Investment Institute
La Versione di Iggo

Sunny with the odd shower

  • 26 Aprile 2024 (5 min di lettura)

The big picture is unchanged. Global growth is positive, and expectations are being nudged higher. Inflation is coming down, but the phrase “the final mile of disinflation is hard” is a well uttered one. This is leading to a divergence in the rates outlook between the US and Europe and US yields have risen relative to European bond yields. Markets have not yet priced out all Federal Reserve (Fed) rate cuts for this year, but they are moving that way. Bond bulls would love Fed Chair Jerome Powell to say he will not raise rates. A lot depends on the data. Just note, however, Japan shows that downside inflation surprises are possible.

Stock times 

Market returns so far in 2024 demonstrate that the macro backdrop has been and remains more supportive for equities than fixed income. Markets have evolved to price out most interest rate cuts for this year, which has been detrimental to the most interest rate sensitive parts of bond markets. The other side of that is that growth is stronger and inflation still higher than desired, which means nominal growth is still healthy. Corporate profits tend to go up as economies expand in nominal terms. Both the US and Europe saw nominal GDP growth of around 6.5% in 2023, and 2024 looks set for another reasonable year of nominal growth. Nominal growth is good for equities but a little too good for central banks to cut interest rates as much as had been expected.

Better for bonds 

Outside of the Fed hiking rates, fixed income markets offer attractive carry returns. The first four months of the year have seen bond prices fall because of the revision to the central bank view, but from now on total returns should become more positive as income dominates. A total return from investment grade credit of 3%-4% over the balance of the year would not be surprising, with something like 5% in high yield. Should Powell explicitly rule out a rate hike then returns would be boosted. Of course, he needs the data to conform to the central bank’s view for that to happen and it has not done so yet.

Positive surprises 

The first quarter earnings season in the US equity market looks healthy. With not quite half of companies having reported, average earnings growth is coming out at around 6% and, in aggregate, earnings have surprised to the upside by around 10% relative to forecasts. All sectors show positive earnings surprises and positive earnings growth (except for energy, materials, and healthcare). On the technology side, results have been strong with Microsoft and Alphabet (Google) reporting strong numbers relative to expectations. Shares in the sector have recently given back much of their year-to-date gains, but the earnings results and the narrative around strong capex spending on technology and artificial intelligence should propel better performance ahead of the US election.

60:40 doing well 

Equity returns have dominated a typical 60:40 type portfolio strategy over the last year. This may become a little more balanced as income returns play their role in the fixed income part. What has not been tested in this new regime is the ability of bonds to offset any meaningful downturn in equity markets. A normal cyclical downturn, triggered by weaker growth and a profits recession, would involve significant cuts in rates, allowing fixed income to outperform. The last time this happened was in the global financial crisis. In 2022, both equities and bonds delivered negative returns at the same time as monetary policy was adjusted. The chances of that happening again are limited, so bonds should provide something of a more typical hedge if equity markets do turn lower in response to a weak profits outlook.

Risk to sentiment

For now though, the fundamental outlook is solid. The biggest near-term threat to equity markets would come through the channel of a hit to sentiment leading to a higher risk premium (lower price-to-earnings ratio). There are all kinds of things that could do that. Most obvious is a Fed rate hike but geopolitical concerns are also a threat to investor confidence. So far, as is often the case, immediate market reactions to geopolitical events have been short-lived. Both the conflicts in the Middle East and Ukraine have the potential to escalate and pose more of a threat to global trade and inflation and create increased uncertainty. However, so far, they have not.

Start-stop tightening 

There had been concerns that a change in the Bank of Japan’s (BoJ) monetary stance would create an incentive for Japanese investors to repatriate overseas investments, putting upward pressure on the Japanese yen and hitting markets like US Treasuries. Nothing could be further from what has turned out to be the case. The BoJ has made some modest adjustments to its monetary stance, but the yen has just hit its lowest level against the dollar since 1990. The Tokyo consumer price inflation number came out at 1.8% year-on-year in April, against economists’ expectations of 2.5% and a March inflation rate of 2.6%. The BoJ expects inflation to average 2.8% this year which would rely mostly on the yen becoming even weaker and energy prices remaining high. There just does not seem to be a lot of domestically driven inflation in Japan. As such, further monetary tightening is unlikely anytime soon. It started, and now it has stopped. Japan is not a threat to global bonds. What it may be, however, is an example of how the deflationary forces at play for much of the last 20 years are hard to shake off, even after a (mostly) transitory inflation shock.

US to become a more costly hedge 

For euro and sterling-based fixed income investors, the US bond market remains attractive from a yield point of view. Hedged back into euros or pounds, US fixed income still provides a pick-up relative to local yields. That could change. If the Fed stays on hold and the European Central Bank and the Bank of England cut rates, the currency hedge cost will worsen. The window for investors who hedge their currency exposure to get a yield pick-up from investing in US credit could start to close soon.

Calm and sunny conditions 

Markets are calm. The VIX index of equity volatility shot up at the beginning of April but has receded. The earnings backdrop is positive. Yet there will continue to be concerns about near-term inflation developments and the stickiness of inflation in the US services sector. As such, short-duration credit strategies should remain in favour, alongside equities that benefit from solid growth in earnings. If seasonals are anything to go by, May should be a decent month for a balanced portfolio.

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 25 April 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.

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