Three Red Queen's Races in Play

The Red Queen's Race
Alice: Well, in our country... you would generally get to somewhere else if you run every fast for a long time, as we have been doing.

Queen: A slow sort of country, said the Queen, Now, here, you see, it takes all the running you can do to keep in the same place. If you want to get somewhere else, you must run as least twice as fast as that.

Big Picture

For 18 months, the market has been trading higher on falling CPI. However, we got the best CPI print in years this week and most of the market hasn't made any progress. This could mean the inflation problem regime has run its course and the market is now more worried about softening growth.

The Russell 2000 is as cyclical as it gets. It's also filled with companies that won't be first-wave market beneficiaries of AI.

While AI-based automation will ultimately help just about every company in terms of the bottom line, it will be a Red Queen's Race when it comes to market positioning and investor interest. Ie, for most companies, AI will be a tool for not falling behind rather than a tool for getting ahead.

Small caps are a concentrated group of companies that fall into this Red Queen's Race track. It's also a good signal group for sniffing out this type of regime change around inflation vs growth as the primary bogeyman in the market.

The market's correlation ratio is a fine testament to the implications here. The SPY ($SPY(SPY)) Liquidity Premium measures how much trading liquidity is being showcased in the SPY ETF versus in the 500 individual stock components of the S&P 500 index. When it is very high, it is often a key buy signal. 

However, here is what we now see:

The End of the EU?

Recent gains by far-right parties in European Parliament elections have prompted French President Emmanuel Macron to call a shock national vote, casting the spotlight back onto political risks in Europe that financial markets had largely overlooked. This shift in political dynamics affected the euro, French stocks, and government bonds, which all saw declines as investors evaluated the potential repeat success of the far-right in French elections and their possible influence on the new European Union executive.

Further economic integration will be slowed down instead of being accelerated, stated Carsten Brzeski, global head of macro at ING, commenting on the EU's rightward shift. Here are five key questions for markets in light of these developments:

What does a snap French election mean for markets? French stocks experienced notable losses due to Macron's unexpected decision following a significant defeat to Marine Le Pen's far-right National Rally (RN) in the EU ballot. Major banks, including BNP Paribas and Societe Generale, saw their shares fall by as much as 8% on Monday.

Emmanuel Cau, head of European equity strategy at Barclays, anticipates that banks and utilities will likely face the most significant impacts due to the uncertainty. Moreover, the potential introduction of a bank tax by populist parties is adding to the market's unease.

French government bonds are also likely to suffer, as large investors had already been avoiding them due to a high deficit and a recent downgrade of France's credit rating by S&P. Deutsche Bank highlighted concerns about a future government's likelihood of complying with EU deficit regulations, especially noting a strong performance by the Socialist party.

The French/German 10-year bond yield gap widened by 7 basis points to 55 bps on Monday, remaining well below the 80 bps peak seen in 2017 when Le Pen, now less eurosceptic, had threatened to exit the euro.

We expect some underperformance of French assets and by extension, some underperformance of European assets because it adds to a bit of a European risk premium, mentioned Mark Dowding, chief investment officer at BlueBay Asset Management. He holds an underweight position on French debt and predicted that the spread could widen to over 70 bps if the RN wins.

During the COVID-19 pandemic, the EU took unprecedented steps towards fiscal union with an 800-billion-euro recovery fund, with France playing a key role. A rightward shift in that country and beyond may weaken the case for more such initiatives. The risk premium on bonds issued by Italy, a significant beneficiary of the pandemic recovery program, widened on Monday but remains well contained.

Long-term, diminished prospects for programs similar to the recovery fund would imply a higher structural risk premium on the bonds of the bloc's high-debt countries, according to analysts at Citi.

The Greens were among the biggest losers of the EU elections. The shift to the right is unlikely to undo existing climate policies, but it could complicate the passage of new ones and add loopholes to weaken laws that are due to be reviewed. At the margin, you might see a bit of pressure on things like renewables within utilities and some relief for sectors like energy if you believe a more right-wing parliament would relax the agenda on the green transition, said Barclays' Cau.

The EU executive, unlikely to change from its current centrist makeup, imposes trade protection measures, not parliament. However, the parliament's rightward shift could still have an impact. The EU is already planning to impose tariffs on Chinese electric vehicles.

The political move to the right in the European Parliament and the outcome of new parliamentary elections in France will undoubtedly lead to more trade barriers between the EU and China, noted Commerzbank's chief economist Joerg Kraemer.

Any retaliation could impact European auto stocks, which have recently taken a hit on prospects for higher Chinese tariffs. China might also target other sectors, such as dairy products, wine, and airplane parts, Kraemer added.

Since Russia's invasion of Ukraine, pressure on Europe to increase defense spending has intensified. While member states are primarily responsible for defense spending, nearly two-thirds of respondents polled by Citi recently expect further joint EU funding for selective purposes such as defense. The bloc has also broached the idea of a new 100-billion-euro defense fund. Any far-right opposition to further fiscal integration could dent those hopes.

There is also uncertainty over what the rise of the far-right in Europe might ultimately mean for support for Ukraine, as markets grapple with a flurry of geopolitical risks.

French Finance Minister Bruno Le Maire issued a stark warning on Friday about the potential for a financial crisis in the euro zone's second-largest economy. He expressed concerns that victory for either the far right or left in the upcoming parliamentary elections could lead to economic instability due to their ambitious spending plans.

Political uncertainty has already led to a severe sell-off of French bonds and stocks. This market reaction followed President Emmanuel Macron's unexpected decision to call for an election after his centrist party was significantly outperformed by Marine Le Pen's eurosceptic National Rally (RN) in the recent European Parliament elections.

