Stock Watch

Stock watch: 3 themes driving markets right now

June has got off to an inauspicious start for global stock markets. UK and US indices are up slightly, while European stocks are lower. This could be a tricky month for stock markets. Economic data is starting to show the strain from global tariff turmoil, and the OECD has slashed global growth expectations along with a big downgrade for the US economy. Below, we look at some key themes that could impact the next move for stocks.

1, Economic backdrop

Recession risks are toxic for stocks, especially if inflation is expected to remain elevated. This is exactly the situation that could be facing the US economy. The OECD slashed its growth forecasts for the US economy for this year to 1.6% down from their 2.2% forecast from March. The economic data has already started to come in below expectations in the US. The Citi economic surprise index has turned lower in recent days, which suggests that US economic data is surprising on the downside. This could be extended if US labour market data later this week deteriorates sharply.

As you can see, the S&P 500 tends to move in the same overall direction as the US Citi Economic Surprise Index, which suggests that a spate of weaker than expected economic data can weigh on the US blue chip index.

Chart 1: S&P 500 and US Citi Economic surprise index, 1-year chart

Source: XTB and Bloomberg 

2, The rise of tech

The tech sector led the recovery rally in US stocks in April and May, leaving other sectors and smaller cap stocks lagging. Earlier this year, the equal-weighted S&P 500 index, which strips out the influence of big tech, was attempting to catch up to the US tech giants, however that has now faltered. There is a widening gap between the equal weighted S&P 500 and the market-cap weighted S&P 500, suggesting that mega cap tech stocks are in control of the US stock market once again.

The Russell 2000 of US mid cap stocks is also lagging. The reasons for this could persist for some time: 1, domestically focused stocks and mid-cap stocks are more closely linked to the US economy. If the economy is faltering, they could suffer more than global tech stocks. 2, If the global economy is slowing, mega cap tech stocks such as Apple, Microsoft, Nvidia etc. could take on a defensive flavor due to the size of their cash piles and their bullet proof balance sheets. Thus, tech may continue to dominate in the second half of this year.

Chart 2: S&P 500, equal weighted S&P 500, Russell 2000, normalized to show how they move together over 12 months.

Source: XTB and Bloomberg

3, Europe’s defense firms have gas in the tank

One of the biggest themes for the European stock market this year is defense. The US’ s determination to get other NATO members to step up their defense spending has worked. Germany has dropped its strict fiscal rules to allow more borrowing to fund defense plans, and the UK is planning to boost defense spending to 3.5% of GDP, although exactly how this will be funded is yet to be disclosed.

This theme is not new. Since Donald Trump became President, he has threatened to reduce US defense spending and force other western nations to stop relying on the US as a de-facto security blanket. This is why defense stocks across Europe, including Rheinmetall, Rolls Royce and BAE Systems have been some of the top performers on the Dax and the FTSE 100 this year. Now that Europe is coordinating defense spending, possibly with the UK in tow, and the extent of the rearmament, this is a theme that may continue for some time.

Although these companies have high P/E ratios relative to their domestic indices, Rolls Royce has a forward P/E ratio of 37x future earnings and Rheinmetall’s is 66, this is about the same level as mega cap US tech stocks. Added to this, the Eurostoxx 50 index’s aerospace index is at a record high. However, it may be worth paying up for these stocks, since the growth outlook, and the earnings potential remain compelling. If the global economy is in retreat, these companies could still produce decent earnings growth as Europe has pledged to boost defense spending for the next decade. Both companies also have decent dividends and share buybacks, and they are more recession-proof compared to other sectors of the market.

Chart 3: Rheinmetall and  Rolls Royce, vs. the Dax and the FTSE 100, 12-month chart

Source: XTB and Bloomberg