The year started off fine and seemed to play to a cautiously bullish outlook vs 2022. January and February displayed all the signs of a risk-on rally. Activity data across the US and Europe (as represented by Composite PMI releases) showed a rebound while falling energy (especially oil) prices provided a good backdrop on the inflation front. Geopolitics remained, and still remains, the only constant with limited signs of progress. The table below shows performance by Asset Class and Style. On the face of it, nothing unusual – in fact an exceptional quarter:
Then we went into March and things started to break around Banks – specifically the small to mid-sized banks in the US. For the first time, we witnessed the impact of rising interest rate hikes in other parts of the economy. For a while now analysts have been asking where the next impact will come from and, in the US, we witnessed it in the form of Silicon Valley Bank (SVB) which saw rapid outflows of depositor monies and its inability to meet these outflows due to unrealised losses on its asset holdings (mostly government securities).
If the Fed-FDIC-Treasury bailout hadn’t come to the rescue, SVB’s liquidity crisis would have fast evolved into a solvency crisis – with profound consequences on the wider market. SVB was not the only Bank to face issues – Signature Bank and First Republic Bank were also in the same group. Worries the resurfaced about Credit Suisse and subsequently Deutsche Bank - though the latter two proved unfounded. In fact, the Swiss Central Bank came to Credit Suisse’ rescue and eventually it merged with UBS to form an entity even bigger than the Swiss CB!
The chart below shows what happened across S&P 500 sectors in March:
If the bailout measures mentioned above had not happened, we would be looking at a very different picture (i.e. carnage). For Q1, the S&P 500 delivered 7.5% while NASDAQ delivered over 15%. Seven mega-cap US tech stocks accounted for over 90% of the indices' rally:
Headline inflation continues to edge its way down and food price inflation continues to moderate. As a result, we have witnessed a gradual decline in the Headline (or Nominal) inflation rate which has brought comfort to Central Bankers. That said, Hawks on both sides of the Atlantic, still seem to be shouting the loudest for further rate hikes. The latest Banking crisis might bring moderation sooner than expected – we will just have to see. All in all, it has meant a good outcome for Fixed Income brought on by a flight to safety following SVB et al as the chart below shows:
A roundup of other releases shows a reasonably stable picture:
Service activity PMIs remain buoyant
Employment data has been robust
Spending is holding up as displayed overall via the retail sales data
Wages are rising modestly but not at a pace that threatens core inflation. That said, core inflation remains persistent and it is concerning the drop in headline inflation is not matching the drop seen in energy price inflation – a key component of the headline rate
The UK continues to outperform economists’ and analysts expectations but it does still remain one of the weakest in the G7. The Bank of England (BoE) raised rates 0.25% but gave its strongest indication yet further rate hikes are not a done deal. From its wording, it is keeping all its options open and will not sacrifice its inflation targeting over anything else. That said, it keeps a very watchful eye on some 40% of fixed rate mortgages that reset by year end
In Europe, activity remains robust driven by services while hawks, at the ECB, argue for more rate hikes. Inflation there also continues to decline. Manufacturing has been hit due to Russia and, until now, the lock down in China as well as rising input costs. However, services remain buoyant and in expansion territory though one area of concern has been the national strikes and protests in France and the lagged effect this will have in subsequent data releases
The complete U-turn over covid policy and lockdowns has been welcomed and is already starting to come into effect as the economy picks up – albeit at a much slower than expected pace. It still faces headwinds from soft, overseas demand and nervous Chinese consumers in the immediate aftermath of covid easing. That said, credit growth is picking up and monetary policy remains fairly loose
Last quarter (Q4 2022 and Q1 2023 Outlook) I spoke of very attractive valuations. These remain so. What we have now is a cautious calm that has set into markets – declining nervousness over banks combined with buying opportunities driven by low valuations and signs of a pause in rate hikes. The chart on the left looks at valuations (12m Forward PE ratios) by Region and the one on the right by Sector/Style.
Compared to last time, the US & Europe have become a little more expensive while the rest have become cheaper. This is where economic context becomes key. We have:
Still rising but slowing headline inflation
Persistent core inflation
A clear slowing down in rate hikes – with the possibility of rate cuts
A cautious calm in the Banking sector
Risk-on starting to set in again (favouring assets that have suffered last year (equities and corporate bonds)
A slow selling-off in the US$ in favour of virtually all other currencies. The US$’s trade-weighted index (i.e. its index measured against a basket of other leading currencies) has been slowly reversing
What does this mean for portfolio positioning?
To an extent, there is room for a revival in growth names. As shown above, these fell heavily last year and, to most investors, these remain the favourite / preferred investment route. The only caution I would sound with this is that the opportunity cost of capital still remains high. In turn, this impacts valuations. The days of cheap money (low inflation/disinflation, low rates, endless money supply printing) are over. Now, money has a value to it – that is evident from rates that can be earned on deposits and in Money Markets. As a result, the yardstick by which these are measured became more stringent seeing as these same growth stocks can’t keep generating high, double-digit growth.
There is good value in stable, growth securities i.e. securities that can repeatedly generate earnings year in, year out with the ability to pass on cost increases through higher prices. These have underperformed their pure, growth counterparts and comprise a range of sectors.
From recent policy action, OPEC+ is determined to support energy prices when they reach a floor. With time, as China’s economy gains traction, energy demand will pick up. Hopefully, as world demand gains, so too will world energy demand. This makes commodities, especially the energy complex, attractive.
A slowly declining (correcting not collapsing) US$ means non-US$ currencies become more attractive as do commodities (they share that inverse relationship with the US$)
Bonds – which have rallied hard of late on both rates pausing talk as well as flight to safety action – still have room to go higher while offering respectable yields (income). The fixed income chart above demonstrates this.
On the geopolitical front, as always, there is plenty to digest and be nervous about. The Ukraine crisis doesn’t seem to show any signs of easing, Finland has now been accepted into NATO, the Chinese have been carrying out war games around Taiwan – but most interestingly, attempts to offer an alternative to the US$ as a means of exchange are stepping up with BRIC nations (and others) accepting financial settlement in non-US$ currency, specifically their own – mostly Yuan. At Davos, there was even talk of a BRICs currency pegged to gold. Gold has clearly risen strongly – but mostly on the back of talk about inflation and especially rates coming down. The argument goes that as rates come down, the opportunity cost of holding gold becomes less making the yellow metal more attractive. Furthermore, if there was an all-out financial crisis with even more banks displaying distress, then gold is the go-to currency.
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