Goldilocks reloaded?

Risk assets rallied at the end of 2023 in anticipation of looser monetary conditions. And despite a countervailing rise in bonds yields, the rally continued throughout Q1 of this year. This suggests that markets not only expect tailwinds from a monetary policy about-face but also from improving economic prospects.

Indeed, at the beginning of 2024, economic indicators implied a broad-based stabilization. Consumer sentiment started to revive from depressed levels in many developed economies as households began to enjoy some relief from last year’s rapid disinflation in consumer prices.

At the same time, business activity in the global manufacturing sector, which had been in retreat since late 2022, showed signs of firming, with February’s JPMorgan Global Manufacturing PMI Index rising above the threshold dividing expansion from contraction for the first time since August 2022. In the US towards the end of Q1, economic activity indicators that also consider high-frequency data also pointed to a slight pickup in economic activity to average levels. In a similar vein, global trade volumes appeared to be emerging from their recent trough, picking up slightly in December.

Adding to the good mood, despite the stickiness in underlying inflation, the outlook remains intact for an imminent pivot to a looser monetary policy stance by the US Federal Reserve and the European Central Bank as the Swiss National Bank, rarely in the vanguard in such matters, officially kicked off the easing cycle when it surprisingly cut interest rates in March.

In this upbeat environment, one equity index after another has posted new highs this year. And the exuberant mood has spread across all risk assets, from gold and high-yield credit to even the more speculative digital assets. All this record-setting could be reason enough to simply join in the celebrations. And we do, selectively. But we should not lose sight of the daunting global challenges that could quickly dampen the party atmosphere.

First, while economic fundamentals have improved recently, we think a lot of that good news is already priced in. For several months now, we have observed a widening gap between rallying stock markets and sluggish macroeconomic fundamentals. While recent improvements in the fundamentals have narrowed that gap, it has by no means disappeared. Second, sectoral and regional economic divergences persist, making the recovery look rather fragile. Third, valuations are stretched, especially considering the current elevated levels of interest rates, making equity markets vulnerable to negative surprises. And potential negative surprises abound these days, with geopolitical tensions running higher than they’ve been in decades Meanwhile, underlying inflationary pressures appear to be persistent, suggesting that the path to the anticipated monetary easing might not be as smooth and unidirectional as capital markets currently anticipate. Finally, in addition to the formidable “known unknowns,” we cannot ignore the possibility of disruptions from “unknown unknowns.”

That said, however, we are not advocating the pessimism of the permabears. With all caveats noted it would be easy to opt for an equity underweight. But the past five quarters have clearly shown that excessive caution can cost investors dearly. Those who chose to refrain from investing in the global equity market – for what they can argue were very good reasons – missed out on a performance gain of around 35 percent, in USD terms. Over longer periods, this stance would prove to be even more costly. If investors only look at their portfolio, missed gains are not obvious since they incur no visible investment losses. However, if compared with common benchmarks that track market performance – best practice, in our view, but by no means the norm – it is an inescapable fact that standing on the sidelines leads to high opportunity costs.

To sum up, we recognize the upside potential from improved fundamentals and a likely near-term turnaround in interest rates, but we are refraining from overweighting equities given the risk factors we’ve mentioned. We definitely believe that Goldilocks should go for a walk, but she should also be prepared for surprises.

1.1            North America

• The US economy maintained its resilience and strong momentum at the end of 2023 and into 2024. In Q4, the US economy expanded by 3.1 percent year-over-year on the back of robust consumption growth and above-average contributions from government expenditures and net exports.
• Thus far in 2024, business activity indicators have even implied that conditions are firming up. As measured by the Markit Composite PMI, overall business activity improved thanks to a robust services sector and improving conditions in the manufacturing sector, too.
• Similarly, the Aruoba-Diebold-Scotti Business Conditions Index, published by the Philadelphia Fed, which tracks economic activity more broadly and considers higher-frequency data, including weekly job market data, suggests that economic activity has improved since January, again approaching average levels in March.
• The job market has been sending mixed signals lately. Clearly, a cooling off is under way, reflected in rising unemployment claims and fewer job vacancies. However, vacancies still exceed the number of unemployed persons, while job growth itself has remained robust, as seen in the non-farm payroll data, which showed growth well above the long-term historical average during the first three months of 2024.
• Various explanations are on offer for the continued strength of the US labor market, including the sustained strong consumer demand, the lower labor market participation rate after the pandemic and the wave of boomer generation workers entering retirement. In our view, the persistent labor surplus following the 2008 global financial crisis had finally normalized prior to the pandemic. In the decade after the GFC, growing labor demand had little impact on wages and consumer demand, and thus on inflation, because the constant labor surplus acted as a buffer. These times now appear to be over, even though the unemployment rate rose from its previous low of 3.4 percent in April 2023 to 3.9 percent in February. In other words, without the buffering effect of a surplus of labor, rising economic activity and labor demand will likely lead to higher wage and inflationary pressures from now on.
• Against this backdrop, the ongoing sticky price inflation in services is unsurprising. Although cooling in February, the so-called “supercore” inflation gauge – core services price inflation excluding housing – continued to increase, up 0.47 percent month-over-month, or 5.8 percent annualized.

