View From The Top: Regime change, again

View from the very top: We now know what data-dependency looks like. A strong US economy has led to more entrenched inflation. US interest rates are therefore not going to come down any time soon. Investors have already had to endure one recent regime change. Long gone are the days of low growth, low inflation, and low rates. Now, however, we are in another new environment. Painless disinflation simply isn’t happening. Correspondingly, we will have to live with higher rates for longer. The Federal Reserve now may not cut rates at all in 2024. Some have even argued that the next move may even be up. The implications of all the above are significant. Risks of an accident somewhere in the financial system look proportionately higher. Equities will need to see meaningful earnings growth to sustain their rally in the absence of more benign monetary policy. Government bond yields may trend still higher, along with the US Dollar. Market progress is rarely linear and resets are healthy, but a higher for longer regime only reinforces the case for diversification, in our view.   

Asset Allocation:

• Equities:Global equities reached all-time highs at the end of March. They are just 4% below this level now. We are encouraged by signs of growing market breadth, and reduced reliance on US mega caps. The performance of the latter group has also helpfully diverged too. However, with the forward earnings multiple of the equally weighted S&P 500 Index in its 92^nd percentile since 1985 (per Goldman Sachs), a lot of expectations appear embedded in equities currently. Earnings growth will need to be sustained, particularly if markets cannot rely on the tailwind of potentially easier monetary policy. Equities at least continue to benefit from small upgrades to consensus estimates for now. We continue to advocate exposure to a range of styles (growth and value, cyclical and quality) and see opportunities in Japan and US small caps.
• Fixed Income/Credit: The yield on 10-year US Treasurys continues to rise, with the realisation that US interest rates are not likely to come down any time soon. 5% yields (last seen in October 2023 and then previously in 2007) may become a self-fulfilling prophecy. Higher yields are necessarily attracting more opportunistic buyers, particularly since 10-year Treasury yields are well in excess of S&P 500 Index yields. Higher-for-longer does, however, increase default risks elsewhere in the credit universe. We believe in being selectively opportunistic across the credit spectrum.
• Currencies: Central Bank policy does not occur in a vacuum. Fed policy explains the year-to-date strength in the US Dollar and why it may endure. Emerging market currencies are at their weakest versus the Dollar in six months, with the Yen at a 34-year low against the US currency. Should the European Central Bank or the Bank of England cut interest rates before the Fed (which seems possible), this would pressure their currencies on a relative basis.
• Gold: The 11% gain in the gold price since the start of the year has been impressive. Further strengthening seems possible, particularly since Central Banks remain active and seek strategies to diversify away from the US Dollar.
• Alternative Assets: Owning assets with collateral-based cashflows brings diversification to portfolios (as well as acting as an additional inflation hedge). We advocate being selective across this broad and diverse area, favouring differentiated and uncorrelated strategies in areas such as pharma royalties, among others.

It’s amazing how quickly sentiment can shift. There have been several realisations for investors in the past month, many of which have proved humbling. Seemingly painless disinflation is just not going to happen. Instead, investors are going to have to learn how to live with a higher for longer regime in the US (both in terms of interest rates and bond yields), with its global implications. We now know (or at least have a better sense of) what ‘data-dependency’ means. Of course, it is only healthy for markets to endure resets. They rarely move in a linear fashion, and it would be naïve to assume otherwise.

Whether investors like it or not, this is a different cycle to normal. We see a distinct regime change from a period of strong growth, normalising inflation and the hope for falling rates to an environment of strong enough growth, stubborn inflation and correspondingly higher interest rates. There is an inherent irony to the fact that since US economic growth has remained so robust, inflation has become more entrenched, or stickier. This dynamic has driven unsurprising uneasiness, or the realisation that interest rates are not going to come down any time soon.

It’s been more than two years since the Fed started to hike rates, so surely some of the lagged effects ought to have been seen by now? On the contrary, the opposite has occurred. Impressively strong growth has bumped up against the economy’s supply limits, translating into persistent inflationary pressures. The sceptics, those who have argued for recession, have been wrong all along – at least so far. An index of global manufacturing activity compiled by JP Morgan moved into expansionary territory last month for the first time since September 2022. The IMF has revised up its forecast for US GDP growth in 2024 (by 100 basis points since its prior forecast six months ago). The US consumer has continued to spend, perhaps helped by 4.1% year-on-year wage growth, based on the latest figure from the BLS. Tight labour markets and constrained supply give workers bargaining power.

Disinflation, then, has been delayed. A strong economy necessarily gives the Federal Reserve plenty of time to wait in terms of its next policy move. Back in December – at peak optimism – most investors had priced six or seven interest rate cuts (or a decline of 150-175 basis points in the Fed Funds Rate). Now, it is possible that the Fed may not cut rates at all in 2024. The futures market accords less than a 25% probability to a rate cut before November’s Presidential Election, which could be a blow for Joseph Biden. The great bet on rate cuts – and it was an enormous one – seems dead for now.

