Two-way pull continues

Investors remain undecided about where markets are heading. The cloud of Gulf-conflict-fuelled stagflation looms on the horizon. But for now the AI boom remains the dominant driver. The glass is still half full.

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New high

The S&P 500 pushed further into record territory last week, adding 200 points to 7399 as investors kept their focus on a buoyant earnings season and stuck to their optimistic assumption that neither side in the Gulf conflict wants to see it continue for too much longer.

Earnings season really is firing on all cyclinders. With about 450 out of the top 500 US companies having reported earnings so far in the first quarter results round, more than 80% of them have beaten expectations by a stunning 18% on average.

That’s a really strong performance at this stage in the economic cycle. Normally you would only expect this kind of forecast-busting growth in the early days of recovery from a recession. Not as now, in the middle part of the up-cycle.

It’s still a narrow rally, though. The gains are centred on the big tech stocks that dominate the capitalisation-weighted benchmark. The equal-weighted index remains below its pre-conflict high.

This suggests that for companies outside the charmed AI circle, investors are starting to worry about a looming energy crisis. Inventories are running low and the ongoing game of chicken in the Strait of Hormuz threatens another 1970s style low-growth, high-inflation stagflation scenario.

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Bond investors keep an eye on Downing Street

Here in the UK, the market focus is on bonds. That’s because last week’s expected drubbing for the government in local elections shines the spotlight on the future of the Prime Minister and ability of the government to see it through to the next scheduled general election in two and half years’ time.

Bond markets dislike political uncertainty. Investors demand more compensation for the small but not completely theoretical risk that the government will not repay them when government bonds - known in this country as gilts - mature.

The 30-year gilt yield rose by a few basis points after last week’s election results became clear and now stands at 5.63%, close to its highest level of the past 30 years. The pound also weakened a little against both the dollar and the euro.

It would be easy to overstate the issue. The gilt market remains open for business. International investors are still willing to fund the government’s spending plans. But the UK has to pay more to borrow than its developed market counterparts, and that looks unlikely to change.

India misses the emerging market boom

UK bonds are not the only asset class that’s out of favour at the moment. Indian shares have also had a bad couple of months as investors have looked at the country’s dependence on imported oil and run for cover.

The MSCI India index has fallen by 10% since the start of the year, missing out completely on the near 20% gain achieved by the broad MSCI Asia Pacific benchmark. The rupee has also fallen to a historically weak 95 to the dollar. And the Indian government is also having to pay heavily to attract lenders. Bond yields have risen above 7%, an all-time high.

Stagflation watch

The economic data this week focuses on the stagflation twins of growth and inflation, although not in the same place at the same time.

The inflation focus is on the US, where rising energy costs are expected to push the April inflation rate to 3.8%, up from 3.3% in March.

That will focus the mind of new Federal Reserve chair Kevin Warsh, who takes over from outgoing chair Jerome Powell this week.

At the start of the year, futures markets were pricing in two or three interest rate cuts in the US. Now there is only a slim chance of one cut this year and a roughly one-third chance of a rate hike before next spring.

The prospect of falling rates has been a key driver of stock market strength so more muted expectations for the path of monetary policy put even more pressure on rising earnings to keep the bull market on track.

Here in the UK, it’s the growth side of the equation that is in focus. A strong first quarter GDP reading of 0.6% is expected on Thursday, and that might raise pressure on the Bank of England to keep rates steady or even push them higher again.

But the first quarter GDP data is essentially backward-looking. Survey data is weaker than the official numbers, and so the Bank may well wait and see what impact the Gulf conflict starts to have on business and household spending.

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