1.2           Europe

• After a difficult 2023, the Eurozone economy has remained under strain in early 2024, with economic indicators implying an ongoing stagnation or mild recession in several member states. The Eurozone has now posted four successive quarters of stagnation or even contraction since the end of 2022, as weak foreign demand, an unprecedented trade-balance shock in the wake of the war in Ukraine, and significantly higher refinancing costs weighed on consumption and investment demand. In 2023, the Eurozone’s GDP grew by sluggish 0.4 percent, with Germany and member states in the north and east mostly contracting. Ireland also experienced a sharp contraction, but this was driven by different factors, notably declines in sectors dominated by multinationals, such as pharmaceuticals.
• At the end of Q1, Eurozone PMIs signaled a stabilization of business activity, with the services PMI narrowly leaving contractionary territory while manufacturing continued to signal contraction, albeit at a slightly slower pace, as the sector faces ongoing struggles with weak demand and high energy prices.
• On a positive note, the slowdown in yearly inflation rates has continued. In February 2024, inflation dropped to a three-month low of 2.6 percent year-over-year, as energy prices fell, and inflation for non-energy goods eased. In contrast, as in the US, services inflation remained elevated, at 4 percent year-over-year. The core inflation rate, which excludes food and energy, fell to 3.1 percent year-over-year, its lowest level since March 2022, but still north of the ECB’s target. Accordingly, the ECB kept its interest rates unchanged in Q1, while acknowledging a further decline in inflation. We believe the disinflation trend and ongoing economic weakness will likely lead the ECB to cut interest rates, possibly as soon as June.
• Expectations for the Swiss economy in 2024 remain muted as restrictive financing conditions, a strong franc and weak external demand have impacted the manufacturing sector and limited investment demand, counterbalancing growth in services and consumer spending.
• If a strong franc has been a curse for foreign trade, it’s been a blessing for the Swiss National Bank as it dampened inflation and enabled the SNB to raise policy rates to a peak of only 1.75 percent, limiting the strain on the hot real estate sector and households and companies, too. With a consumer price inflation rate of 1.2 percent year-over-year in February, Switzerland is the only developed country to have restored price stability. The SNB evidently thinks so, which is why it surprisingly lowered the key interest rate from 1.75 to 1.5 percent in March.

1.3            Asia and Emerging Markets

• The emerging economies continued to exhibit a faster expansion in business activity than their developed market peers throughout Q1. The stabilization in the global manufacturing outlook, the pickup in manufacturing export orders and the associated expected improvement in trade growth should provide tailwinds also in the coming months.
• In addition, while sticky underlying inflation in the US could lead to a slower monetary policy loosening than markets currently price in, we think the US dollar should tend to weaken on balance, providing looser financing conditions for emerging markets in general.
• Consistent with the signs of economic firming and the easing of global supply chain pressures, global trade volumes, which are published with a substantial lag, have again started to increase, growing by 1 percent in December following a decrease of 1.3 percent in November. For the coming one to three months, the Global Manufacturing Export Orders PMI indicates a continuing stabilization of the trade outlook. While still signaling a slight contraction, it has trended further upwards, reaching 49.4 in February, approaching the 50-point threshold separating a contraction from an expansion.
• Nevertheless, from a structural point of view, the era of “trade hyperglobalization” has ended. As the Peterson Institute for International Economics (PIEE) highlighted in a recent comprehensive paper, it has been replaced by deglobalization in goods trade and a slower globalization in services. With hindsight, 2011 marked a turning point, with the ratio of global-trade-to-GDP reaching its peak. While the subsequent volatile development is far from a reversal of globalization, the persistent goods price disinflation and the smoothing effects on the global economy that accompanied the previous dynamic phase of global trade growth, which outpaced global GDP growth, now appears to be over. Thus, we note, future economic shocks are likely to trigger stronger swings in inflation and growth.
• Despite a rather subdued economic development, Japan has experienced elevated inflation, by its standards, and its biggest increase in wage growth since the early 1990s. Nevertheless, the Bank of Japan was the last major central bank to abandon its negative interest rate policy – leading to an extreme weakening of the yen. But in March, the BoJ initiated its long-awaited turnaround. It hiked rates for the first time since 2007, raising them by 0.1 percentage points to a range of 0.0 to 0.1 percent, and finally exited its “yield curve control” regime.

