View From The Top: The beginning of the end

View from the very top: We may be on the cusp of an interest rate cut in the United States. If the Federal Reserve reduces the Fed Funds Rate at its September meeting – an outcome currently viewed as a certainty – then it will be for the first time since March 2020. Higher-for-longer no more, we may be at the beginning of the end of the current rate regime. This has clear asset allocation implications. Mega-cap tech is no longer the only game in town, while fixed income suddenly starts to look more attractive. Most importantly, the Fed’s likely course of action is being undertaken from a position of strength. Cutting rates while the economy is still expanding makes logical sense. We believe that it is still possible for Central Banks to chart a successful course towards a relatively soft landing for the economy. Nonetheless, we would guard against complacency particularly given the hugely heightened uncertainty around the pending US Presidential Election combined with rising geopolitical tensions in several regions. Separate noise from signal, back the broad market rotation and continue to diversify.

Asset Allocation:

• Equities: The MSCI World reached a new all-time high in mid-July, but such a record masks the huge underlying disparities. US equities have massively outperformed those in the rest of the world and mega-cap tech has led the way domestically at the expense of almost every other area. Momentum (and passive flows) have played a strong role in shaping these dynamics. They are now beginning to reverse. The path to lower rates should be beneficial for the S&P 493 (in other words, excluding the Magnificent-7) and small caps in particular. The Russell 2000 Index has never traded at a lower multiple relative to the NASDAQ 100 Index this century, per JP Morgan. Despite some high-profile disappointments, the current Q2 earnings season has surpassed expectations, pointing to underlying corporate health.
• Fixed Income/Credit: The yield on 10-year US Treasuries has fallen over 60 basis points from its April peak. This trend should continue as the Fed gets closer to cutting interest rates. Bonds clearly offer compelling risk-adjusted returns to investors owing to their current sizeable valuation cushions. This also explains the record level of corporate (Investment Grade and High Yield) issuance witnessed year-to-date. Yield-hungry investors are looking to lock in at current levels. We see opportunities across the credit spectrum but remain mindful of potential defaults in certain pockets.
• Currencies: The US Dollar Index has weakened from peak levels but remains up on a year-to-date basis. Although Presidential candidate Donald Trump advocates a weaker currency, the prospect of imminent Fed rate cuts has been the bigger near-term driving force. A lower greenback would clearly be beneficial for emerging market currencies.
• Gold: The precious metal has gained over 17% year-to-date and we believe further appreciation is possible. Recent market dynamics and geopolitical events reinforce our conviction in gold’s status both as a safe haven and as an inflation hedge. Listed gold miners constitute another way for investors to consider gaining exposure to this asset class.
• 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.

Summer may be at its peak, but there is already a distinct change in the air. The same can be said of financial markets. Investors have become accustomed to a narrative based around higher-for-longer and a default positioning towards mega-cap technology equities. These assumptions are now being tested. Equally, just as balmy seasonal temperatures can result in unpredictable behaviour, so market participants have had to overcome a series of surprising shifts in the political landscape. Expect these to endure, even as the weather changes. All the above suggests the importance of judicious navigation, separating the noise from the signal when making asset allocation decisions.

“We need to see more good data.” This has been the insistent message of Fed Chair Jerome Powell and his other Committee members. It now looks as if that wish has been granted. It won’t be said aloud (just yet), but it almost seems as if the Central Bank is in a position now to declare a slightly cautious victory lap. The tightening campaign has worked without too much damage, and we are now almost on the other side of it. Fed policy can potentially move on.

Data released in July show that monthly inflation has now turned negative for the first time since May 2020. Meanwhile, the annualised change in ‘core’ inflation (i.e. excluding food and energy) stands at its lowest since April 2021. Both the Atlanta Fed measure of ‘sticky’ inflation and the Cleveland Fed’s gauge of ‘trimmed mean’ inflation are now lower than at any stage in at least the last two years. The inflation prints from the first quarter now look like an anomaly. Evidence for a clear downturn in inflation appears to be building.

This naturally lays the ground for potential interest rate cuts, a phenomenon not seen in the US since the start of the pandemic. The Fed should logically seize this opportunity, for cutting rates from a position of strength, while the economy is still expanding and the labour market has yet to falter, is clearly a logical strategy. Jerome Powell has even acknowledged this, stating that “if you wait until inflation gets all the way to 2%, you’ve probably waited too long”, at a recent Economic Club meeting in Washington.  

