The return of the Magnificent 7

Good morning. South Korea has a new president — leftwinger Lee Jae-myung decisively won the country’s election. Will he put in place long-sought market reforms? Closer to (our) home, the US job openings and labour turnover survey for April came out yesterday. It came in just fine: lay-offs increased, but so did job openings. Email us: [email protected].

Return of the Mag 7 (and the US) 

World stocks have whipped US stocks this year, as everyone knows: 

If you look hard at that chart, though, you will notice that over the past month or so, the US (as measured by the S&P 500) has caught up a bit. Indeed, with a 7 per cent return since the start of May, the US looks resurgent. The US recovery has a very specific and familiar flavour, though. It is mostly driven by Big Tech. Specifically, more than two-thirds of the gains come from just seven stocks: Nvidia, Microsoft, Meta, Broadcom, Amazon, Tesla and Alphabet. They have added $2.4tn in value over the period. I’ll call them the ‘Magnificent seven’, but this is cheating slightly: I’ve swapped Broadcom in for the canonical Apple, which has fallen as it remains squarely in the tariff war’s no man’s land. 

Still, Big Tech is, once again, holding up the index. Take out the (slightly rejigged) Mag 7 and the market is up a more workmanlike 3 per cent since May. How shall we read this uneven distribution of gains? Glass half-empty types will say that narrow rallies are unsustainable; the half-fulls will say, along with Marion Laboure of Deutsche Bank, that Big Tech provides leadership. “As before, Mag 7 performance will probably serve as a barometer for broader risk sentiment,” she writes.

The appeal of the Mag 7 is what it has always been: putting aside Tesla, these are businesses with high barriers to entry, high free cash flow, and strong growth. Yes, they are expensive (other than Alphabet, they all trade at more or less meaty premiums to the US market, which itself ain’t at all cheap). But it’s hard to find better-positioned businesses at anything approaching the same scale. However, their recent good performance is not down to a re-evaluation of their growth prospects. As you can see in the third column below, earnings estimates for the group are not being revised up much — and some are getting marked down.  

Unhedged is, we’re ashamed to admit, a bit puzzled by this. Tesla’s performance — in spite of its big earnings markdown — may be down to Elon Musk’s decision to leave government and focus on business; after all, the stock never really traded on fundamentals. As for the rest, they may be responding — as quintessentially global stocks — to the possibility of US-China trade détente and the realisation that Donald Trump’s bark is consistently worse than his bite (If only we had a memorable acronym for that). But if that were true, wouldn’t goods-based, non-tech companies be the more obvious trades? Readers, if you have a theory, send it along. 

The dollar

Two months after “liberation day”, it is possible to step back and consider how markets have changed. The most striking and most discussed new trend is the combination of rising Treasury yields and a weakening dollar. As an illustration, here is the dollar index plotted against the gap between the yields on 10-year Treasuries and 10-year German Bunds. There has clearly been a divergence:

It’s a topic we have touched on a few times, but the chatter continues. Some have even held it up as evidence that the US is starting to look more like an emerging market.

There is definitely a change under way — Trump’s tariff policies have reduced the appeal of the US as a destination for capital, and the widening deficit is scary. But it would be an overstatement to compare the US to an emerging market, or even the UK, says Jonas Goltermann at Capital Economics: 

Back in April when [dollar underperformance] first started, it felt like ‘oh my god, there is a crisis, something like the UK’s ‘Trussenomics’. But calls for that have really stopped. The market rebounded. The [dollar and yield] divergence is still there and growing, and it does react to headlines on trade and the fiscal picture; it is related to the administration’s policies to some degree. But it is not a crisis. It is not Trussenomics.

There has not been that big a rotation away from US assets. Though there were two spotty Treasury auctions — one in the week following liberation day, and one in late May — the remainder have been fine. Meanwhile, foreign inflows into the S&P 500 have risen. From the minutes of the Fed’s most recent meeting:

The manager [that tracks flows data] noted that no evidence indicated that foreign investors had sold material amounts of US assets. Available data pointed to modest outflows from fixed-income securities that were largely offset by inflows into equity securities. 

A chart from Bank of America’s Michael Hartnett shows this nicely:

Nor should we overstate the rise in yields. The fall in the dollar alongside rising Treasury yields is anomalous. But bond yields have been rising across the developed world. From Robin Brooks at the Brookings Institution:

I don’t think that the rise in yields rises even remotely to the level of the Liz Truss bond yield blow-up for the UK. What we are seeing is quite different in that the US has yield levels that are rising, but yields are also rising everywhere . . . The rate differential is stable.

Indeed, the gaps between US 10-year Treasury yields and other economies’ bond yields have flattened recently: 

With the benefit of hindsight, there are two likely culprits for the big dollar shift, beyond marginal shifts in foreign flows. The first is hedging. Ed Al-Hussainy at Columbia Threadneedle explains:

If you are a foreign investor, you are buying a cash flow . . . those flows are always subject to the uncertainty of the exchange rate . . . If the dollar is weakening, it subtracts from your cash flows. As an investor, you don’t like the dollar uncertainty, and you don’t like realising the losses of the dollar weakening.

[An investor can hedge] by entering a forward contract. Say I will purchase Korean won, buy US equities, and then enter a contract to buy Korean won at [a specific] exchange rate in the future. That takes the currency risk out . . . But entering that contract puts downward pressure on the dollar: I am selling dollars and buying won in the futures market.

The second is a re-evaluation of the US economy. Remember how strong the dollar was coming into liberation day. Looking at a longer timeframe, the dollar looks strong even now: 

For years, US growth outpaced the rest of the developed world. But growth expectations have softened, and other countries are letting out their own fiscal sails. Recent currency appreciations — with Taiwan’s being the most dramatic — suggest that foreign central banks are adjusting to this new paradigm. But that is an adjustment from a point where the dollar may have been too strong. On the deficit, US economic data is still fine, and as Paul Krugman notes, US taxes are low by international standards; there is room to raise more revenue if push comes to shove.

The US is not an EM. Nor is a Truss-like incident in the offing. It would be more appropriate to call this normalisation.

(Reiter)

One good read

S/OFR.