The Week Ahead

It is likely to be a quiet start to the week, with US markets closed on Monday for Presidents Day. European markets are higher across the board and gold is clinging to the $5,000 level after the tamer than expected CPI report in the US reduced haven flows to precious metals.

Starmer’s wish for closer ties with EU plays out in equity market

Ahead this week, the focus is on some key European and UK data releases. European banking stocks are leading markets higher on Monday, and UK defense names are also some of the top performers, after the UK announced an increase in defense spending and called for a closer relationship with the EU on defense and trade. This seems to be boosting the market mood as we start the week.

US Treasuries brush off China selling fears

The notable feature about last week was the rally in US Treasuries, which outperformed globally and had their best weekly performance in months, at the same time as US equities underperformed. US Treasuries brushed off fears that Chinese officials had directed domestic banks to reduce their UST exposure. This suggests that, for now, the economic data and the tame CPI report for January, is more important to financial markets than stories about de-dollarization.

Diverging performance between US bonds and stocks

The divergence in performance between US bonds and stocks can be attributed to two events: firstly, rising hopes for Fed rate cuts this year as the US economy enters a sweet spot, at the same time as the AI scare trade disrupts US stocks.

AI trade: it’s easy to sell fear

At the end of last week, the AI scare trade targeted logistics firms, after wealth managers and insurance firms had been in the crosshairs earlier in the week. Equity price action has taught us one thing: it is easy to sell fear. The AI scare trade is one of the reasons why US equities are underperforming their global peers so far this year.

Anyone or anything can seemingly plug code into Chat GPT and come out with a new disruptive technology that has knocked more than $1 trillion from the valuation of software and service stocks this year. However, on Friday, there are signs that the AI narrative may start to fray as we move into the second half of February. On Friday, logistics stocks sold off after a penny stock that makes Karaoke machines launched an AI freight product, The company claimed that its new AI tech could help customers scale their freight volumes by 300-400%. These are impressive figures, but if the company is used to selling karaoke machines, what is their customer base like? Can they cope with complex, global freight company logistics, and how tried and tested is this technology?

Has the AI scare trade gone too far?

The AI scare trade has a hint of throwing the baby out with the bathwater about it. The sell-off across tech stocks could have gone too far, too fast. While it is a reality that AI is making great strides, it is untrue that AI plug ins will replace some of the biggest tech companies in the world, and that AI is going to steal your job soon. AI is useful for managing workload, but it still needs humans to be effective, it still needs marketing, managers and sales teams to turn a profit and operate in a  competitive global economy.

The benefits of the stock market sell off

One of the benefits of the AI scare trade is that it has brought US tech firms back into more reasonable valuations. For example, Salesforce, which has been hit hard by AI fears, has seen its P/E valuation drop from 48x earnings a year ago, to 24x times today. Thus, at some point, when the hyped-up fear about AI starts to fade, tech stocks could be a bargain.

US markets are closed on Monday due to Presidents Day, so we may have to wait to see if the excesses of the AI scare trade start to fade this week. US economic data had a bigger effect on the Treasury market last week, and 10-year Treasury yields fell 15bps, outpacing most global bonds. Interestingly, the decline in yields did not have much of an impact on the dollar, which remains weak, but is trading in a tight range as we move through the first half of Q1.

Below are the key events to watch for this week:

1, UK economic data

It’s a big week for UK data releases, retail sales, labour market data and CPI are all released this week. The pound is one of the strongest performers in the G10 FX space on Monday, as we lead up to these crucial releases. Analysts expect an increase in the unemployment rate to 5.2% from 5.1% for December. Wage growth is expected to moderate for both the public and the private sector, and jobs are expected to be lost for January.

The CPI report is also worth watching closely, as inflation is expected to moderate sharply in January, compared to December, which fits with the BOE’s narrative that inflation will fall back to target this year. The headline rate is expected to come in at 3% down from 3.4%, and the core rate is also expected to moderate to 3% from 3.2%. There is a big expectation that UK inflation is on its way down, so any upside surprise could weigh heavily on the pound and on UK Gilts. A weaker than expected CPI report combined with a rise in the unemployment rate could boost hopes for a rate cut from the BOE next month. There is currently a 73% chance of a cut next month, this could increase if inflation plays out as expected.

2, FOMC minutes

The FOMC minutes from the January meeting along with the PCE reading for inflation will be the highlight from the US this week. Will the Fed hint that a third cut is possible this year? If yes, then the dollar may continue to come under pressure, and we could see another strong performance from the Treasury market.