Investors seem clearly to have taken on board this dynamic. The FOMC does meet until 18 September and so its members will have more data points to consider before reaching a decision. Regardless, current thinking backs with 100% certainty, a September rate cut announcement, per Bloomberg’s World Interest Rate Probability function. There is even speculation – or some may call it wishful thinking – that the Fed could cut by more than 25 basis points on this occasion. From our perspective, it is good to caution against over-confidence, especially given the extent to which the market has consistently mispriced expectations throughout 2024.

The prospect of lower rates has, however, already begun to reverberate across financial markets. At one level, the greater the level of signalling (whether tacit or explicit) towards lower rates, the higher asset prices and the tighter credit spreads will go. Good news for many investors, even if this impact could also be inflationary, were it to encourage more risky behaviour. The more interesting dynamic to us has been the spectacular and long overdue rotation that has occurred. Admittedly market concentration had reached extreme levels and momentum as a style does tend to overshoot and then correct abruptly, but the changes witnessed in market leadership point to the potential arrival of a new investing regime.

For 16 consecutive months, the Magnificent-7 mega-cap tech stocks had ranked as the most consensual trade among investors polled by Bank of America Merrill Lynch. Beyond a logical shift in positioning and a reasoned consideration of the relative equity beneficiaries of a lower rate environment (small caps, REITs), there has also been the emergence of growing AI scepticism. We (and others) have wondered whether the massive investments in AI will pay off any time soon. With the growing realisation that AI is perhaps, for now, a ‘show-me’ story, so there has been a reassessment of how perceived beneficiaries are valued and, more importantly, that there are other investable opportunities. Today’s (AI) leaders may not be tomorrow’s winners, especially once the inevitable shake-out occurs.

The optimists, of course, remain of the opinion that AI will deliver considerable productivity gains to the economy. We do not dispute this assertion per se, but it is not necessary to believe in it in order to be positive about the near-term economic outlook. Sure, diverse data points suggest that the macro environment is becoming more challenging, but we believe that an outcome of robust enough growth while inflation continues to moderate is plausible. The much-vaunted ‘soft landing’ for the economy still seems to be in sight.

Consensus growth estimates for 2024 and 2025 are being revised downwards, but a relative cooling is clearly not the same thing as a pending recession. Consider the figures too. A 2.8% preliminary reading for second quarter annual US GDP growth is double the level recorded in Q1 and compared to prior consensus expectations for a 2.0% expansion. Unemployment may be at its highest in two years in the US, but the rate is only 4.1%. Higher unemployment could plausibly be a function of more people being inspired to enter the workforce and actively seek jobs as opposed simply to a higher number of claims being filed.

Beneath the surface we should, however, be mindful of growing evidence of a two-speed economy in the US. Manufacturing surveys are already pointing to contraction, even if the services sector continues to exhibit robustness. Meanwhile, the lagged effects of tighter financial conditions are beginning to be felt. Consumer sentiment is at its lowest in 8 months, outstanding credit card balances are at their most elevated in a year and more Americans currently fear being unable to pay bills than at the peak of the Financial Crisis (per the University of Michigan, Bloomberg and CNN respectively).

A certain fear remains that a gentle slowdown could morph into a more painful downturn. The picture is also complicated by the fact that traditional recession indicators may not be as reliable as in the past owing to the quirks introduced by the pandemic. Even if the likelihood of returning to the pre-pandemic era of zero interest rate policy looks exceptionally low, there is at least comfort in the knowledge that the Federal Reserve and its international peers (the latter of whom may be emboldened to follow the Fed more actively should it embark on its rate-cutting path) currently have a lot of firepower at their disposal.

And what of politics? Markets, in general, have shown a remarkable level of immunity towards worsening geopolitical news. Nonetheless, we would guard against complacency, particularly given a currently febrile situation in the Middle East. After the events of the last month, it seems abundantly obvious to us that the margin of error is currently very wide for predictions on politics and the market’s reaction. What we do know is that Trump 2.0 is no longer a foregone conclusion and that the current race will likely contain further surprises before November. The reality for investors is that whoever becomes President, we know less than we think we do about the short-term implications of their policy. Near-term, the decisions made by the Federal Reserve will trump even those of Donald Trump.

The final days of summer will be a time both for relaxing and for taking stock. Asset allocation decisions remain critical and the logic for diversification only grows in uncertain times.

Alex Gunz, Fund Manager, Heptagon Capital