Q1 2024 Review

After a shaky start in January, equity markets regained the mojo they finished last year with, and it ended up being a very good first quarter of 2024 for risk assets. Many of the world equity markets have hit successive new highs, commodities have rallied and even Gold has broken into new territory. Our own FTSE 100, whilst still lagging most of its global peers, is making a charge toward the 8,000 level and maybe it will break through convincingly over the next quarter. Only the bond markets have disappointed, with prices falling modestly as yields have backed up to levels seen in November of last year. The fly in the ointment is that inflation is proving a little stickier than hoped for. Sentiment, rather than easing monetary policy, seems to be the primary factor keeping the rally going, as the bullish narrative that took hold last November has remained in place. Surveys of both private and institutional investors point to a strong belief from investors that there is money to be made from equity markets and cash has flowed out of deposit accounts and in to shares.

In terms of sector performance, US exceptionalism has continued over the first quarter led by Tech and the charge of AI related companies, with Nvidia at the helm, although it is worth noting the pace of gains has slowed a bit in the last month. Japan has also been on a tear, with the Nikkei 225 breaking through 40,000 for the first time in over 30 years. The European bourses have also been making good gains, led by their own version of the Mag 7, the GRANOLAS — an acronym coined by Goldman Sachs, of Europe’s biggest companies by market capitalisation, namely – GSK, Roche, ASML, Nestlé, Novartis, Novo Nordisk, L’Oréal, LVMH, AstraZeneca, SAP and Sanofi – which over certain time periods have even outpaced the American Magnificent 7 equivalents.

Bringing up the rear of Q1 equity returns have been the UK, Asian and Emerging Market sectors, although they still made meaningful gains, only the fixed income sectors struggled.

As alluded to earlier, the main reason for the move seems all about a bullish investor mindset, as the Goldilocks scenario is not quite playing out as it had been supposed to. By now, according to December estimates, we should have seen Central Banks begin the process of cutting rates, but that still seems quite a way off. The reason why interest rates aren’t already falling across the developed world, is that inflation hasn’t obediently fallen as expected. It’s not surging either but seems to be lurking at a disappointingly high level and, at the time of writing, we can’t see that changing much when the numbers for March are released. Core inflation is expected to be virtually unchanged, but this might be an optimistic take as the recent move higher in oil prices and soft commodities is putting upward pressure on headline inflation.

So if last year’s Goldilocks (1) narrative is being challenged as it most certainly is by bond investors, with yields backing up above 4% on ten-year Gilts and heading towards 4.5% for US Treasuries, why has the bullish disposition of equity investors remained intact? I think the answer lies in the strength of the global economy, not just in the US, as we are seeing economists becoming more optimistic for the UK, Europe, and even Asia including China. With a stronger economy and stubborn inflation, comes higher nominal GDP growth and that is great news for corporate earnings and profitability, especially if productivity gains (perhaps assisted by AI) can continue to improve.

It is just possible that a new 2024 Goldilocks (2) scenario is forming in the mind of investors. One where we don’t necessarily see lots of rate cuts and a soft landing, but rather a stable rates environment accompanied by an acceleration of economic growth and an uptick in corporate earnings, similar to the mid to late 1990s. Remember, equities enjoyed an exceptional run higher throughout that period, even with rates held around the 5% mark and with comparable P/E valuations.

Outlook

US Monetary Policy

Looking first at monetary policy, if the futures market, as gauged by Bloomberg’s World Interest Rate Probabilities function, has it right, we should now expect only two rate cuts from the Fed by the end of 2024, with a 50/50 shot of a third. Events in US monetary policy matter for everyone else. With the Fed staying higher for longer, it grows harder for other central banks to cut without weakening their currencies against the dollar. Much now rests on the economic data releases we get over the course of the year and specifically those covering the jobs market and inflation. Compounding the problem of forecasting the direction of interest rates is the fact we have a US Presidential vote in November and that the ‘election season’ is now only a few months away. The Federal Reserve cannot be seen to be a political animal, so it will most likely resist any cuts from August onwards for fear of being accused of favouring the incumbents with an economically stimulative move.

So far, J Powell has signalled to the markets that the Fed are still looking to cut rates unless the data suggests otherwise. The February inflation data was just about within tolerable bands to allow them to cut, but they will probably want to take a closer look at the March, April and May reports before they move, with the earliest expectation for a cut in June. The UK and ECB will probably see further confirmation of inflation falling over the next few months and they will arguably both be in a position to cut ahead of the Fed. The question is if they will have the courage to break ranks first and cut ahead of the Fed as they probably should.

