Riding the Wave… For Now.

April 4, 2024

Monthly View 

Aleksey Mironenko

What a quarter we’ve just seen. This election year is living up to the historical pattern so far. Election years typically start strong, have a mediocre middle and a positive finish once election uncertainty is removed from the equation. So far, we are right on track.

In our 2024 outlook and the last few monthly notes we’ve repeatedly said that we are not yet in bubble territory and that U.S economic resilience will support risk assets to start the year. So far, this has proven to be the case with global equities up nearly ~10% year-to-date, commodities firmly in the green and bonds in marginally negative territory. But will this continue? Let’s dive in.

The Case for Yes: The U.S. Economy Continues to Show Strength in Numbers

It’s hard to argue with better-than-expected U.S. data. On the corporate side, both Q4 earnings and sales were ahead of expectations, with the former outpacing the latter. This means that while sales growth may be starting to slow, companies can manage costs and continue to grow their bottom line. With wage growth slowing, there is no reason to think this trend cannot continue and we expect a positive Q1 earnings season ahead.

The macro story supports this logic. Friday’s third revision of Q4 GDP showed stronger-than-expected momentum, driven by an upward revision to consumption. At the same time, Q4 inflation, as measured by core PCE, was revised lower to 2.0% annualized. It’s important to remember that this level is already in line with the Fed’s goal.

Financial conditions have eased materially since last autumn, led by a $10 trillion increase in the market cap of the S&P 500 (and more if you include non-U.S. stock markets). Household wealth is up and consumers with assets are feeling wealthier, fueling their propensity to spend.

Fiscal policy remains accommodative, with the 2023 federal budget deficit at 6.2% – an elevated level given the low unemployment rate. Manufacturing activity has stabilized, and capex intentions have improved, particularly in tech-related manufacturing construction.

Finally, the U.S. is once again at the forefront of innovation and is leading the global implementation of AI. This allows U.S. corporations to amass a disproportionate share of global profits, justifying the elevated valuations of the U.S. stock market.

The Case for No: Possible Storm Clouds Ahead

The above clearly adds up to a good outcome for risk assets in the near term. However, we would not be doing our job if we did not monitor the risk of storm clouds on the horizon.

Slowing wage growth is great for corporate bottom lines right now, but longer-term it starts to impact spending. Leading indicators like job openings, the quits rate, advertised wages and business surveys all suggest further slowing of both wage growth and the labor market overall.

The hiring rate is already at a six-year low, which is relevant as companies stop hiring before they start firing. Temporary employment is back to 2014 levels and temporary workers are the first to be let go. A popular heuristic for recession expectations is whether unemployment is 0.5% higher than its 12-month low, the so called Sahm rule. That measure is trending upward and now sits at 0.27%. In twenty states it has already surpassed the 0.5% increase level. Time will tell if the increase is due to immigration or if indeed it is a preview of slowdown to come.

Beyond employment, there are signs of a coming economic slowdown. Bank lending is down, and corporate bankruptcies are starting to rise. While the magnificent 7 are still seeing earnings growth, the other 493 are seeing earnings decline.

On the consumer side, both credit card and auto delinquencies are rising as credit card balances sit at all-time highs. The explanation for this is simple – pandemic era savings have been largely used up, particularly by lower income households, and they are now spending on borrowed dime, so to speak.

The personal savings rate sat at 3.6% in February – roughly half of the pre-pandemic average. It has been below 4% only three times before: ’99-’01, ’05-’08 and ’22. These levels are not sustainable, and all three periods were followed by a tightening of belts, leading to an all-too-predictable negative effect on consumer activity and thus the overall economy.

Momentum for Now, but Positioning Consensus is a Concern

None of this means that we expect an imminent market correction. In fact, as the title suggests, we are riding the wave for now. Consumer activity remained strong in Q1 and we expect a reasonable earnings season, kicking off with financials in two weeks.

Housing, which is the most interest-rate-sensitive sector, seems to have finally adjusted to higher rates. Supply is limited due to people with 3% mortgages refusing to move and demand is growing due to newly employed immigrants (legal and not) needing a roof over their heads. As a result, houses under construction are up again, single-family permits are up 33% year-on-year and existing home prices are up 7% from a year ago.

The bulls clearly have the upper hand for now with most bearish investors capitulating on their positions. This is actually our only concern in the next ~3 months or so: complacency in markets seems to have reached a recent high.