2.           Financial Markets

2.1           Equities

• The first quarter of 2024 was one for the record books as optimism around economic growth and easing financial conditions led several indices to all-time highs, along with record swings in market capitalizations and increased market concentration. Markets around the globe set new all-time highs. The US S&P 500 Index crossed the 5000 mark for the first time. In Europe, several national markets rose above previous highs and the broad Stoxx 600 Index also set a record. Similarly, in Asia, India’s Nifty 50 Index climbed past its previous all-time high and Japan’s Nikkei 225 Index eclipsed its previous high after a 34-year wait.
• Swings in market capitalization for single stocks have also been getting bigger. In early February, after reporting strong quarterly earnings, Meta set a record for the largest single-day gain, adding nearly USD 200bn in market cap on the day. But this record only lasted twenty days, as Nvidia’s Q4 earnings sent it soaring to all-time highs and added nearly USD 280bn to its market cap, equivalent to the market cap of Nestlé.
• Stock market concentration also surged to multi-decade highs. The ten largest US stocks now account for roughly 33 percent of the S&P 500 Index market cap and 25 percent of its earnings. In Europe, similar behavior can be observed. All these records beg the question: is the market getting ahead of itself? To assess this, we look at the two key variables, earnings and multiples.
• While corporate profit margins have declined from their recent peak in 2022, companies largely managed to maintain their profitability despite a slowing economy, not least as they started to cut costs. However, the higher interest rate environment has created haves and have-nots. While technology is thriving from investments in artificial intelligence, the environment for regional banks and commercial real estate looks different. Multiples, on the other hand, look elevated, especially in a higher-for-longer interest rate scenario. In the decade from 2010 to 2020, the average multiple for the S&P 500 Index was 16x while the 10-year US Treasury yield averaged 2.2 percent. Today, the market is trading at 21x while interest rates are at 4.3 percent. The story in Europe is similar, albeit at lower levels. However, one must be careful with averages. While some of the mega caps trade at high multiples, other stocks trade at more reasonable levels.
• Despite elevated valuations, technicals continue to be supportive, with positive momentum and strong seasonality ahead, as April usually enjoys strong performance. Given this mix, we keep our neutral allocation to equities.

2.2           Fixed Income

• After a strong year-end rally, 2024 began with a consolidation in fixed income markets. US consumer, economic and labor market data remained solid while US Treasury bond issuance was up by more than 50 percent over the previous year’s level in February. Taken together, these developments drove Treasury yields up by about 0.3 to 0.4 percentage points across maturities. Following the softening in US consumer price inflation rates, markets now expect the Fed to lower key interest rates three times by the end of this year. However, the number of expected rate cuts has been fluctuating significantly, as some measures of underlying inflation look sticky while others, especially the US personal consumption expenditures (PCE) inflation rate, the Fed’s preferred inflation metric, have approached levels consistent with price stability.
• As in the US, sovereign yields in Europe, represented by German government bonds, rose by up to 0.45 percentage points across maturities. Futures markets price in three rate cuts by the European Central Bank through the end of the year. The yields of Swiss Confederation bonds also rose slightly across all maturities – albeit to a lesser extent than sovereign bonds in the US and Eurozone. Following the Swiss National Bank’s surprise policy rate cut in March, futures markets are now pricing in two more cuts by the end of 2024.
• Despite the broad-based rise in government bond yields, the Bloomberg Global Aggregate Index, Hedged USD, ended the first quarter narrowly without a loss.
• In contrast, credit spreads narrowed further: investment grade by 0.1 to 0.5 percentage points (iTraxx Europe Index) and high yield by 1 to 3 percentage points, according to the iTraxx Europe Crossover Index. We noted in the previous issue of MFO Investment Outlook that we no longer felt fairly compensated for taking on risk in the high-yield segment, so we used its renewed strength to exit our remaining high-yield exposure in March by also selling our position in EM corporate bonds. We invested the proceeds in high-quality government bonds and quasi-government bonds of medium and longer durations.
• Consequently, the fixed income portfolio now exhibits the highest quality in years, with little credit risk and a substantial allocation to liquid, high-quality bonds of medium and longer durations that should prove resilient in an environment of slowing economic activity, rising credit spreads, and declining yields. Our overall allocation remains unchanged, close to the strategic allocation.

