Landslide Victory

Here are some of the biggest stories from last week:

• Inflation in the eurozone decreased slightly in June.
• The Labour Party won the UK general election by a landslide.
• US stocks could remain expensive for a while.
• Global interest rates are forecast to come down at a much slower pace compared to how fast they shot up.

Dig deeper into these stories in this week’s review.

Macro

Inflation in the eurozone decreased slightly last month, adding to evidence that price pressures are gradually moving toward the European Central Bank’s target. Consumer prices in the bloc rose by 2.5% in June from a year ago, down from the 2.6% pace seen in May and in line with economist estimates. But it wasn’t all good news: core inflation, which strips out volatile food and energy items to give a better idea of underlying price pressures, unexpectedly remained unchanged at 2.9%.

What’s more, services inflation also stayed flat, at 4.1%, which is a bit too high for the ECB’s liking. That strength is mainly due to upward wage pressures from the bloc’s robust job market (labor costs hold a bigger sway over prices in the services sector compared to other industries). All in all, the data suggests that the central bank will probably take a break from lowering borrowing costs this month and wait until September for its next move.

Over in the UK, the Labour Party won the general election by a landslide, securing a huge parliamentary majority and ending 14 years of Conservatives rule. The party’s been pledging to boost economic growth, keep spending tight, rein in debt, build new homes, upgrade crumbling infrastructure, and more. Strategists at JPMorgan expect the victory to be a “net positive” for financial markets, and will benefit the nation’s banks, homebuilders, and grocers the most. They’re betting on sharper gains for the more domestically focused FTSE 250 index of medium-sized UK companies, compared to the more internationally focused big-cap FTSE 100. And that adds up: historically, the FTSE 250 has done better than the FTSE 100 after elections, with even stronger outperformance following Labour victories.

However, not all businesses will welcome a Labour government in 2024, JPMorgan said, citing the promised nationalization of the train network and proposals to increase taxes on energy firms. Water companies are also likely to face increased regulation, but other utilities could benefit from increased spending on green energy infrastructure.

Separately, analysts at MUFG said that Labour’s landslide victory will be most positive for the British pound, as it will end political instability and potentially help usher in a more constructive relationship between the UK and EU, post-Brexit. Investors seem to agree: more than half of the 268 respondents to a recent Bloomberg poll said that a Labour win would be the best result for the pound.

Stocks

Many investors are worried that US stocks are expensive, and it’s not hard to understand why: the S&P 500’s forward price-to-earnings (P/E) ratio, at over 21x, is roughly 17% higher than its ten-year average. That, despite interest rates being much higher today than they were over the past decade (higher rates normally lead to lower P/E ratios). However, some analysts reckon that valuations alone are uninformative, arguing that there’s a strong chance that US stocks will remain expensive compared to history for years to come, supported by rising profit margins. They contend that this expansion justifies higher P/E ratios.

The prospect of higher profit margins is driven by three key things. First, there are cyclical factors. Inflation and wage growth are slowing in the US, suggesting that input costs are starting to mellow out for American firms. That, combined with still-strong revenue growth and potentially lower interest rates next year, should support profit margins in the short run. In fact, nearly three-quarters of the firms in the S&P 500 are expected to expand their margins over the next 12 months. Analysts are often poor forecasters, sure, but research shows they are right nearly 75% of the time regarding whether margins are headed up or down in absolute terms.

Second, there are structural factors. Put simply, there are far more capital-light, higher-margin companies today than in the past. For example, information technology is by far the biggest sector in the S&P 500 today, with a 31% weighting. What’s more, research shows that a record 36% of US firms have gross profit margins of over 60%.

Third, there’s AI, which has a huge potential to support long-term margin expansion. Economists at Goldman Sachs, for example, estimate that generative AI could potentially lift US productivity growth by roughly 1.5 percentage points per year over the next ten years. And based on the historical relationship between productivity growth and corporate profitability, this boost could lift S&P 500 profit margins by roughly four percentage points over the next decade, everything else being equal. That would take average profit margins from roughly 12% today to 16% in ten years.

Interest rates

Stubborn inflation and still-strong economic growth in the US have pushed the Fed to delay interest rate cuts, but that won’t deter other major central banks from their own easing efforts, according to Bloomberg Economics. Among the 23 of the world’s top institutions featured in the firm's quarterly central bank research, only the Bank of Japan won’t end up lowering borrowing costs within the next 18 months. Most are already set to do so this year, with some having already begun.

In total, the aggregate global benchmark interest rate compiled by Bloomberg is expected to decrease by approximately 1.4 percentage points by the end of 2025. That’s a far slower pace downwards for borrowing costs compared to how fast they went up. In other words, central banks aren’t set to swiftly remove the unprecedented global tightening delivered during the post-pandemic inflation spike.

What’s more, monetary easing throughout the developed world is turning out to be relatively unsynchronized, which could add a ton of new volatility to the currency market. In Europe, for example, the Swiss National Bank has already cut rates twice this year, the European Central Bank has moved once, the Bank of England has yet to do so, and Norwegian officials just signaled that they’re unlikely to act before 2025. In North America, the Bank of Canada delivered its first cut in June. But that same month, the Fed, which has yet to move, signaled that it expects to lower rates far fewer times this year than previously forecast. In Asia, the BoJ is increasing borrowing costs. And while Australia’s central bank is on pause for now, it hasn’t ruled out further rate hikes.

But it’s important to remember that while there's a general move toward lower borrowing costs, any uptick in consumer price rises could disrupt this trend – highlighting the tricky balance that central banks need to strike as they seek to cool inflation without denting economic growth.

Next week

• Monday: China loan growth (June), eurozone economic sentiment (July).
• Tuesday: Nothing major.
• Wednesday: China inflation (June).
• Thursday: UK GDP (May), US inflation (June). Earnings: PepsiCo.
• Friday: China trade balance (June), US consumer sentiment (July). Earnings: Citigroup, JPMorgan, Wells Fargo.