View From The Top: Important things

View from the very top: We can’t predict the future, but we can attempt to plan sensibly for it. If we accept that the most important thing is not to fight the Federal Reserve, then the path for interest rates will most likely eventually be lower. It’s the direction of travel that matters. An ongoing cyclical rebound in corporate profitability combined with inflation metrics continuing to move in broadly the right direction could buttress the current bull market. Rate cuts based on lower inflation, rather than in the face of pending recession, would be a major positive for risk appetite. We believe that pullbacks should be seen as opportunities, particularly in the context of current cash levels sitting on the sidelines ($8tr in money market funds, per Bloomberg). At the same time, we counsel against complacency. Avoid the herd, continue to diversify and don’t forget about the growing debt time bomb in the background.

Asset Allocation:

• Equities: The MSCI World Index recorded another all-time nominal high during May and is now up almost 10% year-to-date. Notwithstanding the disproportionate impact that NVIDIA continues to have (shares have gained 120% in 2024 and the business comprises 3.4% of the World Index), corporate earnings on both sides of the Atlantic have been less bad than feared. Consensus estimates therefore continue to move up, with Bloomberg assumptions discounting an acceleration in growth for 2025 over 2024. We do not believe that momentum as a style factor is durable and that there will be a mean-reversion in market leadership over time. Diversification makes sense, in our view, and we see opportunities for truly active managers in both the growth and value vectors. Japan and US small caps are also potentially interesting.  
• Fixed Income/Credit: The yield available on 10-year US Treasury debt has fallen in the past month but is still markedly higher than at the start of the year (by over 60 basis points). According to Bloomberg, the continuing bond market drawdown is the longest in history. Nonetheless, we note the current tightness of credit spreads and high levels of corporate credit issuance as being indicative of appetite for this asset class and see the logic of locking in elevated rates while they are still available. Credit offers a reliable income stream in the face of uncertainty and would be a clear beneficiary of a lower rate environment.
• Currencies: Central Bank policy does not occur in a vacuum. Fed policy explains the year-to-date strength in the US Dollar. Even if the Dollar is lower versus its start of May level, we expect its relative strength versus other currencies to endure, particularly given that the European Central Bank and the Bank of England looked poised to start cutting rates.
• Gold: We have been long-standing gold advocates and continue to see a case for the precious metal in portfolios, even after its year-to-date performance. Gold acts as both a diversifier and an inflation hedge. Supply is constrained, while demand from Central Banks (as a strategy to reduce Dollar dependence) continues to be supportive. 
• Alternative Assets: Owning assets with collateral-based cashflows brings diversification to portfolios (as well as acting as an additional inflation hedge). We advocate being highly selective across this broad and diverse area, favouring differentiated and uncorrelated strategies in areas such as pharma royalties, among others.

When will interest rates come down, and does it matter? The only constant in this debate has simply been that almost everyone has got it wrong, just as many commentators were in their calls for recession. May should have been the month when the Federal Reserve made its first cut to interest rates. At least that was the consensus prediction back in December, when 5-6 reductions in the Fed Funds’ Rate were discounted. Now, just 1-2 interest rate cuts are pencilled in. It’s possible that the Fed decides not to cut at all. Against this background, Howard Marks’ dictum, “face up to the limits of your knowledge on the macro future” (cited in his worthwhile work The Most Important Thing and summarised in his July 2003 newsletter) seems appropriate.

Fund Managers are currently their most bullish on equities since January 2022, with more than 80% of them overweight equities, per the latest Bank of America Merrill Lynch survey. The VIX Index of volatility is also close to its lowest since before the pandemic. . The market, seemingly, has gained confidence in the fact that at least the Fed won’t have to raise interest rates again – a fear that had arisen earlier in 2024. Might emotion and momentum be driving the market?

To the credit of Jerome Powell and the members of the Federal Open Market Committee, they have been consistent in their messaging, particularly around data-dependence. The Fed Chair has continued to remind investors that they must be “patient” since the US Central Bank “did not expect this [the path to lower inflation and lower rates] to be a smooth road.”

At least so far, the US economy has adapted to the new normal of higher rates. The world has taken the onset of 5%+ interest rates largely in its stride. The collapse of Silicon Valley Bank in March 2023 seems like a distant memory; ZIRP (zero interest rate policy) even further away. In its own commentaries, the Fed notes that on this occasion, monetary policy has been less effective at slowing the economy than in previous cycles – hence why inflation and interest rates have both remained higher for longer. Both the pandemic-inspired supply shock and subsequent fiscal demand stimulus have probably played a significant role. Cynics may even have a point in noting that given the current pace of economic activity, rates are not restrictive enough.

