Investment Institute
Viewpoint CIO

Boom boom pow

  • 12 April 2024 (7 min read)

It feels like boom time. Markets are hitting all-time highs. The US economy continues to defy expectations, adding 303,000 non-farm jobs in March. There are green shoots of recovery elsewhere in the world. The idea that the Federal Reserve (Fed) might not cut interest rates at all this year is met with a collective shrug. Cash returns will remain attractive for some time. This year, equity returns are beating cash. High beta credit is also beating cash. Long-duration fixed income is down because of the shift in rate expectations. With yield curves remaining inverted, the longer-term bond yields are probably stuck in a range. The long duration trade will only perform strongly if growth and the inflation cycle weaken substantially. I gotta feeling that’s not on the cards.


Cash for longer? 

I had the pleasure of visiting clients in Uruguay and Argentina last week. Despite the well-publicised economic problems in parts of South America, there is a lot of wealth there and local investors tend to favour US dollar-based assets. Like elsewhere, there is still a lot of cash being held in portfolios so the prospect of above-5% cash returns in 2024 and something like 4.5% next year means the idea of investing in credit or equities, at current valuations, is rather a hard sell. The fact that US investment grade credit has an average yield below cash rates does not get investors very excited about high-grade corporate bonds. High yield is more attractive but the tightness of spreads relative to recent history does not go unnoticed.

Excuses have their uses 

Given the outlook for cash returns there are numerous reasons why investors might choose to stay on the sidelines. They can largely be distilled into concerns over several potential risks relative to current valuations. The inflation and interest rate outlook is key. The surprise 0.4% monthly increase in the US Consumer Price Index (CPI) - both headline and core - makes it harder for the Fed to cut rates. We can argue endlessly about what is really happening with inflation given the computational issues with many components of the inflation index (owners’ equivalent rent, for example) and some strange price increases (motor vehicle insurance rates up 22% in the year to March 2024). But the cold hard truth is that progress towards the inflation target has stalled in the US and may even be reversing. Some members of the Fed may take comfort in looking at measures such as the CPI excluding food, shelter and energy (2.4% year-on-year in March) and argue that underlying domestic inflationary pressures are under control. But others won’t. For now, and this is the view the market is taking, a cut in June is off the table. Betting on any cuts this year has become a riskier undertaking.

Table Mountain redux 

Months ago we were talking about a ‘Table Mountain’ profile for US interest rates. That is how it is looking again. Rates have been on hold since last July. It looks like at least a year of rates at 5.25% - 5.50%. Just as a reminder, in the mid-2000s the Fed kept rates at the peak for 15 months. That profile creates one risk (notwithstanding where the neutral rate is), rates being held constant and forcing further adjustments in longer-term borrowing costs raises the profile of a hard landing at some point.

For bonds, credit and short duration 

For fixed income investors the rates on hold for longer profile has mixed implications. First, it keeps yields higher in general as the market is lacking in confidence now to price in significantly lower rates. That means income returns from bonds remain attractive, especially in credit and especially at the short end of the yield curve. Second, it makes a long duration strategy look less attractive. Yield curves remain inverted and longer-term rates are not particularly high, so the opportunity for them to fall is limited unless a harder landing starts to emerge (which it isn’t). The market has punished long duration trades on many occasions in recent years and it is doing so again. It is unlikely to be a rewarding trade until there is more evidence of rate cuts or until there is a blow-off in the long end (US Treasuries above 5% yield) to improve the longer-term valuation argument. Finally, inflation-linked bonds, especially short duration bonds, might be something worth considering again as a hedge against inflation continuing to surprise to the upside. Five-year US breakeven inflation rates are just 2.55%.


A hike, anyone?

Rates on hold does not need to be a disaster once markets have re-priced the timing of rate cuts. What would be more of an issue is a Fed hike. No Fed officials have hinted at that publicly and it would be a surprise. But a mid-1990s profile could be a genuine scenario. After hiking in 1994-1995 (300 basis points), the Fed started easing in July 1995 only to have to reverse that and take interest rates to a higher peak than had already been reached. Why? Because inflation started to increase. The result was the bursting of the dot.com bubble. It was the last time that real short-term interest rates were significantly positive for an extended period. If inflation moves back towards 4%, thus reducing real short-term rates again, then a rate hike is not unthinkable.

A higher rate profile is a genuine factor for investors. It means higher returns from cash, a higher discount rate on which to value corporate earnings, and potentially some additional stress on cashflows in the household and corporate sectors as a result of higher interest costs. In this cycle, overall, higher interest costs have been absorbed, largely because of homeowners being on fixed rate mortgages (at lower rates than today’s) and companies having built up large cash balances and having extended their own debt at low fixed rates. At some point the rate environment may have less benign implications, but for now credit continues to look solid.

