Sell in May & Go Away?

May 8, 2024

Monthly View 

Harmen Overdijk, CFA

Traditional market wisdom tells us to “sell in May and go away and remember to come back in September.” Could this investment wisdom be true this year?

It is true that based on long-term data summer months tend to deliver lower equity market returns than winter months. And as we mentioned last month, U.S. election years typically have a good start, a mediocre summer and positive ending. The problem with these general rules based on long-term averages is that every year is unique.

As it becomes clear that economic growth and the U.S. job market are softening, we think that inflation will come down soon as well. And despite the Fed’s decision to keep rates ‘higher for longer’, we think expectations of rate cuts will start to increase again, potentially giving another boost to the equity market in the near term.

If the job market keeps cooling off and inflation starts to show signs of weakening, it is also still possible that the Fed will do one rate cut this summer, which would likely be positive for bonds, equities and commodities.

Why Did Markets Sell Off?

In April we saw risk aversion rise in global markets as risk assets sold off, largely due to sticky inflation and worrying signs about the sustainability of growth. After making record highs in March, the rallies in Japanese and US equities tapered off and they led the way lower for global equity markets in April.

The key reason was that the market suddenly realized that the Fed is unlikely to make three rate cuts this year, as previously expected. In fact, the market started to worry about further rate hikes.

Another reason was increased geopolitical tensions in the Middle East when Iran attacked Israel and Israel retaliated. This pushed up oil prices temporarily, although for now tensions seem to have cooled.

All of this led U.S. fixed income to perform poorly as well. Hotter-than-expected inflation releases contributed to growing evidence that the Fed will begin cutting rates later than previously thought, pushing the U.S. 10-year Treasury yield back up to 4.7% over the course of the month. At the same time, tightening lending standards also widened corporate bond spreads.

Not All Negative in April

Meanwhile, a rebound in global manufacturing activity contributed to the rally in industrial metals. Industrial metals were by far the best-performing asset, rallying 14% in April. The stabilization in global manufacturing was initially led by the US, but the improvement has since broadened, with China now leading the way. Indeed, global refined copper demand is dominated by Chinese economic activity.

China was among the best performing equity regions; this is largely because Chinese stocks valuations are very low, Q1 earnings were better than expected and the recent implementation of a government program supported equity prices.

High – Not Higher, for Longer

The Federal Reserve has signaled that U.S. borrowing costs are likely to remain high for longer, as it wrestles with persistent inflation across the world’s biggest economy. The Federal Open Market Committee said after its May meeting that there had been “a lack of further progress” towards its 2 percent inflation goal in recent months. “It is likely to take longer for us to gain confidence that we are on a sustainable path down to two percent inflation,” Fed Chairman Jay Powell said during a news conference after the announcement. “I don’t know how long it will take.”

Importantly, the Fed also indicated that it was not considering new rate rises to counteract the recent uptick in inflation, saying that the risks to meeting its joint goals of full employment and subdued price pressures had “moved towards better balance over the past year”. “I think it’s unlikely that the next policy rate move will be a hike,” Powell said. The comments from Powell came as the US central bank held interest rates at 5.25 percent to 5.5 percent, a 23-year high that has been in place since the summer of 2023.

Powell suggested that it was unlikely that the next move would be a hike, stressing repeatedly that the committee’s focus remains on the timing of the first cut and not on the possibility of rate hikes. Chair Powell’s downplaying of the possibility of rate hikes suggests the Fed will only consider tightening if inflation surprises further to the upside. Given that we think disinflationary forces in the US economy will outweigh upward price pressures, we expect that the 10-year Treasury yield will not exceed its 5% October peak.

A Cooling U.S. Job Market

Recent job market data points to a labor market that continues to cool. U.S. employers scaled back hiring in April and the unemployment rate unexpectedly rose, suggesting some labor market cooling is underway after a strong start to the year.

Nonfarm payrolls advanced 175,000 in April, the smallest gain in six months, a Bureau of Labor Statistics report showed Friday. The unemployment rate ticked up to 3.9% and wage gains slowed. At the same time, the number of U.S. job openings decreased to 8.488 million in March.

Workers seemed to be less confident switching jobs, with the quits rate declining to 2.1%, the lowest since August 2020. Other indicators corroborate weakening labor market conditions.

While the latest data points to a weakening labor market, it is too early to conclude that a recession is at our doorstep. In the next few months, we expect the effects of a cooling labor market to outweigh the inflationary pressures in the economy. Meaning that the Fed could be comfortable enough to cut interest rates in a few months.

China’s Sudden Stock Market Rally

2023 was a bad year for Chinese equities. The MSCI China Investable index declined by over 10% even as global equities rallied by 20%. The pain extended into January of this year, with Chinese stocks underperforming the global benchmark by 12% in that month alone. The weakness of the Chinese economy as well as fears that policymakers would not provide enough stimulus to revitalize the economy caused Chinese equities to fall to their lowest level since 2022.

However, Chinese equities have since recovered some lost ground and are now ahead of global equities on a YTD basis. There are several reasons to explain this rally. First, Chinese stocks got very cheap, with the 12-month forward price-to-earnings ratio falling to a 12-year low of 8. At this valuation level, a lot of the bad news was already in the price. Second, Chinese authorities began to provide some support to equity markets in order to prevent a full-blown crisis of confidence.