Monetary policy has largely dictated the direction of both the bond and equity markets over the last few post pandemic years. Bonds and equities fell as rates went up and then rose on the expectation that rates would come down, so the performance of financial assets is likely to remain closely tied to policy moves. Coming off the fence that I typically inhabit, I think we will see one rate cut from the Fed before the November elections and possibly one or more from both the BOE and the ECB and that this will be enough from a policy perspective to appease both equity and bond investors, but there is a big caveat, in that we need to see the Oil price stay broadly flat from here. Any Oil spike would probably undermine the case for early rate cuts, although conversely it could bring more rate cuts in to the equation further out as a high cost of Oil is ultimately a drag on economic growth.

US Fundamentals

Over the long term, earnings are the most significant driver of stock market performance, much more so than the vagaries of monetary policy. Providing corporate earnings can deliver this year, then I think after a period of turbulence, the market will get over the sparsity of rate cuts and finish the year significantly higher than it currently is. The chart from Bloomberg, underpins a very healthy outlook in projected profits for Big tech and where Big tech goes, so typically follows the market.

In terms of the broad US equity market, looking ahead, analysts expect (year-over-year) earnings growth rates of 9.4%, 8.5%, and 17.5% for Q2 2024, Q3 2024, and Q4 2024, respectively. For the whole of 2024, analysts are calling for (year-over-year) earnings growth of 10.9%.  In terms of valuation, the forward 12-month P/E ratio is 20.5, which is expensive but completely justified if we are entering a period of economic growth with improving productivity. So, whilst rich, we think valuations are sustainable if earnings deliver as expected.

The reason the economy is so robust is that American consumers are doing what they do best – they are buying goods and services, with the consumption of services especially strong. Remember consumption accounts for nearly 70% of nominal GDP in the US and there was much talk that this was being sustained only by dwindling Covid savings. We think enough time has passed for this particular argument to have run its course and it seems more likely that consumption is being maintained from higher wages and the comfort of job security.  We have also been suggesting for some time now that there is another factor at work, largely ignored by market commentators, and that is the trickledown effect from the asset rich retiring Baby Boomer generation. This cohort is the richest generation of senior citizens in the history of the United States and the oldest of them turned 65 during 2011. Since the start of that year, the population and labour force of seniors (65 years old and older) increased dramatically and that’s a lot of seniors who are no longer working. Presumably, most of them are retired and are no longer saving, but rather spending their retirement savings and/or the income it generates.

Thanks to all the retired and retiring seniors, spending on air transportation, hotels & motels, food, health care and funeral services (we all die eventually!) have all been soaring to new or near record highs. That’s because seniors are traveling more, dining out more, and visiting their health care providers more. As a result, payroll employment in all these industries continues to rise to record highs. Much of their wealth is also moving down to the next generation who are also becoming more willing to consume, as they are gifted money, inherit money or merely spend on the anticipation of receiving it. To put the figures into context, the entire Covid stimulus response by the Fed was put at $5 trillion, whereas the baby boomers estimated net wealth is around a staggering $75 trillion and that can move any economic dial. To my mind, this helps to explain the resilience of the economy and why there hasn’t been a consumer-led recession over the past two years, as was widely feared.

Why US Economy Might Surprise to the Upside (GDP 2%+) …

High job security and plentiful job openings should prime consumer spending, this is bolstered by rising wages and high levels of savings and personal income ; American households’ record-high net worth and diversified assets, including significant liquid assets, provide a solid foundation for increased investments in bonds & equities ; Lower mortgage rates are coming which could revive the housing market, which can stimulate related retail sectors, supporting broader economic growth ; Record-high corporate cash flow, despite cost pressures, demonstrates corporate resilience ; Investment in technology to enhance productivity is at an all-time high, Generative AI is already making a difference, signalling a potentially strong productivity cycle that could boost earnings and help reduce inflation.

