View From The Top: That inflating feeling

View from the very top: The bubble keeps on getting bigger. The rally in equities continues to be supported by an intoxicating combination of economic and earnings growth. As a result, the path of least resistance seems upwards for now. Although exuberance levels do seem markedly higher than at the start of the year, not all indicators are currently pointing to outright euphoria. For gains to be sustained, economic and corporate fundamentals will need to remain favourable, particularly given currently high expectations.  Gone are the days of low growth, low inflation and low rates. While the market has adjusted to living with higher rates for longer, further progress on reducing inflation may be necessary to sustain the current bull run. This is certainly possible, but very little is priced for potential disappointment. We think it important to be mindful of possible pullbacks. Proactive portfolio diversification is also logical.   

Asset Allocation:

• Equities: Little has stood in the way of disrupting the bullish narrative in equities year-to-date. The rally has, encouragingly, broadened beyond just mega-cap tech stocks. Further, the dispersion of performance among the ‘Magnificent Seven’ businesses also shows that investors are being more selective when contemplating potential AI beneficiaries. Nonetheless, quality, growth and momentum remain the dominant style factors sought by investors. With elevated positioning in these areas (particularly momentum), we advocate diversification and have made the case for both US small caps and Japanese equities.
• Fixed Income/Credit: Treasury yields have continued to rise in 2024 as the timing of rate cuts has been pushed out. At the same time, record Investment Grade and High Yield corporate bond issuance since the start of the year (per Bloomberg) speaks to investors’ desire to lock in currently elevated yields. Corporate spreads have correspondingly tightened. Yields typically peak when inflation does, and we believe that fixed income could benefit from softer economic growth and lower inflation prints in the latter half of 2024. We see 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: The precious metal made a new nominal high in March. We believe its price has been supported by the ongoing purchases by Central Banks around the world as a strategy to diversify reserves (away from the US Dollar). At the same time, gold serves as a store of value, a hedge against inflation and a buffer against geopolitical uncertainties. We remain positive.
• 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.

Bubbles are beautiful things. Until they burst. The story for 2024 so far has been one of new nominal highs, at least if you’ve been an equity investor, or an owner of gold and bitcoin. The dilemma investors face is when to get off the train, particularly when things seem so attractive. The economy is performing well, Central Banks are broadly dovish and corporate earnings continue to improve. The path of least resistance seems upwards. Our counsel is to remain invested, but to be mindful of pullbacks and to continue diversifying actively.

Equity investors certainly have good reason to be pleased. The MSCI World Index has rallied by over 45% since its October 2022 low and by more than 25% from its more recent October 2023 trough. During this latter period, the Index has only seen two weeks where it has closed down. NVIDIA, the poster child for the current boom, has enjoyed 11 consecutive weeks of gains through to late March. Upgrades to earnings estimates have certainly helped. For the S&P 500 Index (and the MSCI World Index), these have now risen for four consecutive quarters, or by an equivalent of 22% for the former, according to Bloomberg data. Look ahead and consensus assumes that the up cycle in earnings can continue for the coming year and beyond.

Against this background, it takes a brave investor to bet against equities. However, when everyone appears to be feeling this good, perhaps disappointment is the only place to go. Nothing creates a bubble like a crowd’s simultaneous and collective belief that the best is yet to come. Equity allocations are at current two-year highs (per the latest Bank of America Merrill Lynch Fund Manager Survey) and many other metrics of optimism or bullishness are in their 90^th percentiles (or higher) relative to history.

There is, then, a risk of some market participants engaging in their own form of AI-induced hallucination. We have certainly heard a step-up recently in allusions to this time “being different”.  Some pockets of the investing landscape (perceived AI boom stock beneficiaries, bitcoin) appear to be exhibiting if not complacency, then certainly froth. High starting points for any asset class, by definition, imply lower future returns. The burden on earnings to keep delivering only rises too. Bloomberg consensus assumes over 80% revenue and earnings growth for NVIDIA over the coming fiscal year. No surprise, perhaps, that 40% of investors interviewed by Bank of America Merrill Lynch believe AI stocks to be in a bubble currently.