Some uncertainty over the economic outlook could be seen as a positive. It prevents the development of excessive groupthink and may mitigate the risk of a major market correction. Amidst the noise, what stands out to us as quite remarkable – and also a little ironic – is that the Fed has managed to anchor market expectations about where it thinks the Fed Funds’ Rate is going even if its forecasts have almost always been wrong.

We think it is possible to resolve this potential contradiction through acknowledgment, once again, to Howard Marks. The ‘most important thing’ is simply not to fight the Fed. What matters is the direction of travel. History would suggest that investors believe what they want to believe. The wisdom of Keynes and his observation about irrationality versus solvency (“the market can stay irrational longer than you can stay solvent”) springs also to mind.

Against this background, view pullbacks as opportunities. Do not forget, that partly as a function of persistently high interest rates, over $8tr of cash is sitting on the sidelines in money market accounts (per Bloomberg) waiting to be deployed. If there is further counsel that can be provided by Howard Marks, then take on board that “no asset class or investment has the birthright of a high return… [it’s] only attractive if it’s priced right.” We take this to mean embrace the logic of diversification.

Should investors want to make a bull case, then it’s not difficult. Put simply, the world is enjoying a global cyclical rebound. Bull markets are generally killed either by abrupt increases in interest rates or rapidly declining corporate earnings. Both currently look unlikely to us.

Begin with the profit cycle. Based on rising earnings estimates, the cycle has much further to run, in our view. First quarter earnings on both sides of the Atlantic were less bad than feared. After the mini recession of late 2022 (when earnings growth fell for two consecutive quarters), the rate of earnings growth for the S&P 500 Index is now back to pre-pandemic levels (albeit helped by a small number of mega-cap tech stocks). Earnings growth can also be seen as a lead indicator for corporate capex spend, as business leaders gain in confidence. Even if the street is incorrect in its assumption for 10%+ earnings growth for the S&P 500 Index for the next two years (per Bloomberg), downside economic surprises might only bring forward rate cuts.

A prolonged rate cutting cycle would help sustain the bull market for longer. Should Central Banks stop hiking and start cutting owing to falling inflation as opposed to recession, then this would be highly supportive for risk appetite. Based on the various moving parts of the inflation equation, there is a strong argument that US inflation should be more likely to drop than rise, particularly with homeowner equivalent rent (shelter costs) falling and wage pressures diminishing. Some Central Banks – in Sweden and Switzerland – have already commenced their rate cutting cycles. The Bank of England and European Central Bank may follow shortly.

Of course, the battle on inflation is still far from over. Sceptics might justifiably assert that it is up to the data to prove that inflation is not heading in the wrong direction. April’s US inflation data may have been the first downside print of the year relative to prior consensus expectations – May’s figure will be released on 12 June – but it still could have been a lot better. Headline US inflation has trended at over 3% for 37 consecutive months (April’s figure was 3.4%) while both the Atlanta Fed metric of sticky inflation and the Cleveland Fed’s report on trimmed mean inflation show figures of more than 4%. These numbers are a long way from the Fed’s official 2% target. Ask consumers how they feel about inflation and survey findings from both the New York Fed and the University of Michigan suggest 3%+ readings are likely one-year out. Achieving 2% may be harder with higher embedded expectations.

Look longer term and if the AI bulls are correct, then this technological shift could result in a productivity boom. Productivity gains would allow for a happy combination of both improved growth and lower inflation. As pleasing as this world view sounds – and we think it is plausibly correct over the medium-term – our concern is that inflation continues to monopolise much of the current macro narrative to the potentially erroneous exclusion of other considerations.

Do not forget about debt. Inflation has helped to deplete excess consumer savings accrued during the pandemic. Credit card balances stood at $1.2tr in the US at the end of the first quarter (per S&P Global), close to record level. Delinquencies have risen to above pre-pandemic levels. 6.9% of credit card balances are ‘seriously delinquent’ (in possession of an unpaid balance of more than 90 days) versus 4.6% a year ago, per the New York Fed. No surprise, perhaps, that US consumer confidence stands at its lowest in almost two years. And it’s not just the consumer: consider commercial real estate, corporate refinancings and the elephant in the room of the government’s budget deficit. Outside of wars and the pandemic, the deficit is already the highest on record. More stimulus – under a Biden Presidency – or tax cuts – under a Trump leadership – will only exacerbate this problem. At some stage there will be a reckoning. Even if this moment can continue to be delayed for now, it cannot be denied. In the meantime, continue to diversify, while enjoying the current party in equities.

Alex Gunz, Fund Manager, Heptagon Capital