When asked about the likelihood of political instability causing a financial crisis, Le Maire responded affirmatively on franceinfo radio. He highlighted that both the far right and the left lacked the fiscal means to support their proposed expenditures. I'm sorry, they do not have the means to afford these expenses, said Le Maire, who had been working on plans to implement multi-billion euro savings to stabilize France's finances.

Current opinion polls suggest that the RN, which has advocated for reducing electricity prices and VAT on gas as well as increasing public spending, might secure enough votes to win the upcoming election and potentially lead the government. This possibility has raised alarms about the financial implications of such a shift in power, considering the extensive spending increases proposed by these parties.

French President Emmanuel Macron's decision to call an early election appears to be backfiring, according to recent polls. Macron took a significant political gamble, hoping that voters would shy away from the extremes of the political spectrum and rally behind his centrist agenda.

However, the latest poll results indicate a different trend:

- Far-right (National Rally): 29.5%

- Far-left (Popular Front): 28.5%

- Macron's centrist party: 18%

This shift suggests that instead of consolidating the moderate vote, the political center is splintering. A notable portion of Macron's own party is even showing tendencies to align more with the far-right.

Elections can be unpredictable, and while there's still time before voters head to the polls, the market's reaction has been decidedly negative. Both the far-right and far-left are advocating for significantly larger budget deficits, a stance that typically causes concern among investors and could imply economic instability if either side gains power.

Policy

Monetary policy is becoming another Red Queen's Race.

In a surprising turn of events at its June meeting, the Federal Reserve has opted for a conservative approach, signaling only one rate hike this year despite recent data suggesting a slowdown in inflation and GDP growth. This cautious stance, mirroring past errors, might be setting the stage for future economic constraints.

Back in 2020, the Federal Open Market Committee (FOMC) decided not to raise rates until the economy achieved full employment, leading to a delayed response to rising inflation in 2021. This misstep resulted in a significant inflation surge, with interest rates now 100 basis points higher than if earlier action had been taken.

Today, the Fed seems to have repeated this error but approached it differently. Despite a deceleration in GDP growth and easing inflation rates since May, the FOMC's projection of a mere 2.3% annualized inflation rate from June to December suggests an overly cautious outlook. With a forecasted core-PCE inflation of 2.8% for 2024, the current rate stance of 500-525 basis points appears excessively high, where a more appropriate level would be around 350-400 basis points.

Chair Jerome Powell emphasized the importance of proactive measures, stating the Fed aims not to wait for things to break and then try to fix them. However, this approach seems contradictory as the Fed continues to overlook signs of slowing economic growth. Despite a first-quarter GDP growth of only 1.3% in 2024, the Fed sticks to a hopeful forecast of 2.1% for the year, necessitating an average growth of 2.4% in the remaining quarters.

The optimistic outlook disregards the slowing sectors like housing and non-residential investment, which are likely to keep GDP growth around 1.5% for the rest of the year. Fortunately, the current trajectory does not yet pose a risk of recession.

Initial expectations that the May Consumer Price Index (CPI) report might prompt a rate cut in July have been dampened. Nevertheless, the consensus among eight of the nineteen FOMC members anticipates two rate cuts later this year—one in September and another in December. Powell noted that most FOMC officials do not revise their projections based on data presented during the meeting, such as the May CPI data, suggesting a shift might occur by September when the economic slowdown becomes more apparent.

This recent decision by the Fed reflects a recurring theme of hesitancy and misjudgment. While it's clear the FOMC is attempting to avoid past mistakes of reacting too late, their current strategy of potentially overestimating the economic strength could limit growth and delay necessary adjustments to the monetary policy.

The FOMC has again adjusted its estimate of the neutral rate, raising it from 2.6% to 2.8%. This likely represents the endpoint of the Fed's easing cycle, whenever it may begin. This adjustment is typically a positive sign, often reflecting an improvement in trend productivity. However, it's noteworthy that the FOMC hasn't revised its long-term average growth forecast, which remains at 1.8%.

We maintain our forecast of a 3.6% target for the 10-year Treasury yield, once the Fed initiates rate cuts, based on a projected neutral rate of 2.9%. However, current market valuations suggest a neutral rate of 3.5-4.0%, which seems overly optimistic.

The May Consumer Price Index (CPI) report provides reassuring news for those concerned about persistent inflation. The core CPI rose by just 2.0%, while the 'supercore' rate, excluding shelter, fell to -0.4%, bringing the year-over-year rate to 1.8%—below the Fed's 2% target. The Personal Consumption Expenditures (PCE) inflation, preferred by the Fed and less influenced by shelter costs, is expected to register even lower.

Although month-to-month reports can be volatile, several factors indicate a continuing downward trend in inflation. A significant contributor is the drop in transportation services costs, which, after peaking with an 11.1% increase from April 2023 to April 2024, have decreased by 6.0% on an annualized basis. This decrease is a strong indicator that transportation inflation has reached its peak. Additionally, with normalized productivity growth, there is little basis for sustained inflation, especially given the current tight monetary policy and the diminishing effects of previous fiscal stimuli.

One element of the May inflation data that might concern some FOMC members is the 5.6% increase in average hourly wages, the most substantial rise since March 2023. Despite historical data showing no direct link between wage growth and inflation in recent decades, the fear of a wage-price spiral remains. However, real wages, adjusted for inflation and productivity growth, are still below their pre-pandemic levels. We expect wages to align with previous trends over the next two to four years. While this adjustment may compress profit margins, it is unlikely to be inflationary.

The case for reducing rates is now more evident, dictated more by the psychological readiness of the Federal Reserve than by economic imperatives. This points to a critical juncture in monetary policy where the decision to start cutting rates will significantly influence economic stability and growth.