CIO View

Navigating markets between politics, a softening U.S. economy, and artificial intelligence

Maybe it’s just our perception, but we have the strong feeling that there is an unusually large number of factors influencing markets, and in different directions.

There’s politics, this time the decisive Round Two of the French parliamentary election. Generally, our job is not to judge whether we like an election result or not. The risk of violating Marty Zweig’s Investing Rule Number 9 —‘Don’t let your opinion of what should happen bias your trading strategy’(1) — is just too high. Last week’s market relief following the withdrawal of plenty of left-wing and centrist candidates (so as to avoid splitting their votes) and the release of poll-based seat estimates that showed the far-right Rassemblement National winning only a moderate 170-220 seats, confirmed that the market would be unhappy with an overly strong far-right performance. Similarly, it would be unhappy if the left bloc performed surprisingly well, especially if that mainly reflected gains by its most radical candidates. Thus, applying a traditional left-right framework, a parabolic reaction function in risk premiums emerged. However, esoteric considerations by financial markets about risk premia didn’t bother French voters. While markets will be relieved that Rassemblement National failed big way to get even close to an absolute majority, analysts will have to assess what the strong performance of the left bloc will mean.

In any case, the developments in France since June 9 hold some interesting lessons and could actually serve as a prototype for a typical market pattern around political events. It began after the European elections with President Macron surprisingly announcing snap parliamentary elections. In a hurry, analysts scrambled to collect all sorts of data. What to make of the revival of the moderate left in the European elections and to swiftly form an alliance with the far-left? What do opinion polls say and how reliable have they historically been in France? How useful are polls and previous election results, anyway, given the two round voting system? What would one or the other election outcome mean, for example, for French state finances? How exactly does the French electoral system work? If there were an escalation in markets, could the European Central Bank come to the rescue? Summing up: high uncertainty. Markets dislike uncertainty, so how do they react? Risk premiums rise, such as the CDS prices on French government bonds. Coming from AA-typical 25 basis points, costs to insure French debt against default rose to over 40 basis points, thus trading approximately at the same levels as a good BBB issuer like Spain. The day after the first round of the election, and to the great relief of markets, came the realization that once again the world had not come to an end. Quickly, risk premiums began to erode again, first slowly, then faster, and in the case of France CDS were back to 30 basis points by Friday. Given yesterday’s election outcome, however, a quick return of risk premia to pre-European Election levels might take some time.

Of course, politics is not just about France. What would a Trump victory mean? Again, let’s ignore our own opinion on how the election should play out and focus on market implications. As the Wall Street Journal reported last week(2): ‘Sudden Return of the Trump Trade Sends Treasurys Reeling.’ And the article goes on: ‘Investors bet that a Republican sweep would allow tax-cut extensions.’ What’s more, a ‘rule of thumb on Wall Street holds that budget deficits tend to be larger under one-party control.’ Before we forget, there was also a ‘historic’ UK election. But we wouldn’t be the only ones to miss that. As former MI6 chief Sir Alex Younger lamented in an ITV interview(3): ‘Particularly since I've left office and I've travelled around Europe, I'm profoundly depressed. Just nobody mentions the UK. We've made ourselves irrelevant. And this is extraordinary. At the beginning of this century, we were the dominant force. France has effectively eclipsed us and you just don't hear a discussion of us.’ Brexit at work, but maybe not as envisioned by Brexiteers.

Another force impacting the markets is the economy. The mystery of how the U.S. economy managed to defy gravity and grow by 4% in H2/2023 despite 5% in rate hikes seems to be unravelling. Now that the fiscal stimulus has faded, the true strength — or rather weakness — is becoming obvious. Weak consumer and housing data were complemented last week by a sharp 5-point drop in the service sector ISM index and a lackluster jobs report. The unemployment rate rose to 4.1%, confirming that there’s no sideways movement in unemployment—it’s either rising or falling. At the moment, it’s rising. Can the AI boom save the economy? Dave Rosenberg has his doubts(4): ‘If the Internet couldn’t prevent a 2001 recession, why would AI stand in the way of Mother Nature in 2024?’

Bad economic news, however, doesn’t necessarily have to be bad for markets, as it rises the likelihood that the Fed will graciously join it peers and begin to cut rates. After last week’s dismal data, two full cuts are now priced in for the remainder of the year. Some brave souls are even betting on July as the starting point for cuts.

But back to AI. A week ago, we shared the observation that critical voices regarding the AI hype are growing louder. Market veteran Ed Yardeni has now joined the chorus(5), warning against excessive optimism. ‘Determining when an investment trend has run its course is more of an art than a science,’ Yardeni asserts in a LinkedIn post titled “AI Hype is Hyper.” And he continues: ‘While we love the productivity-enhancing possibilities that artificial intelligence (AI) offers, the AI phenomenon has many of the hallmarks of an inflating bubble. There are big bucks chasing the AI dream. New kings of industry have been crowned. And the hyperbole is flowing.’

This week’s data releases start with a bunch of countries publishing their May industrial production numbers. After Germany and France reported surprisingly soft activity last week, expectations might be low already. China will be releasing June CPI and PPI inflation data on Wednesday. Marking this week’s highlight, U.S. CPI data comes on Thursday with markets expecting the headline rate to drop to 3.1% from 3.3%. U.S. CPI will be followed by PPI numbers as well as the University of Michigan’s consumer confidence survey on Friday.

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1. Source: Marty Zweig’s Investing Rules, November 1990, via LinkedIn.

2. Source: The Wall Street Journal, July 3, 2024.

3. Source: X, July 4, 2024.

4. Source: X, July 3, 2024.

5. Source: LinkedIn, July 4, 2024.

Forecasts are based on assumptions, estimates, views and hypothetical models or analyses, which might prove inaccurate or incorrect. Past performance is not a reliable indicator of future returns. Source: DWS Investment GmbH as of 7/8/24.