2.3           Alternative Investments

Hedge funds, private markets and commodities

• The HFRX Global Hedge Fund Index gained 2.5 percent in Q1. The top-performing strategies were trend-following and equity long/short. The former gained as markets exhibited strong trending behavior. The latter were helped by strong equity markets but also by astute stock selection. The equity market is increasingly differentiating between the haves and have-nots, which should continue to be a good backdrop for this strategy. The environment for discretionary global macro managers was more challenging, as many were positioned for a steepening US yield curve that has not yet materialized. Given the record issuance of Treasuries, we think the term premium should normalize from its depressed levels.
• Gold languished at the beginning of 2024 but took off in March, setting new records against various currencies. The drivers of this surge are not entirely clear as the USD strengthened and real yields rose, which is usually negative for the yellow metal. Anecdotal evidence suggests that demand from central banks continues to be high.
• Private equity firms experienced a substantial slowdown in deal activity in Q4 2023 compared to the previous year. The value of deals decreased by 37 percent, while exit values fell by 44 percent. Although the number of funds declined, dollar commitments in buyouts surged as several large funds closed. However, there are early indications of a rebound, with the deal value in Q4 being the highest of the year, suggesting an emerging opportunity to acquire top-tier assets at discounted valuations (Preqin, Dealogic, and Bain & Company).

Currencies

• Since the end of 2023, when the Swiss franc reached peak levels against both the USD and EUR, it has seen a decrease in value. During Q1, the CHF weakened by 7.0 percent against the USD and by 4.6 percent against the EUR. The turnaround initially reflected the positive market mood, reducing demand for safe-haven currencies and was amplified by the SNB’s surprise policy rate cut.
• Despite the Bank of Japan’s long-awaited pivot from negative policy rates, the last of the big central banks to do so, the extremely undervalued JPY has not begun to recover, in total depreciating by 3 percent against the USD over Q1. The CNY remains significantly overvalued against the USD, too. A dovish shift in monetary policy by the US Federal Reserve may eventually trigger an unwinding of these significant valuation discrepancies.

3            Investment Views

• The firming of economic conditions during Q1 reinforced the likelihood of a smooth economic deceleration, which, at least in the case of the US economy, implies a normalization of economic growth towards the long-term trend rate rather than a stagnation or even contraction of economic activity. Accordingly, sentiment turned bullish as investors saw they could indeed be rewarded in the desired “soft landing” or even “no landing” scenarios. But, as we pointed out in January, this optimistic outlook appears already factored into current equity valuations. And given the looming geopolitical risks, at these valuations we think markets remain vulnerable to shocks. We therefore maintain our neutral stance on equities. At least, after a fresh rise in bond yields and a repricing of futures markets that anticipates fewer rate cuts than foreseen in January, we think market expectations now seem more in line with the reality of relatively sticky underlying inflation.
• The sharp compression in bond yields during Q4 2023 was not fully compensated by the yield increases that followed in Q1 of this year, which has led to less attractive bond valuations. Nevertheless, in absolute terms, yields look attractive and investment grade bonds have finally regained their diversification function following the demise of the central banks’ long-held zero-interest-rate stance. In addition, near-term policy interest-rate cuts, should they occur, could lead to gains in longer-dated bonds.
• In contrast, while interest-rate risks are once again compensated more fairly in a historical context, investors are poorly rewarded for credit risk, as, despite higher interest rates and a slowing economy, credit spreads have fallen below their long-term average. We therefore decided to reduce our credit risk exposure further in March by selling emerging market corporate bonds. Overall, we prefer high-quality, longer-term bonds that we think are likely to benefit from declining yields or a flight to safety, steering clear of areas prone to higher defaults and expanding credit spreads.
• We maintain a slight overweight position in gold due to its valuable diversification benefits. Moreover, we think a return to negative real interest rates in the coming years is likely, as this would help to devalue the very high post-pandemic sovereign debt levels. A further easing in US policy rates and a subsequent weakening of the USD would also likely benefit gold.

Source: MFO