Surveys of individual investors, traders and advisors in the U.S. all sit well above historical averages in terms of bullish sentiment, not far away from post ’08 highs. In fact, soft-landing to no-landing has become a consensus call.

That on its own makes us use extra cash to increase allocations to diversifiers such as fixed income, private credit and funds that can go long and short, i.e. hedge funds. Within equities, we remain overweight U.S. technology-related names with wide moats but underweight the rest of the U.S. stock market in favor of cheaper non-U.S. names.

Higher for Longer Until It’s Not

Recent inflation data suggests that stronger economic growth in the U.S. has put a floor under inflation and as such the Fed won’t cut rates soon. Fed Chairman Powell and Governor Waller all but confirmed this by focusing on the growth numbers and saying that there is no hurry to cut.

At the same time, however, Chairman Powell dismissed the January and February inflation numbers and views them as part of the overall downward trend. In fact, February’s 0.26% core PCE, which is the Fed’s preferred measure of inflation, is not overly problematic for a Fed that wants to see progress toward 0.17% per month (2% annualized) from a high of 0.61% just 2 years ago.

We do not put much faith in the permanence of the recent inflation data. Post pandemic, statisticians have struggled to adjust to new consumption patterns and the start of year numbers have not been reliable. Looking at the details, most of the increases are driven by one-time adjustments and lags, not newly emerging inflationary trends.

Importantly, we are firm believers in watching what the Fed does, not what it says. In 2021, the Fed was not even thinking about thinking about raising rates, but over the subsequent two years we saw the second fastest rate hike cycle in history.

Today, they are not in a hurry to cut, which means the cost of money (Fed rate minus inflation) will remain higher temporarily, further slowing the economy. This will require a more aggressive cutting cycle in a shorter period, but the end destination will be the same.

Our best bet? An “insurance” cut in June, July, or both, then a pause into the election, followed by more cuts in late 2024 and early 2025 as economic data deteriorates. We would not be surprised if the Fed Funds Rate were in the 3% territory 12-18 months from now.

As such, we’ve steadily increased interest rate sensitivity in our fixed-income portfolios. Bond prices are likely near their bottom and will start to rise in the medium term.

What Happens in Sweden Doesn’t Stay There

Looking beyond the U.S., Sweden is not typically the first country that comes to mind. However, as a small and open economy that depends on global growth, Sweden can often be a leading indicator of things to come in Europe and beyond.

Swedish export orders, new orders-to-inventories data and expected production plans are all in positive territory. The Swedish economic surprise index is back above zero. Korean and Singaporean data (both open and dependent on global trade), corroborate the upturn in the global manufacturing cycle. Even China’s manufacturing was back in positive territory in March.

This suggests better times ahead for Europe, an economy that is dependent on industrial growth. Though Germany’s economy shrank late last year, one could argue it was unique in having to replace Russia’s energy and being exposed to China’s slowdown at the same time. France, Italy and Spain all posted positive GDP numbers in Q4.

Like the U.S., inflation in Europe is falling, leading to positive real wages. But unlike the U.S., European households still have plenty of savings as they already tightened their belts due to the energy squeeze and nearby war concerns.

All of this should result in an uptick in activity on a relative basis throughout 2024. This should support European equities, and thus our bias is now neutral instead of underweight for the first time in quite a few years.

A Tale of Darlings and Pariahs in Asia

There’s no question that Japan is everyone’s darling right now. It’s not hard to see why. Japan’s formal labor union wage negotiations occur once a year in spring. Just two weeks ago, the largest federation of trade unions reported a 5.3% wage increase for fiscal 2024.

Just like slowing wage growth in the U.S. can lead to a slowdown, positive wage growth for the first time in 30 years in Japan is likely to lead to better-than-expected economic activity. In addition, a weak yen supports exports while driving inbound tourism on a scale not seen since the ‘80s.

Continued efforts to decrease cross-shareholding (a shareholder-unfriendly practice), increase buybacks and dividends, and promote higher return on equity business lines all play a role in supporting the local stock market.

Topping things off, Japanese equities remain relatively cheap, trading at a forward Price to Earnings multiple of 16x, vs 18x for global equities and 21x for the U.S.

In contrast, China remains a pariah in the investment world. While investors keep adding exposure to Japan, there is almost no one overweight or even neutral China in the global investment community.

