View From The Top: ‘Normal’ for longer

View from the very top: It is easy to build a positive narrative. The economy remains robust, interest rates have probably peaked, and corporate earnings are improving. No surprise then that surveys show investors are almost unequivocally optimistic. We do not disagree but add nuance to the debate. Beware of excess confidence and extreme equity market concentration. Rates may also not fall as quickly as some hope. For us, the ‘new normal’ could be one of both higher growth and higher inflation, with correspondingly higher rates. Ongoing fiscal dominance implies a logic for continued monetary restraint. Inflation expectations also remain elevated. At the least, the current interest rate regime does give Central Banks room for manoeuvre. This may matter should conditions change quickly. Deploy cash judiciously and continue to diversify. There are opportunities in equities beyond mega-cap tech. Starting points in fixed income are also attractive. Portfolio diversification also makes sense with geopolitical uncertainties likely to heighten over the remainder of 2024.   

Asset Allocation:

• Equities: The MSCI World has enjoyed a ~30% rally since its October 2023 trough. Stock markets across the world saw meaningful gains in the first half of 2024. However, performance has been driven by a very small number of (mega-cap tech) stocks and only 30% of actively managed funds in the US have beaten their benchmark year-to-date. Given the outsized impact that technology has had in terms of driving recent returns, we believe that momentum investing needs to be balanced against mean reversion. We note that the performance of the Russell 2000 Index relative to the NASDAQ 100 Index hit a record low during June (all data per Bloomberg). Small cap, Japan and high-conviction active funds look interesting to us. We expect the improvement in corporate earnings to continue and also to broaden as 2024 develops.  
• Fixed Income/Credit: Bond market fundamentals are improving. We are encouraged to see that 10-year US Treasury yields have fallen ~30 basis points from their 2024 peak. High starting points and a current 4.4% yield imply attractive potential future returns, particularly if the direction of travel for US interest rates is slowly downwards. Treasuries may also hold some appeal as a relative safe haven amidst geopolitical uncertainty. We see opportunities across the credit spectrum, but investors should remain mindful of potential default risks given current interest rate levels.
• Currencies: The US Dollar remains robust, with the DXY currency index up ~4% year-to-date. We believe this is a function of diverging interest rate policy (the Fed has refrained from cutting rates) combined with political uncertainties in Europe. Current trends could continue near-term. A higher Dollar clearly impacts EM currencies adversely.
• Gold: There is no change in our positive stance on gold. We see it as both a portfolio diversifier and an inflation hedge. Supply is constrained, while demand from Central Banks (as a strategy to reduce Dollar dependence) continues to be supportive. Many EM Central Banks remain underweight gold in their reserves relative to their DM counterparts.
• Alternative Assets: Owning assets with collateral-based cashflows serves two major benefits, bringing diversification to portfolios and 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.

Halfway through the year. The economy has remained on track, equities have recorded notable gains and bond yields have retreated downwards from their highs. All the above has occurred despite the consistent stream of curveballs thrown at investors, from geopolitics to regularly changing assumptions about the number of interest rate cuts in the US. Focus on the bigger picture. GDP is robust, inflation is high but falling, the direction of travel for interest rates is down and corporate earnings are recovering from their mid-2022 trough. The AI narrative has added further fuel to the fire.

What’s not to like about this set-up? Long may it continue, say the bulls. And there are certainly no shortage of them. Investors are currently their most optimistic since November 2021, per the latest Bank of America Merrill Lynch monthly Fund Manager survey, with cash levels at two-year lows. We do not dispute the positive narrative but would nuance it. Stay invested but be judicious. Our concerns are three-fold: equity market concentration, complacency around a ‘Goldilocks’ scenario for growth and inflation, and the wildcard of geopolitics. All the above supports the logic of diversification.

Begin with concentration. It is hard to ignore the disproportionate impact that NVIDIA has had on informing sentiment. Tech bulls will continue to dance for as long as the music is playing. The sector is seeing record weekly inflows (per EFPR data) and ‘long Magnificent Seven’ is the most consensual trade (backed by 69%), per the previously cited survey. NVIDIA alone has driven one-third of the S&P 500 Index’s gains year-to-date. No other single stock in history has ever contributed more. As has been well documented, NVIDIA became the world’s most valuable business for a brief period during June. It took just 32 trading days for the company to gain its most recent $1tr of market capitalisation.