More importantly, the first quarter earnings for the large China tech companies came in much better than expected. Better earnings with low valuations can lead to a sustainable rally in stocks despite the fact that the outlook for Chinese economic growth is still subdued.

Longer Dated Bonds are Increasingly Attractive

The recent rise in Treasury yields makes buying longer-dated bonds increasingly attractive. Strong economic growth and hotter inflation has led the market to reprice expectations of rate cuts, from an expected six cuts in 2024 (as of Jan 2024) to the current single cut today. Despite softer leading indicators, there are subdued expectations for a rate cut prior to U.S. Presidential Elections. Fed monetary action during an Election year is more common than one would think, but the start of a new rate cycle seldom occurs. While bond markets have now repriced this reality, the weakening of leading indicators and high absolute yields are tailwinds for bonds in a path to less rate volatility and an after-Election November ‘Fed Put’.

The Fed has been steadfast in calling for material movement towards their 2% inflation target, their ‘data dependency’, despite the likelihood of slow inflation and labor markets softening. While the Fed has enacted policy changes in all but one election year since 1980, the majority have been a continuation of a prior year’s policy. New monetary cycle actions are elusive, with a hiking cycle in 2004 and cuts during shocks seen in 2008 and 2020. A one-off June or July rate cut may be possible, prior to Party Conventions, but rests on seeing weaker inflation prints in the coming months.

The current environment is a likely conundrum for the Fed as leading indicators oppose trending growth. Expectations for the first rate cut now aptly sit just two days after the November elections. While current yields are up to start the year, the backdrop (Fed, macro data, oil prices and yields) are uncannily like September 2023. However, unlike the past six months, interest rate volatility is likely to fall between now and November, with range-bound yields presenting a new opportunity to extend duration. While Fed action remains low in the coming months, the ‘carry’ of 5%+ yields in sovereign bonds presents a good opportunity to lock in attractive yields versus the path of declining yields in floating rate cash instruments.

Could the Euro Rebound?

The Euro has fallen by almost 5% since July last year versus the dollar. There are fundamental reasons why this move has taken place. The U.S. economy has shown more resilience than the European one. Consumption continues to be strong, and GDP is still growing. Meanwhile, most large European economies are stagnating with growth rates coming very close to zero.

That said, this divergence is already reflected in market expectations and pricing. Growth expectations for the U.S. and the Euro Area have massively diverged. Likewise, rate expectations for the Fed versus the ECB have also increased significantly, as the market now expects the ECB to be much more dovish than its American counterpart.

Given that markets have already priced the relative strength of the U.S. over the European economy, we could see a rally in the Euro. Economic data surprises in the Euro Area are now higher than US ones. Moreover, net earnings revisions for the European market have begun to outpace US ones, historically a good leading signal of EUR/USD returns.

What is Happening to the Yen?

The Japanese Yen has depreciated by more than 10% in 2024, making the yen the worst performing G10 currency year-to-date. The USD/JPY cross seems to have a 160 threshold, at which point the Bank of Japan started to intervene.

On the surface, this weakness in the yen is somewhat surprising. Last month, the Bank of Japan hiked interest rates for the first time in almost two decades. Global risk sentiment has also deteriorated, as fears of war in the Middle East has roiled markets while volatility has risen. Historically, the JPY tends to benefit during these risk-off environments.

So, what is happening to the yen? The answer lies not in Japan but in the U.S. USD/JPY is strongly correlated with interest rate differentials between the U.S. and Japan. As U.S. inflation has surprised to the upside, Fed rate cut expectations have decreased and rates have risen anew, acting as a tailwind for the USD vis-à-vis the JPY.

We think the yen could appreciate substantially in the coming months. Not only is the yen very cheap, currently trading at a 48.6% discount to Purchasing Power Parity fair value, but further rate moves by the BoJ and potentially lower U.S. interest rates, could give a boost to the yen.

Portfolio Actions

We made changes to a number of our single stock portfolios in recent months, emphasizing quality, safety, and diversification characteristics at the portfolio level. We believe these tilts will help portfolios weather volatility in coming months.

We have for some time advocated for a diversified portfolio that does not overweight the magnificent 7 or U.S. stocks only. Our focus on global exposures across all asset classes – stocks, bonds, commodities, hedge funds, and private credit – paid off in April.

In a negative month for U.S. stocks, our global and income-seeking exposure fell less than the market. Private credit and hedge funds were positive for the month. While the interest rate risk we added late last year and early this year detracted from returns in April, already in May we see that reverse and continue to believe it will benefit portfolios later this year.

DISCLOSURES

The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.

This material represents an assessment of the market and economic environment at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred.  Returns do not include reinvested dividends.

The MSCI China Index captures large and mid-cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 738 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalization.

Diversification does not guarantee a profit or protect against a loss in a declining market.  It is a method used to help manage investment risk.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

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Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments are often sold by prospectus that discloses all risks, fees, and expenses.  They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain and should not be deemed a complete investment program. The value of the investment may fall as well as rise and investors may get back less than they invested.

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