View From The Top: Wants versus needs

View from the very top: Lean into risk, even with equity markets at record highs. Rate cuts are not necessary to sustain markets as long as the economy remains robust and corporate earnings growth continues to improve. The current macro set-up looks compelling and investors have spent much of the past year being too cautious in their positioning. Of course, the path towards higher asset prices is rarely a straight one. The Fed (and other Central Banks too) need to be mindful that keeping rates at too restrictive a level for too long could do unnecessary damage to the economy. Ironically, the stronger the economy remains, the harder it becomes to cut rates. Geopolitical grey swans may also upset current market dynamics. Do not, therefore, abandon all caution. A correction may be inevitable after the recent surge, but fading exuberance would create clear opportunities. Stay humble and nimble. Embrace diversification.    

Asset Allocation:

• Equities: The MSCI World Index continues to make record highs, having risen over 35% from its October 2022 nadir. Further gains are possible, as earnings estimates continue to recover and the rally broadens beyond the US mega-cap tech stocks that have driven much of the recent return. The fourth-quarter earnings season has been robust to-date, with the average S&P 500 Index business having beaten estimates by 6%. We see a strong case for broad equity allocations but prefer to focus on areas that have lagged on a relative basis. Europe and Emerging Markets have underperformed the US. Within the US, small caps look more attractive relative to large, although just 23% of S&P 500 Index constituents beat the benchmark last year – the lowest since 1991 – creating clear opportunities (all data per Bloomberg).
• Fixed Income/Credit: Yields on 10-year US Treasury debt have moved higher since the start of the year as the timing of the Federal Reserve’s planned interest rate cuts has shifted outwards. Nonetheless, long bond yields clearly have further to fall from current levels. We believe it is logical for investors to look to lock in current yields before Central Bank rate-cutting commences. Evidence of (progression towards) lower rates would naturally restart a hunt for yield. Record Investment Grade issuance in the US year-to-date speaks to strong appetite. Our approach is to play credit across the spectrum and to be flexible, especially as a more normal business cycle likely comes into play again.
• Currencies: Dollar strength in 2024 reflects a repricing of rate expectations in the US and the fact that other currencies are now beginning to discount rate cuts in their own regions. We believe this trade could run further in the near-term.
• Gold: The precious metal’s performance remains correlated with real yields and the Dollar. However, the gold price has gained 13% since its February 2023 low and may see further appreciation given its status as a potential hedge amidst more heightened geopolitical tensions. We believe holding gold also brings diversification benefits to portfolios. 
• Alternative Assets: Owning assets with collateral-based cashflows brings diversification to portfolios. We advocate being selective across this broad and diverse area, favouring differentiated and uncorrelated strategies in areas such as pharma royalties and certain real estate segments, among others.

Investors want the Fed to cut rates. They expect it. One-year out, a 3.75% US interest rate is discounted, 175 basis points lower than current levels. Whether the Fed needs to cut rates is, of course, a different matter. This could prove to be a source of tension down the line, but maybe the distinction is irrelevant. Rate cuts are not necessary to sustain markets as long as the economy remains robust and corporate earnings growth continues to improve.

Markets are anticipatory. The rally experienced in equities globally since late October is not surprising in itself, more so its pace. The S&P 500 Index has already gone through many strategists’ year-end targets after only a month of 2024. While such recent gains may have caught some off guard, the story for the past year is that investors continue to be too cautious, with too many perhaps still locked into a negative paradigm.

Even with US interest rate cuts now likely to take place at a slower pace than previously imagined, the equity market is not showing any signs of unravelling at present. We are certainly not in the camp that says abandon all caution; rather, lean more into risk. Note that some $6tr in money market funds (per Bloomberg) should provide a tailwind for both equities and fixed income. Of course, the road towards higher asset prices may not be a straight one. Some correction may be inevitable after the recent surge, but fading exuberance will create opportunities.

What’s not to like? The US economy continues to exhibit remarkable robustness, contrary to the sceptics. There is certainly no (current) sign of recession. Fourth quarter GDP expansion of 3.3% took full-year US economic growth to 2.5% in 2023, a surprising show of stamina. Unemployment has remained below 4.0% for the last two years and inflation has fallen. In a quite remarkable volte-face, headline inflation has dropped from 7.1% to 2.9% in the past year, while core personal consumption expenditure (the Fed’s preferred measure of inflation, which strips out food and energy costs) has been at 2.0% – in-line with targeted rates – for the last two quarters.