UK

There has been a lot of doom and gloom surrounding the outlook for the UK economy since the Brexit vote, but we are not alone in sensing a more upbeat tone of late. We doubt if the new £5k British ISA is going to suddenly reverse the fortunes of our domestic market, but it is at least a start and if nothing else improves sentiment. The economy is finally expected to grow at a low baseline of about 0.5%, but according to Bloomberg analysis the expansion could accelerate to as much as 1.9%. While that’s hardly boom times, it would be enough to push Britain towards the top of the G-7 table

Although the optimism is yet to feed through into our listed equity markets, it would appear that business investment is on the up thanks to government policies that allowed companies to write off first 120% and then 100% of capital expenditure. In fact it has grown faster than any G-7 nation since the tax relief was introduced in April 2021. Irrespective of the result of the next election, which still looks like a Labour shoe-in, both Sunak and Starmer are very pro-business and looking for this route to grow the economy. Longer term, the artificial-intelligence revolution promises a more fundamental revival as the technology plays to the UK’s strengths

The big picture for the economy isn’t that bad, unemployment continues to hover at historically low levels, with wage growth outpacing inflation for half a year. The Bank of England (BOE) predicts that living standards are set to improve in the years 2024 and 2025. According to the central bank, household financial health is at its strongest since 2002. Furthermore, businesses have significantly cut down their debt levels, and banking institutions maintain robust capital reserves.

So, when we think about the valuation placed on UK equities, which as we all know is showing a huge discount to other markets not just the US, it does look cheap enough to entice some buyers. Now, cheap can always get cheaper, but we are seeing a large uptick in M&A activity with bids coming in at significant premiums to current share prices. Perhaps it is just wishful thinking, but this could be the catalyst we have all been looking for and I think there is a growing argument and willingness for global investors to revisit the UK market.

Why UK Economy might Surprise to the Upside

A decline in interest rate expectations has already led to lower mortgage rates, with the Bank Rate cut expected in June rather than November ; There is an improved outlook for house price growth, with forecasts now showing an increase rather than a decline and we all know how sensitive UK consumption is to how well the housing market is doing;  Fiscal policy could play a key role, with the possibility of another tax cut before the election;. if world growth is stronger than expected the UK will get dragged along

Europe

Although Europe has often been the ‘go to’ region for investors when an economic upswing is underway, largely through the cyclical exporting prowess of Germany, I am not sure it will play out that way this time. In fact, the Eurozone economy might be the region to disappoint going forward as even though inflation is set to decrease, the ECB might delay lowering interest rates, as they probably will not want to move ahead of the Fed. The big hit from last year’s high energy prices is mostly over and while government spending helped lessen this impact, the benefit of lower prices now is being cancelled out by stricter government budgets. Moreover, these budgets are expected to get even tighter.

Household incomes aren’t likely to increase much, as job growth halts and wages rise more slowly. That said, as is the case in the UK, the consumer is at least getting more upbeat about the outlook albeit from a depressed base and maybe this increasing optimism will allow them to spend more than we currently think.

UK & Eurozone Consumer Confidence

Investment looks weak too, especially in construction, as the housing market slows. Businesses also seem less keen to borrow money for investing, given that factories aren’t running at full tilt. European companies have also noticed they’re not doing as well overseas, with exports dropping recently. So, it is likely that exports might stay low this year, but they could rebound as the world economy picks up in the next couple of years.

Putting all this together, we expect the economy to grow slowly, lagging behind what others and the ECB predict, as the government keeps a tight hold on spending and as changes in the population start to affect the workforce more. Eventually, easier monetary policy might help, but the ECB is likely to start lowering rates cautiously, and not before June. The job market is still strong, which complicates things and while the general inflation rate might reach 2% this summer, the underlying inflation rate could remain high for a while longer as wage increases materialise. On valuations, while there are individual mega-caps that look expensive to us, overall the historically modest valuations on display in Europe’s stock markets mean we still see upside potential, even after a strong opening quarter for the region’s indices. European stocks remain favourably priced versus international stocks, most obviously versus the United States, where the 13.8x earnings for the MSCI Europe Index compares to a 20+ multiple for the S&P 500 Index, a near-30-year relative low

China

China’s economy has recently seen improvement, partly thanks to government support, but the outlook for the medium term remains uncertain. The economy has gained momentum, especially in manufacturing, but service and construction sectors are lagging. Short-term growth prospects are modest due to a weakening job market and falling house prices, making significant increases in consumer spending unlikely. Government policies, particularly in investment and fiscal support, are currently driving growth, however, these measures are most likely temporary fixes. The property market shows signs of slight recovery due to eased regulations and improved affordability, but consumer confidence in the real estate sector is low.

