Be cautious: The US stock market may experience another tech bubble! The biggest risk is...

Recent positive trends in the US stock market indicate a growing optimism about the prospect of an economic soft landing. Despite the deep inversion of short and long-term US bond yields, a recession has not yet arrived. What is currently driving the upward momentum of the US stock market? And what are the impending risks?

Severe labor shortage has not significantly affected the employment market despite rising interest rates

Although the decline in the number of new jobs is often associated with a slowdown in economic activity, the current trend suggests that the decrease in new jobs is more likely due to a shortage of labor. On the positive side, employment data remains strong, with low unemployment rates indicating that a recession is not yet imminent.

However, the tight labor market implies that inflation risks remain severe, providing continued impetus for the Federal Reserve to raise interest rates. It is highly likely that the July rate hike will not mark the end of the current rate hike cycle.

Further slowdown in manufacturing activity

The Biden administration's strong fiscal support for manufacturing has provided a safety net, boosting confidence in the economy's soft landing. It is worth noting that the ISM Manufacturing PMI experienced its most severe decline in June 2023 in the past three years, and the New Orders Index has remained below the 50 threshold for 10 consecutive months, indicating a weakening in demand for goods.

At the same time, manufacturing employment growth has been relatively low compared to overall non-farm employment. Although the growth rate of commercial and industrial loans remains favorable, the rising cost of borrowing, as reflected in the 2-year interest rate reaching a 16-year high, is expected to significantly slow down manufacturing activity.

The biggest risk is the potential decline in abundant liquidity

Guotai Junan Securities believes that another important factor contributing to the current strong performance of the US stock market is abundant liquidity.

Firstly, despite the ongoing quantitative tightening (QT), US bank reserves remain above $3.2 trillion, as QT primarily consumes funds from the reverse repo market, thereby having limited impact on the economy. Ample reserves also encourage banks to lend.

Secondly, a large amount of household savings has been converted into assets, driving up asset prices and increasing household purchasing power. The Federal Reserve's Bank Term Funding Facility (BTFP) and other tools also inject liquidity into the market. The decline in the Reverse Repo Program (RRP) balance to below $2 trillion also indicates liquidity injection. However, it is important to note that the pace of QT is accelerating, and with the signing of the debt ceiling bill, the Treasury Department needs to replenish its checking account at the Federal Reserve, which will weaken market liquidity.

If we calculate the liquidity in the US market using the formula: Federal Reserve assets + BTFP funds released - Treasury General Account (TGA) funds absorbed - RRP balance, it becomes apparent that the liquidity injected by RRP and BTFP is insufficient to offset the liquidity absorbed by TGA and QT. Based on the relationship between this indicator and the historical trend of the S&P 500, the driving force behind the upward momentum of the US stock market is expected to weaken.

Since May 2023, short-term US bond rates have been rising, and now long-term rates are also increasing, indicating that the market expects rates to remain high in the long term. At the same time, the rise in long-term real interest rates reflects a decline in long-term inflation expectations. These trends seem to suggest that the market is very optimistic about the economy, expecting a future of low inflation and avoiding a recession.According to Dongwu Securities, the current market expectations may be overly optimistic. If we exclude the impact of technology giants, the performance of weighted indices such as the S&P 500 in the first half of this year is not significant. The increase in valuation indicates that the gains are almost entirely contributed by the seven technology giants, while the valuations of other stocks are declining.

From historical data, the valuation trends of technology giants and other stocks will not be decoupled in the long term. Compared to May, global fund managers have started to express concerns about the technology bubble.