At the same time, it doesn’t feel quite as if we are in a full stampede yet. That some investors are willing to question the current bull run is indicative that there is at least healthy debate on the topic. Cash levels (per the Bank of America Merrill Lynch survey, again) are not yet at record lows, implying that investors have not gone all-in, for now. It is also notable that M&A activity and new IPO issuance are nowhere close to dotcom boom levels. Interestingly, Bloomberg data also show that insider selling is at a 12-month high. Many executives appear to be cashing in after recent gains.

Risk assets clearly cannot continue to appreciate forever, but upside remains favourable for as long as the odds of prolonged inflation or recession remain low. Valuation tends to be only of limited use as a guide to near-term returns. The reality is that the current market environment is one where investors are looking for stories. The current story is a simple one of a strong economy and earnings growth.

Interest rate cuts have seemingly moved off the agenda. FOMC Chair Powell’s statement that cuts “can and will begin this year” seems sufficient. Consider it quite remarkable how the equity market has rallied despite consensus (implied by Fed Funds Futures) having shifted in the space of less than three months, from an 85% chance of six US interest rate cuts in 2024 to a 70% chance of three or fewer reductions now. The reason for this volte-face is simple: even with a 5.5% US interest rate (that has remained unchanged for eight months), both economic and corporate earnings growth have shown enduring robustness.

The narrative has, therefore, shifted. Be clear, all the data point to the fact that the US (and global) economy has permanently exited the low-growth, low-inflation, low-rate environment of the prior decade. With 38 consecutive months of payroll expansion and US unemployment at a 50-year low, US GDP is currently growing above trend. Both the IMF and the OECD have revised up their 2024 world economic growth projections. Even the Bank of Japan raised interest rates for the first time in 17 years during March.

However, with this shift, so have expectations changed. Rather than worrying about too little growth, the concern is arguably over too much growth, and what this means for the Fed’s quest to quash inflation. It’s certainly fair to note that recent progress on further inflation reductions has remained stubborn. Core consumer price inflation in the US has remained over 3.0% for almost three years, a phenomenon last seen in the early 1980s. On a three-month annualised basis, core US CPI stands at 4.3%. No wonder many consumers are frustrated with the Biden administration. In absolute terms, prices in the core basket of goods used by the Census Bureau to calculate inflation are 16.5% higher than levels at the start of 2021. Look ahead and medium-term inflation expectations are moving up. Per the New York Fed, consumers believe that US inflation three years out will now be 2.7% (versus 2.4% when previously polled) and 2.9% in five years’ time (against 2.5%). These metrics are well above the Fed’s stated 2.0% target.

Inflation numbers will need to be cooperative in order to sustain the current bull market thesis. Jerome Powell seems sanguine for now. Investors should now be aware that inflation remains non-linear. Forecasting it is also complicated, particularly given the number of moving parts. The FOMC is, arguably, no better at doing so than any other macro commentator. There are good reasons to believe that inflation should be lower over the next six months, helped by falling rents and shelter costs, which account for a large percentage of the inflation calculation. Furthermore, real wage growth is running markedly lower than headline figures (1.7% versus 4.3% based on last month’s data), helped by gains in productivity.

Were consumers to keep spending or supply chain shocks to become more pronounced, then this could upset the current calculus. Given existing balance sheet health and the fact that most mortgage debt in the US is locked in at low rates, there is certainly scope for consumers to lever up. Delinquency data on credit card debt and auto loans – both approaching ten-year highs according to Bloomberg – would support this contention. Meanwhile, blockages in the Suez Canal are beginning to cause some supply chain issues. The risk of further geopolitical flare-ups is probably weighted to the downside too. Both these factors could result in potential earnings disappointments down the line.

Nonetheless, investors may be able to have their metaphorical cake and eat it. Excess growth will sustain the market for now. This won’t (and can’t) endure forever. The lagged effect of prior rate rises and the shift from fiscal stimulus to drag will have an impact. However, with lower growth, the hope is that inflation will correspondingly dip too. This, then, would open the door to the Federal Reserve being able to commence its rate cutting strategy. If only things were quite so easy. Sure, as close to an immaculate disinflation and soft-landing has been achieved to-date (and credit to the Fed, where it is due), but as every investor knows, past performance is no guide to the future, particularly when current expectations are so elevated. Keep on diversifying.

Alex Gunz, Fund Manager, Heptagon Capital