View From The Top: For how long can we party?

View from the very top: There are many good reasons to believe the party can continue. Take robust economic growth and improving corporate earnings. Add in falling inflation expectations and AI-led productivity gains. Were the Federal Reserve to cut interest rates in the absence of any sign of recession, then this could fuel an additional level of optimism. We believe it is only appropriate to lean into risk at present, albeit with caveats. Markets rarely follow a linear path and growing exuberance can lead to disappointment should increasingly elevated expectations not be met. There is still the risk of a policy error or miscalculation on the part of either Central Banks or politicians, particularly in a world of heightened geopolitical uncertainties. We favour diversification both within equities and across the broader asset allocation spectrum.   

Asset Allocation:

• Equities: Further gains in equities are possible, particularly if current earnings momentum continues. Strategy is complicated by the extreme concentration among market leaders in both the US and Europe as well as the corresponding valuation premiums they command. With the MSCI World Index up over 40% from its October 2022 nadir, there is a natural tendency to lock in some gains. We believe that diversification therefore makes sense and see merits in allocations to a range of styles and themes embracing both growth and value. Areas that look interesting include US small caps and Japan. A broadening rally would also be supportive of the contention that not all bullishness is currently discounted in investors’ assumptions.
• Fixed Income/Credit: All the post-Powell pivot gains in US Treasuries have now been erased, with investors increasingly discounting higher rates for longer. The yield on 10-year US Treasury debt has therefore moved from its 3.8% trough in December 2023 to 4.2% currently. We believe it is logical for investors to look to lock in current yields before Central Bank rate-cutting eventually commences. A higher-for-longer world may increase the risk of corporate defaults and the resumption of a more normalised credit cycle will almost certainly create clear opportunities across the credit spectrum.
• Currencies: A combination of a robust US economy (relative to the rest of the world) and a recalibration of interest rate expectations has continued to push the Dollar higher, close to record levels versus a basket of other global currencies. Although consensual, we believe this trade could run further in the near-term.
• Gold: We have not been surprised to see the relatively lacklustre performance of gold given the current economic context. In the near-term, the precious metal may remain range-bound, with its performance correlated with real yields and the Dollar. However, we continue to see gold as a diversifier and a political hedge.
• Cash: With interest rates still at record levels this cycle, the attraction of holding cash for its yield remains compelling. Over $130bn has been added to money-market funds year-to-date (per Bloomberg). We counsel its judicious deployment.
• Alternative Assets: Owning assets with collateral-based cashflows brings diversification to portfolios. We advocate being selective across this broad and diverse area, favouring differentiated and uncorrelated strategies in areas such as pharma royalties, among others.

Investors are high on a potent cocktail of economic growth and expanding corporate earnings. There’s also the extra shot of lower interest rates to look forward to. There are many good reasons to believe that this party can continue. Why leave now when there’s more fun to be had? Timing one’s exit is never easy. To the extent history is a guide, there are multiple precedents for when markets can get overblown. We think it makes sense to continue partying, but just try not to think too hard about what may come after. Hangovers are never pleasant things.

The story so far. Equities across the world are touching all-time highs. The S&P 500 Index crossed the symbolic 5,000 mark in February, while Japan’s Nikkei 225 Index returned to a level last seen 34 years ago. Europe’s leading STOXX 50 Index is back in territory last enjoyed at the turn of the Millennium. Big tech and AI euphoria have certainly played a role, but corporate earnings are showing robustness. 80% of S&P 500 constituents beat consensus estimates during the most recent earnings season, versus a 10-year average of 74% (per Bloomberg).

While earnings strength is driving (justified) optimism, macro has almost occupied a back seat. This, however, is not to take anything away from the almost unicorn-like soft landing that has seemingly been achieved in the US. There appears to be a growing body of evidence that inflation can be beaten without provoking a painful downturn. Both the OECD and IMF have recently upgraded their global GDP assumptions for 2024, driven by a better US economic performance. The American consumer remains in good health for now, with still over $300bn of excess savings on which to draw. Corporate CEOs are their most positive in two years. And, inflation expectations are at their lowest since March 2020 (data per Alpine Macro, US Conference Board and New York Fed respectively). As a result, bears are increasingly hard to come by.

Look ahead and there are other reasons to support further economic and corporate momentum. The remarkable resilience of the global economy can be buttressed by falling inflation and a productivity boost from AI. Both could cause global GDP to accelerate. Put another way, the global economy could be poised to enjoy a disinflationary boom. Take inflation first. It should trend lower given the impact of falling shelter costs – a large contributing factor in its calculation – collapsing natural gas prices and stable shipping rates (even with current Middle East tensions). Next, consider AI. Similar to the Internet a generation ago, increasing deployments of the technology should drive productivity gains. In turn, these can help boost corporate margins and hence equities. We are also pleased to see that despite growing optimism, there are currently limited signs of corporates taking on excess leverage or contemplating potentially value-destroying M&A activity – signs that often mark irrational exuberance. 