Look further out and the picture also appears roseate. Consumer sentiment (as measured by the University of Michigan’s monthly survey) continues to improve, helped by the above dynamics. Almost every study forecasts that inflation both one-year out and over the longer-term should trend lower. The New York Fed’s latest research puts 12-month inflation at 3.0% and a three-year figure at 2.6%, close to pre-pandemic levels. Such a macro set-up should broadly translate into a strong picture for corporate America – improving margins and better earnings. Where the US leads, much of the rest of the world tends to follow.

There may be further to go. Not all assets have participated in the rally. Small cap stocks (as measured by the Russell 2000 Index) have markedly underperformed both the S&P 500 Index and the NASDAQ Index in the past year. The performance of the latter two indices has been markedly distorted by the concentration of the Magnificent Seven mega-cap tech stocks. Market breadth should improve. Watch for a potential resurgence in broad M&A activity, particularly with a record $3.4tr of corporate cashflows on the sidelines (as of the end of Q3 2023, per Bloomberg). The IPO market for new flotations is also showing some signs of life.

Sceptics who point to euphoric sentiment, particularly with timing surrounding the easing cycle increasingly uncertain, miss the point. The market has already been highly effective at repricing rate cut prospects. At the end of December, the Fed Funds Futures were according a 90% probability to a Fed rate cut in March. This has now shifted to a less than 50% likelihood (the data can be seen using the WIRP function on Bloomberg). It is all about the direction of travel. The Fed can afford to be patient, for now.

The messaging from the US Central Bank is that it is no rush. It wants to see more evidence that the inflation battle has been won. A similar message has been transmitted by the European Central Bank. Even if some data are encouraging, core US inflation continues to run at an annualised rate of 3.3%, well above the Fed’s target. Wage growth (at 5.2%, per the Atlanta Fed’s latest wage tracker) remains above target too. The last mile in cutting inflation may be the hardest. Crucially, the stronger the economy remains, the harder it becomes to cut rates.

Data-dependency remains the ultimate get-out clause for the Federal Reserve. Nonetheless, there is a nagging fear that the Fed may have done (or be doing) the wrong thing. Keeping rates at too restrictive a level for too long would do unnecessary damage to the US economy. Do not forget the lagged effect of prior rate hikes. Most economists are of the view that interest rate changes take 12-18 months to feed into the real economy. At the least, there is no room for complacency.

The fact that a recession hasn’t taken place yet is no guarantee that it won’t. You only tend to know you’re in a recession once it has started. Unemployment has a habit of being notoriously non-linear too, subdued right up until the moment it rises sharply. It would also be naïve to assume that there won’t be some casualties from the changing rate environment. Necessary refinancings at higher than previous rates could spur bankruptcies and dent sentiment. Crucially, the onset of a recession would constitute a shock. It’s certainly not discounted. Just 17% of investors polled in Bank of America Merrill Lynch’s latest monthly survey expect a hard landing in the next twelve months. Meanwhile, FactSet estimates currently assume 10%+ earnings growth for the S&P 500 Index in 2024.

There is, of course, some circularity to consider. Were the Fed to cut rates and the labour market to remain robust, then the odds of avoiding recession would increase. Similarly, a softening labour market would add disinflationary pressure by constraining aggregate demand, spurring the Central Bank to consider reducing rates. If markets are anticipatory anyway, investors may be better off focusing on potential grey swans.

Geopolitics should figure foremost as a risk. Prior broadly pain-free disinflation may be tested by the 100%+ year-to-date rise in container shipping rates. Current bottlenecks on the Suez and Panama Canals constitute a clear source of tension. Over 80% of trade by volume and 50% by value travels by sea globally (per the OECD). Even if it is generally hard both to predict geopolitical outcomes and to link these to investment decisions, where there seems to be agreement is that US politics represents a major source of potential concern. A fragile US-China détente may be put to the test in 2024. A second Trump term – far from guaranteed but looking increasingly likely – would arguably be the most consequential political event for the rest of the decade, heralding a more isolationist, illiberal and protectionist America. Given that the Presidential Election does not take place until November, it may feel like a very long year. Stay humble and stay nimble.

Alex Gunz, Fund Manager, Heptagon Capital