Sure, AI will be revolutionary in ways that we may all struggle to imagine currently. FOMO (fear of missing out) is also a powerful emotional force. Equally, momentum can carry on for a very long time – until something stops it. This is less the debate, rather that a top-heavy market (NVIDIA, along with Microsoft and Apple comprise 20% of the S&P 500’s Index) does help to paper over a lot of cracks. Consider the performance of the equally weighted S&P 500 Index. It peaked in March and has fallen since. Further, momentum as a style has historically been mean-reverting. Reversals are as easy as gains. Data from Alpine Macro show that average peak-to-trough drawdowns are bigger than start-to-peak gains for this style factor.

We have heard too that “this time is different” for AI. Nonetheless, many corporates are already struggling to enunciate the (revenue) benefits of AI. We wonder whether we may be close to the peak of inflated expectations. A trough of disillusionment may follow, should this technology follow the traditional Gartner hype cycle. Put another way, what happens if the market decides that there is less profit in AI than is currently priced in?

More importantly, the interplay between inflation and growth will be crucial to the direction of markets. Perfect landings rarely occur in reality, even if many economic indicators currently support this notion. Our best-guess is that both economic growth and inflation could end 2024 above trend. Think of this as the new normal. Rewind to December 2023. Then, the Fed ‘pivot’ drove easier financial conditions and spurred the rise of riskier assets. However, easier conditions also helped to neutralise the impact of prior interest rate hikes, helping to spur growth and inflation.

The recent path of inflation prints shows that none of us can predict it accurately. Two relatively more positive months of data (April and May) do not constitute a trend. Investors seem to believe what they want to when they digest the information. Annualised core inflation for the last three months may be the lowest since October 2023, but it is still 3.3%. The Fed’s target is 2.0%. We believe that it will be difficult for the Fed to cut rates (regardless of its counterparts in Canada and Europe) when both inflation and inflation expectations remain elevated. Project one year out and the latest University of Michigan survey shows expectations at 3.3%. On a longer-term (5-10 year) view, the figure is 3.1%.

At the same time, it is not unreasonable to assume that the US economy may hit a softer patch later in 2024. Job openings are falling, unemployment has risen above 4% for the first time in 27 months and there is growing evidence (from businesses as diverse as McDonalds and Target) that inflation-weary consumers are being more selective in their purchases. The dwindling stimulus cheque surplus may also be playing a role. To call this a slowdown or recession precursor would be wrong. Think of these dynamics as part of a post-pandemic normalisation. The US economy can still grow at above trend, just at a slower relative pace versus the recently turbo-charged past.

Keeping interest rates high naturally gives the Federal Reserve ample room for future manoeuvre. There would be little to gain from cutting too early. Indeed, there is a logic attached to sounding hawkish – “we need to see many more months of good data,” says Jerome Powell – so as not to have the stock market front-run future rate cuts. Somewhere between one and two interest rate reductions are currently priced for the remainder of 2024, but future economic data points will probably matter more than what the Fed says, even before it acts.

From our perspective, forget ZIRP (the zero-interest rate policy of the 2010s). 3-4% US interest rates and perhaps a similar level of inflation could be the new normal. Research from the Cleveland Fed suggests that it could take until mid-2027 for US inflation to return to 2%. Even this may be optimistic. Our sense is that Central Banks may be willing to tolerate an inflation overshoot as long as unemployment remains low. Ongoing fiscal dominance also complicates the picture. In this world view, monetary restraint acts as a necessary break. Regardless of who wins the next US Presidential Election, expect the budget deficit to widen further. Joseph Biden would likely to continue to spend and subsidise, while Donald Trump would preserve current tax cuts and potentially look to further increase the tax burden. Both may also increase defence spending. More isolationism and protectionism (via higher tariffs) are unlikely to help subdue inflationary pressures.

Who will assume control of the White House remains to be seen at this stage, with the race likely to take many turns before November. Nonetheless, investors should prepare for a potentially long, hot summer of geopolitics. Markets are notoriously bad at pricing geopolitical risk, but multiple political and social crosscurrents provoke an aura of uncertainty and again reinforce the logic for portfolio diversification. It is hard to dispute the idea that Donald Trump is probably the most polarising political figure in the US, if not the globe. But beyond the US, there are also elections in France and the UK with which to contend in the very near-term. Then there is the Middle East, where a more militant Hezbollah could result in heightened instability even before it is clear who will lead America.

Against this background, we should not be too surprised that over $6tr remains invested in money market funds (per Bloomberg). At the same time, even if rates could stay higher for longer – the new normal – it does seem likely that we are beyond the peak. Believe that Central Banks have broadly finished their tightening process and that the direction of travel is slowly downwards, and this calls for judicious and timely deployment.

Alex Gunz, Fund Manager, Heptagon Capital