Perhaps the most compelling reason to look at China is not from an economic growth perspective, but more from a valuation opportunity. The Chinese equity market has massively underperformed not only the US, but also other Emerging Markets especially the runaway Indian equity market. We have seen instances of this occurring before, typically followed by some degree of mean reversion and there is reason to believe we could see China catch up lost ground. Remember growth may be slowing, but it is still much higher than the developed world and company valuations are cheap by all comparative measures.

Japan

At its March meeting, the Bank of Japan (BoJ) made a historic decision to end its negative interest rate policy, which had been in place for eight years. This move, coupled with unexpected wage increases from recent labour negotiations, suggests that Japan’s long battle with deflation might be ending.

The BoJ has shifted its strategy, moving away from its yield curve control policy to focus on short-term interest rates, now targeting a rate of 0% to 0.1%. It also announced the end of its program to buy exchange-traded funds (ETFs) and Japanese real estate investment trusts (J-REITs), along with a plan to reduce its purchases of commercial paper and corporate bonds over the next year. However, it will keep buying Japanese Government Bonds at a rate of about ¥6 trillion monthly to prevent a quick rise in long-term interest rates. Despite these changes, the BoJ’s stance remains cautious, especially with core inflation at 3.2%, indicating the economy will still experience negative real interest rates for some time. The stop of ETF and J-REIT purchases was expected, as significant buying hadn’t occurred recently, and there’s no plan to sell off current holdings.

Wages in Japan are on the rise, with this year’s spring labour negotiations suggesting increases between 3% and 4%, indicating growing inflation from within the economy. This supports the BoJ’s move and signals a shift towards normalizing policy, with more rate hikes anticipated by the end of the year. This marks a significant step away from Japan’s deflationary past. There are also signs of changing behaviours among Japanese households and companies, indicative of a shift away from a deflationary mindset. This includes strategic acquisitions by Japanese firms abroad, increased capital expenditure, and evolving investment behaviours in the household sector, highlighted by the recent changes to Japan’s Nippon Investment Savings Account program.

In summary, we think there is enough good news and momentum to conclude that the outlook for Japanese equities remains positive, helped by ongoing improvements in corporate governance and a transition from deflation to inflation. Despite recent gains, Japanese stock valuations remain attractive, and any short-term market pullback could present a buying opportunity, reflecting the positive structural changes in Japan’s economy.

Conclusion

Quite how long it takes for investors to get over the disappointment of a more subdued rate cut environment remains to be seen and we suspect that this may lead to heightened volatility over the second quarter. But once we clear through, we can find reasons to be more constructive on the outlook for equities in a more traditional way, by which we mean economic growth and rising corporate profitability. We do still expect to see inflation behave itself and come down very gradually and we think that this will allow central banks to still cut rates, even against a backdrop of improving economic growth. That probably means we will not see aggressive interest rate cuts, but we are always much happier with a market driven by fundamentally good news (economic expansion & rising corporate profits), rather than being driven by policy expectations (interest rates being dropped to combat recessionary fears).

If we are right about the big picture, then it will be good news for stock markets, and I think equity markets might even get through the second quarter on an upward trajectory, especially if we get a strong US Q1 earnings season. If we are wrong and we don’t get any cuts, then we think the key question is whether the Fed is ready to cut rates if we get a weakness in economic data. And the answer to that question still remains a definite yes. That keeps the Fed ‘Put’ in place which should continue to support risky assets.

We are less sanguine about the opportunities from the mandatory fixed income exposure within the portfolios. That said, most bond markets now offer a decent yield of more than 4% which, as we saw in the first quarter, should at least ensure these investments are stable from a total return perspective. There is also an outside chance that inflation falls away quicker than expected, particularly in the UK and Europe and that more rate cuts occur as a result. If that were the case, then bonds could offer not only a decent income but also register some capital appreciation.

A note of caution though, equities are expensive and there is still a chance inflation could reignite especially if we see some exogenous shock to the Oil price, most likely from an escalation of tension in the Middle East. If a rise in Oil is driven by increased global demand through economic strength, markets could probably live with that, but a sharp shock would put rate cuts on hold and challenge the expensive valuations of markets.

Again, finishing this quarterly report on an upbeat note as we like to do, we have updated the following chart from JP Morgan which puts the recent bull market in context. There have been a wide array of lengths and returns from US bull markets over the last 70 years, but the average length has been 65 months and the average return has been 184%. So far, this current bull market is only 17 months in length with a return of 41%, suggesting that it could still have quite some way to run.