There’s no question that geopolitical risks, centralized control, housing market difficulties, deflation and competition from Japan and India warrant lower valuations. As a result, China trades at a forward Price to Earnings multiple of just 9x, a far cry from the valuations commanded by most major markets today.

When there’s no one left to sell, opportunities arise. Arguably, at current valuations, the major risks are priced in. It’s not hard for valuations to rise marginally, leading Chinese stocks to outperform, as authorities support the economy with a drip feed of fiscal and monetary measures and prop up the stock market with government-sponsored purchases.

Indeed, since January, both Chinese and Japanese stocks have outperformed global equities in local currency terms. We continue to like both markets.

A Word on India

Astute readers will notice no mention of the other Asian market darling – India – above. To some extent, we missed the trade. In contrast to China, which trades at a substantial discount to emerging markets (9x vs 12x forward price to earnings), India at this point trades at a substantial premium of 22x.

The early gains are largely gone with Indian equities outperforming broader emerging markets by ~30% in the last year. We feel the main opportunity going forward might be in mid-small caps, which are less efficient, putting foreign and “non-insider” investors at a disadvantage.

As a result, a better play on India and Southeast Asia may well be via private markets, where valuations are not as stretched, and investors can be picky. In public markets, we will wait for better entry points.

Stock Markets in the Age of AI

It’s hard to comment on markets today without mentioning AI and the resulting market concentration. Clearly the early impact of AI has been felt in the “picks and shovels” trade, with just a handful of names leading the charge.

However, we caution investors from assuming that this run-up will be any different than the dot-com era. While many are quick to point out that earnings have led stock prices, and valuations are far from bubble levels, it doesn’t mean that prices won’t mean revert.

As a reminder, Cisco grew earnings consistently in the ‘90s and in 2000 traded at 37 times sales as a result. Since then, earnings per share are up nearly 10x, but its share price remains ~40% below its 2000 high.

History is littered with companies whose earnings grew seemingly exponentially, only to fade into oblivion once competition emerged. Already, the Magnificent 7 has become the Magnificent 5.

The capex investment stage of the AI trade is getting closer to maturity. Multiple competitors are entering the space and will compete on price and supply chain diversification arguments, if not yet on innovation. There will still be growth, but margins will come under pressure fast.

In our view, future growth will come from two areas. The first is “AI as a service” – companies that provide AI infrastructure and application build-out expertise to those who cannot afford to build their own AI. This will happen faster than most think, not unlike websites after the internet or mobile apps after the smartphone.

The second area of growth is too broad to define as all companies will start to implement AI in their operations. Initial benefits will accrue to the early movers in every industry via increased productivity, but a rising tide will ultimately lift all boats. This newsletter is still written the old-fashioned way, but we would be lying if we said we haven’t explored AI to improve it.

The early winners will still grow, but we doubt their recent outperformance will continue. For this reason, we think a broadening out of the AI effect will support equity markets, dampening the effect of the slowdown we expect in late 2024, or early 2025. In short, we would rather be diversified than concentrated going forward.

Portfolio Positioning

To sum up, we think markets are following an election year playbook. Earnings momentum is likely to hold up a bit longer in the U.S. and the global manufacturing uptick should support international equities. AI benefits will accrue to an ever-broader range of companies.

But as we head toward year-end, election uncertainty will increase, consumer activity will slow, and employment growth will deteriorate. This will lead the Fed to cut rates faster than they and many others expect, with the hope of maintaining current economic momentum. There will, in fact, be a landing.

To that end, we are neutral on equities vs bonds and prefer not to hold cash at this point as reinvestment risk becomes an issue with lower rates in coming months. Within equities, we remain positive on US tech and internationally have a bias to Euro area, Japan, and China equities.

Within bonds, we prefer government risk over credit and have been adding duration. We recently decreased credit exposure in favor of government-guaranteed mortgage-backed securities. We prefer a quality bias in high yield and continue to like emerging market debt for its higher yield and improved credit profile.

We remain positive on commodities, particularly energy and industrial metals, which we feel do not adequately reflect geopolitical risk and the global manufacturing upturn. We are neutral on gold as lower rates will support it, but gold’s price has already run up materially.

Lastly, outside of liquid markets, we prefer allocations to exposures that can protect portfolio downside, such as private credit and hedge funds. We are more cautious on broad private equity exposure as elevated rates and slower growth are likely to lower relative outperformance vs public equity markets.

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