It is also important to consider that the current melt-up in risk assets can be sustained for as long as there is ample room for the Federal Reserve to manoeuvre. One month of hotter-than-expected inflation data is unlikely to change the Central Bank’s bigger picture assessment of the economy. Even if February’s 3.9% CPI inflation was the highest since August 2023, it should be noted just how far inflation has already come, from its peak of 9.1% in mid-2022. Nobody ever said that the path forward on inflation was going to be linear. Inflation as a phenomenon remains poorly understood and difficult to forecast.

The Federal Reserve is keeping its eye on the prize – of price stability. The risk of easing too quickly or too much could undermine all its prior hard work. Data-dependency remains the ultimate get-out clause, but it is fair to assert that the last mile to defeat inflation could become proportionately harder were the Fed to turn dovish too soon. For now, staying “nimble and vigilant”, in the words of Jerome Powell, should be enough – for as long as the economy remains in rude health.

The same mutually reinforcing cocktail of economic strength and recovering corporate earnings has allowed investors to take the recalibration in the timing of anticipated interest rate cuts in their stride. At the end of last year, the first US interest rate cut was expected in March, with the Fed Funds Rate set to fall by 150 basis points over 2024. Now – just eight weeks later – the initial cut is being priced for June. The futures market is currently discounting just 75 basis points of rate decreases over the rest of the year. It’s no more complicated than it has ever been – don’t fight the Fed. The remarkable volte-face in rate expectations has brought investor expectations into line with the Fed’s thinking.  Imagine, however, what would happen were the Fed to cut rates when there is no recession. If rate cuts were simply a function of lower inflation, then this could allow the market to continue making new highs. 

Without wanting to be a party-pooper, it’s only reasonable to ask what could go wrong, especially when consensus ‘appears’ to have everything figured out. Expert opinion on both inflation and interest rates has, of course, been consistently confounded in the past five years. It may be so again. Two contradictory lines of argument both bear some consideration. Where there is consistency lies in the notion that the Fed may be behind the curve. On the one hand, if significant disinflation is in the pipeline, then should the Central Bank not be considering cutting now, before the labour market (and broader economy) start to deteriorate, when rates are still high? Alternatively, a case can be made that current rates are not restrictive enough, given current growth momentum. It’s certainly possible to imagine a scenario where the economy continues to operate at high levels of capacity and inflation remains sticky. Inflation expectations can easily become unmoored again. Follow this line of reasoning to its conclusion: if things get too good, then rates may have to rise.

Investors should also be mindful of US exceptionalism. The rest of the world looks in less robust economic health, with China a particular cause for concern. Should the Chinese authorities be unable to stem the intrinsic weaknesses in its economy, then some contagion effects might be possible. The US does not operate in a vacuum. Even if a prospective Trump Presidency would likely see America becoming more isolationist, there are still eight months to run before the election. This could prove a tricky period, with scope for miscalculation on the part of many parties. Bear in mind, that there are over 50 state-based conflicts globally today (per the Oslo Peace Research Institute), near the highest level since 1945.

Any sober assessment of the world would also highlight that markets can get overblown. Even if the equity rally has broadened recently, there is a lot resting on the tech sector. Incredible innovations don’t always make for incredible investment opportunities. As tantalising as a ‘this time it’s different’ narrative is to believe, previous periods of exuberance show that investors believe consensus estimates at their own risk.

At the same time, extreme equity market concentration leaves investors vulnerable to any stumble by its elite. This will inevitably happen. By way of a sanity check, consider that NVIDIA, the poster child for the current rally, trades on a forward earnings multiple that places it at a greater than 50% premium to the S&P 500 Index. A broader historic arc might also note that the path being taken by the Magnificent Seven mega-cap tech stocks is not dissimilar to that followed by the Four Horsemen in the 1990s. A generation ago, the quartet comprising Cisco, Dell, Intel and Microsoft witnessed a trough-to-peak rally of 192%. At zenith, they commanded an average earnings multiple of 65x. This time around, the Magnificent Seven have rallied 150% from their October 2022 trough and trade on ‘only’ 50 times forward earnings (all data per Bloomberg).               

There might be further to go then. However, not only is history often a poor guide to the future, but timing an exit is always hard. Against this background, our counsel is to embrace diversification, not just within equities but across broader asset allocation decisions. For as long as the music continues to play, there is an argument to keep dancing – albeit with some caution. 

Alex Gunz, Fund Manager, Heptagon Capital