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Investors are shifting their attention to this coming week's Fed rate decision

The major indexes were higher this week, with the S&P 500 posting its fourth consecutive weekly gain that was more than 20% above its 52-week low and climbing to its highest level in nearly 10 months. Each of the major U.S. indexes produced a fractional weekly gain in a mostly quiet week of trading. A U.S. small-cap stock benchmark outperformed its large-cap peers for the second week in a row, narrowing small caps’ year-to-date underperformance gap versus large caps. The Russell 2000 Index has gained more than 5% over the past two weeks. After the closing on Thursday at 4,293.9, the S&P 500 has exited the bear market that it had been in since January 2022. The index now has entered a bull market after rising 20% since a low on October 12, 2022. An equally weighted S&P 500 Index also rose more than its capitalization-weighted counterpart for the first time in eight weeks. Sector performance was mixed, as small caps had solid gains. Treasuries were weaker with some curve flattening, as the two-year yield reached its highest level since the stress in the banking sector began in March. Bond investors are having a wait-and-see stand ahead of a U.S. Federal Reserve meeting this coming week. U.S. government bonds traded in a narrow range. The 10-year U.S. Treasury bond was trading at a yield of around 3.74% on Friday, up from 3.69% at the end of the previous week. The dollar index was lower this week. According to analysts’ reports approximately 65% of S&P 500 constituents providing negligible or negative contributions to the index this year and just 14 companies accounting for the entirety of gains. The dispersion between the best- and worst-performing sectors and stocks is the widest it’s been in at least 20 plus years.

May’s Institute for Supply Management (ISM) and Services Purchasing Managers’ Index (PMI) data show that services activities are slowing, signaling a slower future economic growth. The ISM services index fell to 50.3 in May from 51.9 the prior month. While we expect economic growth to slow in the second half of 2023, services will perform better during the slowdown. The headline ISM services index slowdown was driven by declines in all four primary subcomponents. The employment index fell to 49.2 in May from 50.8 in April, presenting a weaker picture than the sharp growth in nonfarm payrolls in May. The business activity index fell to 51.5 from 52 the month prior, its lowest level since May 2020. The new orders index fell sharply to 52.9 in May from 56.1 in April. The decline in every main subcomponent supports economists’ view that growth will slow this year; we believe that the slowdown will be mild. Investors are waiting on next week’s Consumer Price Index release and the Federal Open Market Committee Meeting. It is expected that the FED will pause rates thus keeping its key benchmark interest rate unchanged at a range of 5.00% to 5.25%, after 10 consecutive meetings in which it has lifted rates. In our view, there’s a high probability that the Fed will raise rates again in July by 25 basis points, although this decision will be data dependent by next week’s inflation data and June’s labor market data. If next week’s data show that inflation and June labor market remain resilient, we expect it will force the Fed to raise rates again in July to slow inflation closer to the Fed’s 2% goal.

In euro terms, the pan-European STOXX Europe 600 Index and the EURO STOXX 50 blue-chip Index ended 0.46% and 0.78% lower respectively amid caution ahead of central bank meetings in Europe. Germany’s DAX eased 0.63% and France’s CAC 40 Index fell 0.79%, while Italy’s FTSE MIB gained 0.35%. The UK’s FTSE 100 Index lost 0.59%. ECB President Christine Lagarde and Bundesbank chief Joachim Nagel reiterated their hawkish stance for more rate increases, pointing out that there were few signs of inflationary pressures easing. However, Dutch central bank Governor Klaas Knot appeared to be less hawkish saying that rate decisions must be taken step by step as there was more evidence that tighter monetary policy was working. Median consumer expectations for eurozone inflation in the year ahead fell in April to 4.1% from 5.0% in March, according to an ECB survey. Eurozone falls into mild recession; revised data showed that the eurozone economy shrank by -0.1% sequentially in both the first quarter of this year and the final Q4 of 2022, technical definition of a recession. Meanwhile eurozone retail sales were flat in April indicated that consumption remained weak. Germany’s industrial sector also continued to deteriorate. Factory orders unexpectedly fell 0.4% compared with March, while industrial output grew 0.3% sequentially—less than the 0.5% uptick expected by FactSet’s economists.

A Japanese stock index on Tuesday closed at its highest level since 1990. The Nikkei 225 Index gained 2.4% and the broader TOPIX Index was up 1.9%. Positive sentiment was supported by an upward revision to Japan’s Q1 economic growth which grew at an annualized rate of 1.6%, stronger corporate investment, as well as hopes that the services sector will benefit from rebounding foreign inbound tourism and investments. The yen traded close to a six-month low against the U.S. dollar, close to 139 JPY level as the continuing monetary policy between the dovish Bank of Japan and the other major central banks remains diverge weighing on the Japanese currency. The weak yen continued to benefit Japan’s exporters as well as boosting the attractiveness of local assets to foreign investors.

China’s reopening hasn’t boosted domestic or global growth as much as most expected. China’s import and export data in May suggest that global demand isn’t as strong as anticipated. China’s exports fell by 7.5% year over year in May. This indicates that global demand for goods is lessening despite China’s recent reopening. China’s imports also fell in May by 4.5% year over year, though less than expected. China’s slow economic recovery and structural changes it is expected to have global implications. Structural changes in China’s trade will slow growth in the near term but likely lead to an increase in the medium term. China is shifting its focus to domestic manufacturers to become less dependent on foreign inputs.

Equity and bond markets will continue to have elevated volatility until there’s a meaningful and consistent decrease in inflation and the “data-dependent” Fed considers changing course on rates. We remain defensive in our positioning, and we’d look for opportunities to upgrade portfolios during market weakness. Within equities, we continue to favor U.S. Large Cap exposure, since China’s economy shows ambiguous signs on manufacturing and growth. In the United States, large-cap equities provide an attractive blend of quality, yield, and growth at a reasonable value, albeit at higher valuations, as earnings expectations continue to deteriorate. For fixed income, we remain defensive in our credit positioning and higher in credit quality. We expect that credit spreads will leak wider to account for slowing growth and recession risks.

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