With hindsight, it seems as if investors clearly read what they wanted to read from Fed Chair Jerome Powell’s comments in late 2023. Correspondingly, the market started to price a too dovish Fed, driving the equity market rally that endured through to the end of the first quarter of this year (2024 was the strongest start to a year for the S&P 500 Index since 2019, per Bloomberg). Further, the de facto pivot at the end of 2023 generated looser financial conditions as well as greater risk appetites. Notably, data from the Chicago Fed show that financial conditions are looser now than at any time since the start of 2022, when the Federal Reserve was still claiming that inflation was ‘transitory.’ Mr Powell and his team have always said that they would be ‘data-dependent’ and adherence to such a principle clearly works both ways.

There is no getting away from the current inflation data. March’s CPI reading of 3.5% showed an acceleration relative to the prior month. For each report issued this year, the inflation print has exceeded consensus expectations. When ‘core’ (ex-food and fuel) figures are considered, the picture is even more concerning. On this basis, the three-month annualised data show a figure of 4.5%. This is corroborated by information from the Atlanta Fed. In their calculations of ‘sticky’ inflation, prints remain consistently above 4.0%. There is also little comfort to be drawn from Jerome Powell’s preferred personal consumption expenditure (PCE) figure, which stands at 3.7% on an annualised basis. As a reminder, the Fed’s ‘formal’ target for inflation is 2.0%.

No-one ever said it was going to be easy. At least inflation is not back at 2021 and 2022 levels, but it is still markedly higher than is palatable for both the Federal Reserve and consumers. The expectations of the latter group have risen over the past month, with a 3.0% rate now assumed one year out and an estimate of 2.9% pencilled in for three years’ time (a 20 basis point increase relative to when the New York Fed conducted its poll a month prior). Higher energy prices and container shipping rates are factors to watch. Such dynamics only increase the complexity of the Fed’s job.

In fairness to Jerome Powell and his adherence to data-dependency, at the start of this year and after six consecutive months of benign price movements, he said he wanted more confidence that inflation was going lower before starting to ease. At the time, some saw such caution as excessive. Now, it looks prescient. Investors have been reminded that you can’t (or certainly shouldn’t) try and hurry rate cuts.

Furthermore, not only are the odds of no easing in 2024 rising, but also the once-unthinkable prospect of the Fed having to raise rates again is, by now, not an impossibility. The options market on Bloomberg shows that investors accord around a 20% probability to a rate hike in the US over the next twelve months. Consider what impact an oil-driven inflation scare might have at a time when the US labour market is tight and the global economy is slowing. Whisper it (quietly) but some have even begun to mention the term stagflation again. Data readings at the end of April pointed to both slowing economic growth and higher inflationary pressures.

In almost all scenarios, then, investors are now looking at a higher-for-longer regime. Beyond the readjustment, it is important to recognise that such an environment will increase the risk of some sort of financial ‘accident’ within the system. Higher interest rates make the cost of servicing debt more significant for all parties. At the end of the first quarter, 159 companies had defaulted in the US, according to Moody’s. For context, 192 companies defaulted in 2023. Such a high number is rare, with 2023’s figure exceeded only in 2001, 2009 and 2020 (the TMT bust, the credit crisis and the pandemic). For the US government, the interest it will need to pay on its fiscal deficit will reach 3.2% of GDP next year, the highest ever seen outside of a period of war, per the Congressional Budget Office.

There is also geopolitical uncertainty with which to contend. Sure, investors do not necessarily understand war any better than the rest of us, but both more spending on defence and greater government debt accumulation to fund such activities are de facto inflationary. Even with the much-vaunted productivity gains that artificial intelligence may be able to deliver to economies, there are potentially equally as compelling explanations for why upward inflation pressures could become secular in nature. A combination of ongoing fiscal spending (or stimulus), remilitarisation, restructuring of global trade flows and capital required to green the economy is not a palatable one for inflation doves. Some have even suggested that the Federal Reserve is perhaps too optimistic in wanting to aim for a 2% target. Regime change may argue for a higher figure. Nonetheless, targets do matter, particularly since (consumer) expectations can easily become untethered.

Perhaps the best investors can hope for in the near-term, then, is growth now and disinflation later. The economy cannot grow above trend forever, the labour market should soften, and shelter inflation (one of the main current culprits) will likely drop over the remainder of 2024. Lower investor expectations now relative to at the start of the year only provide for more surprises to the upside later. Stay nimble, proactive and diversified across portfolios.  

Alex Gunz, Fund Manager, Heptagon Capital