below 50 suggesting contraction. On the sector level the past week saw modest gains for the communication services and utilities sectors while health care was the biggest underperformer down 2.1%.
Despite the setback for health care this week making it one of the worst performing sectors this year on a relative basis, the expected returns for the sector are still among the highest and only surpassed by the energy sector. The highest expected returns for the health care sector are driven by a modest 1.7% dividend yield and modest buyback yield of 0.9%, but the highest expected real earnings growth rate at 3.7% annualised over the next 10 years. The sector performance the past week has been driven by momentum effects with the highest momentum sectors outperforming the weakest momentum sectors. The worst sector in terms of expected returns remains real estate.
AI: Are Salesforce and Dell Technologies earnings a canary in the coal mine?
No week passes without something new on AI. This week earnings results from Salesforce and Dell Technologies negatively surprised investors questioning whether the massive investments in generative AI workloads are in fact translating into higher growth rates for the wider technology ecosystem. These relevant questions came as DeepMind CEO and co-founder Demis Hassabis recently talked about that generative AI focusing on content creation is diverting attention and resources away from the area of AI research that will matter in the long run. This week, Nobel laureate Paul Romer also talked about the risks of the current AI enthusiasm might be creating a bubble.
The ECB might be headed into a policy mistake
The ECB is set to cut its policy rate Thursday next week with the market assigning a 97% probability of a cut. ECB speakers have effectively talked themselves into a corner this year which would mean loss of integrity if ECB did not cut its policy rate.
We have argued for some time now that the ECB might be headed into a policy mistake. The key dynamic to understand is that the European economy has bounced back regardless of what the ECB sees as a restrictive policy rate which indicates that it was not the policy rate that weakened the European economy in the first place. It was the energy shock due to the war in Ukraine and the lagged effects of high inflation. The global economy has entered into an expansion phase with Europe’s economy also accelerating and inflation surprising to the upside (Eurozone core CPI today came out at 2.9% YoY vs est. 2.7% YoY). If the ECB chooses to cut rates into this cycle they might add to inflationary pressures medium term prolonging the inflation problem. The issue is that the ECB remains too confident in its econometric models on inflation and underestimates the future impact on inflation from fiscal expansion related to military expenditures and demographics which will keep labour market tight.
The bond market seems to be having the same thinking with the German 10-year yield at 2.7%, the highest level since November 2023, which indicates that the bond market is worried that the ECB will add to inflationary dynamics longer term. So by cutting the interest rate the ECB might achieve looser financial conditions for those in the economy that refinance regularly such as consumer credit and high yield bonds, but financial conditions for longer term financing could actually go up.
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