Shrinking Dragon

China-watchers are getting really nervous after data out last week showed the country’s manufacturing activity contracted for a second straight month while activity in the services sector slowed by more than expected. But at least investors can take a huge sigh of relief after the US’s debt-ceiling drama finally got resolved last week. Across the pond, eurozone inflation fell more than expected last month but it may still not be enough to convince the European Central Bank to stop raising interest rates. Over in equities, US stock indices have never relied on such a small number of stocks to stay afloat, with the market being largely bolstered by the growing frenzy for AI. That narrow breadth is exacerbating concerns among bearish investors, many who recall how the tech sector’s extreme dominance in the late 1990s set the stage for the dot-com crash. Find out more in this week’s review.

Macro

The latest purchasing managers’ index (PMI) data out last Wednesday showed China’s economic recovery weakened in May, raising fresh fears about the growth outlook in the world’s second-biggest economy. The manufacturing PMI fell to a five-month low of 48.8 – down from 49.2 in April and below the 50-point mark that separates expansion from contraction. The PMI also missed forecasts for an increase to 49.4. A non-manufacturing gauge of activity in the services and construction sectors, meanwhile, slid to 54.5 from 56.4 in the previous month, also below expectations.

The worse-than-expected data led to a sell-off in everything exposed to China, from the country’s shares and the yuan to copper and iron ore. The carnage even spread to the wider Asia Pacific area, with regional stocks falling sharply last Wednesday alongside the Australian and New Zealand dollars. But it’s in Chinese stocks where investors are really hurting: down 8% in May, the Hang Seng China Enterprises Index is one of the worst performers among 92 global equity gauges tracked by Bloomberg. The index, a measure of Chinese shares listed in Hong Kong, has now dropped over 20% from its January peak, meaning it’s officially in “bear market” territory. That prompted some China bulls to start retreating in frustration, marking a sharp reversal from earlier this year when almost all of Wall Street’s major banks made bullish calls on the country.

The activity slump also prompted more calls for the Chinese central bank to take action by, for example, cutting interest rates or lowering the reserve requirement ratio for banks. But while these measures may provide a temporary boost to China’s financial markets, they are unlikely to significantly improve consumer and business confidence, which remains low. The extent of China's economic recovery also hinges on a revival in its property market, which constitutes approximately one-fifth of the economy when including related sectors. However, home sales have decelerated following an initial rebound, and real estate developers are still grappling with financial challenges. Finally, to round up all the bearish sentiment, tensions between the US and China show no signs of easing.

Speaking of the US, investors can take a huge sigh of relief as the country’s debt-ceiling drama finally got resolved. Last week, the US passed debt-limit legislation that restricts government spending until the 2024 election and averts a disruptive debt default. The deal represents a big shift in curbing government spending following huge Covid-related bailouts and significant government investments in infrastructure and climate change initiatives under the Biden administration. However, economists widely project that the overall impact of reining in all that spending will be minimal, potentially tempering growth next year by a couple of tenths of a percentage point.

Across the pond, Europe got some good news last week, with new data showing inflation in the bloc falling more than expected last month to hit its lowest level since the Russia-Ukraine conflict broke out. Consumer prices in the eurozone advanced by 6.1% in May from a year ago, decelerating from April’s 7% rate driven by falling energy costs. That’s the lowest reading since February 2022 and was below the 6.3% level forecast by economists.

Core inflation, which strips out energy, food, and other highly volatile items to give a better idea of underlying price pressures, also decelerated, falling from 5.6% in April to 5.3% in May. While that was a bigger drop than economists had expected, it may still not be enough to convince the European Central Bank (ECB) to stop raising interest rates at its next meeting. Investors and economists widely predict another quarter-point move on June 15 and reckon there’ll probably be one more after that to round off the cycle.

The good news for the ECB is that eurozone consumers’ price expectations have fallen to the lowest since 2020, providing the central bank with some reassurance that the inflation surge seen as part of a once-in-a-generation shock isn’t getting entrenched in the economy. The measure, part of a long-running economic sentiment survey run by the European Commission, reflects responses from consumers on how prices will develop over the coming year. And according to the latest results out last week, the measure dropped from 15 in April to 12.2 in May – its lowest level since October 2020.

Stocks

US stock indices have never relied on such a small number of stocks to stay afloat, with the market being largely bolstered by the growing frenzy for AI. The top-heavy nature of the market’s advance, which has been in full force all year, can be seen by comparing the Nasdaq 100 to a version of the same index that strips out market-value biases. The equal-weighted index has trailed its cap-weighted cousin by 16% since January. In the S&P 500, the equal-weighted version is losing by the widest margin since Bloomberg’s data began in 1990.

This narrow breadth is exacerbating concerns among bearish investors. After all, the AI craze is the only thing propping up the market right now – so what happens when the hype dies down? You don’t need to look too far back in history to remember that the tech sector’s extreme dominance in the late 1990s set the stage for the dot-com crash. But some argue that things are different this time because the handful of tech stocks pushing the market higher today all belong to good companies with assured growth. If the leadership consisted solely of low-quality companies, similar to what we witnessed in 2000, then matters would be really worrying. Having said that, investors are starting to pay exorbitant prices for today’s mega-cap tech stocks, with the biggest seven trading at a forward P/E of 35x – 80% above the market’s average.

So does this narrow breadth mean that investors need to hit the exits? If we use history as our guide, then the answer is “not necessarily”. There have been a total of 15 years over the past three decades when the equal-weighted S&P 500 trailed the cap-weighted version. Among them, only three gave way to losses 12 months later. In 1998, when the gap between the two widened to 16%, stocks kept rallying for another year. What’s more, according to a recent investor survey by Bloomberg, some 41% of the 492 respondents said the highest returns this year would come from buying quality stocks focused on profitability (like Microsoft, Apple, and other mega-cap tech stocks). Put differently, investors reckon that Big Tech's rally has further room to run, fueled by the risk of a US recession that pushes people towards stocks that provide profitable growth during challenging economic conditions.

This week

• Monday: Eurozone Sentix Economic Index (June), US factory orders (May).
• Tuesday: Australian central bank announcement, eurozone retail sales (April), Japanese household spending (April).
• Wednesday: Australian GDP (Q1), China trade balance (May), Canadian central bank announcement. Earnings: GameStop.
• Thursday: China loan growth (May). Earnings: DocuSign.
• Friday: Chinese inflation (May), Canadian unemployment rate (May). Earnings: NIO.