Sideways 

Consumer prices rose in March this year by a larger amount than in March 2023 but by much less than in March 2022. Core prices have risen marginally less in the first quarter (Q1) of 2024 than they did a year ago. If some of the slower moving components do start to move lower and energy prices stabilise, it is conceivable that we could see inflation stay between 3.0% and 3.5% for the remainder of the year. Look at the headline year-on-year rate on a chart and it has been going sideways since the big drop below 4.0% last year. This suggests the Fed on hold, not the Fed tightening. Anyway, for now, it is prudent to reduce expectations of significantly lower inflation or rates for the rest of this year.

Equity risks 

For equity investors there is obviously a crossover from the rates markets. Weaker sentiment on bonds driving yields higher will impact on equity market sentiment. In simple terms there are two risks to equity returns – one coming from disappointing earnings, the other coming from a multiple de-rating triggered either by higher bond yields or some other factor hitting sentiment.

Earnings should hold up 

I am relaxed on the earnings side. The current consensus is for earnings per share for the S&P 500 to grow by 11% this year. For the European and UK markets, forecasts are for between 5.5% and 6.5%. Stronger growth and stickier inflation mean nominal GDP growth in the US looks to be stronger than it did a few months ago. Consumer and capital spending appears to be strong and there are no obvious reasons to look for an erosion of profit margins compared to last year. The upcoming earnings season could easily surprise to the upside. The picture from the small number of S&P 500 companies that have already reported is pointing that way. 


Multiples not outrageous 

Global markets tend to move together. I plotted the z-score (a value's relationship to the mean of a group of values) for 12-month forward price-to-earnings (P/E) ratios for several global benchmark equity indices and it is remarkable how correlated they are (even though the actual P/E rates are different). Multiples bottomed in late 2022 and have moved steadily higher since, with the S&P 500 leading the way. Comparing today’s P/Es with their three-year moving average, the US is about one standard deviation above the mean while non-US markets are close to their three-year averages. The US certainly has that growth premium in its valuation rating (expensive for a reason).

Momentum has been strong, and multiples have moved up, without looking over- extended. Post-pandemic multiples are generally higher compared to the previous decade, reflecting shifts in supply chains, the technology boom and the strength of balance sheets. There is probably also a reflection of more pricing power in recent years.

De-rating risk? 

So, what takes multiples down and negates the positive impact of earnings growth on total returns for this year? The rates outlook is certainly one suspect, given what happened in 2022. There is hardly any gap between the implied earnings yield on the S&P 500 and the 10-year Treasury yield. If bond yields move higher, then equity P/E ratios might need to move lower. Signs of a recession would also do it as confidence in sustaining earnings growth would be undermined. But as I have argued, right now, there are few signs of a recession on the horizon. Political uncertainty could impact valuations. The US election is one source, but we won’t really know until Q3 how things are panning out.

Global political risks are perhaps more concerning as a threat to investor sentiment that would require a higher risk premium in equity markets. It is hard to assess what the true situation is like in the Russia-Ukraine conflict, as there continues to be reports of a potential Russian surge while other reports highlight infrastructure issues and unrest in Russian regions which could potentially undermine the regime. In the Middle East, the threat of an escalation of Israel’s conflict beyond Gaza to Iran looms. Geopolitical analysts are going to turn up the volume as they debate issues ahead of the US election. All of this has the potential to be reflected in greater investor uncertainty and thus higher volatility and less certain returns. The recent rise in commodity prices could be a sign of concerns about geopolitical risks to the supply of key commodities, or just a sign the global economy is stronger than we thought.

Boom or pow? 

I started with a suggestion that the global economy is doing well. Growth momentum is improving, and disinflation is still the trend, although disrupted by higher energy and other commodity prices and post-COVID-19 price trends dictated by structural shifts in spending and market structures. It’s fair to say that nominal growth is going to be higher than in the pre-pandemic period, which means higher interest rates than back then. In addition, companies have proved to be resilient and can grow, adapting to changed demand and supply conditions and the opportunities provided by new technology. Investors have the opportunity for more balance in their portfolios, as I have been arguing for a while. Bonds for income (manage the interest rate sensitivity), US equities for growth, and global markets for diversification offered by signs of more balanced global growth (even if that is a derivative of a strong US economy).

Tango 

It was my first time in Buenos Aires. A city that is famous for red wine and football has many merits. I sampled some very fine Malbec and took a city tour, passing by the stadiums of Boca Juniors and River Plate. I said to my wife that I would like to go again and take in El Superclásico. She agreed if we also go to see an Argentine tango performance. Life is all about compromise. Vamos!

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 11 April 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.

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