Got nowhere to run to, baby – nowhere to hide!
Author: Tom McGrath – Chief Investment Officer, 8AM Global
Market Review
Now, you might wonder why this weekly missive is named after a classic Motown number from Martha Reeves & The Vandellas, but if you look at the moves in the financial markets last week, you should get the gist. Almost everything was down across all geographical equity regions and asset classes, although gold did nudge a bit higher. With representatives of the Federal Reserve showing no urgency to reduce interest rates, the S&P 500 ended its five-week winning streak. Treasuries and investment-grade bonds also declined despite a favourable inflation report on Friday that briefly lifted bond prices.
The week was filled with significant events, including lacklustre Treasury auctions that sent bond yields whipsawing, a glitch in live pricing for the S&P 500 index, an ‘OK’ US inflation number and a guilty verdict for former President Donald Trump. These developments contributed to market volatility, and for the first time in a while, the ‘naysayers’ or disbelieving bears looked less contrarian. Still, let us not lose sight of the fact that May was another good month for equity investors, with many regions setting all-time highs during the month.
It looked like it was shaping up to be a poor finish to the week after we got news that Euro area inflation had accelerated more than expected in May, rising 2.6% versus expectations for 2.5%. A measure stripping out volatile components like food and energy also surpassed expectations by quickening to 2.9%. German Bund yields rose to their highest level in over six months. It is worrying, but the ECB has been clear that they expected the journey down to their 2% target to be choppy. They are nevertheless still likely to reduce the deposit rate from its current record high of 4% next week, moving before either the Fed or the BoE.
After the disappointment in Europe, all eyes turned to the big event of the week: the release of April’s inflation data in the US, where we finally got some good news, although you must go out to 3 decimal places to find it! The Federal Reserve’s preferred measure of underlying US inflation, Core PCE, rose by 0.249% from March, versus 0.25% expected. Inflation-adjusted consumer spending fell by 0.1% due to reduced spending on goods and softer services, and wage growth also slowed. It took a while for the good news to sink in, but in the final hour, we got a surge higher from the Dow Jones and the S&P 500, but the Nasdaq remained in negative territory.
The lag in the Nasdaq was unusual, to say the least, countering everything we have seen so far this year, as big tech and high growth stocks sold off, whilst cyclical and value stocks powered the S&P 500 higher. Investors betting tech giants will continue to drive gains could be in for a rough ride when other sectors start to catch up, according to strategists at Bank of America, who said the outperformance of value over growth as market breadth improves could be the next pain trade. That’s a brave statement, and I think I wouldn’t be in a rush to ditch my technology stocks in favour of ‘old industry’ after one strange day of trading.
Still, it was the first inflation report in a while that suggested things might be moving in the right direction. Households cut back on restaurant meals and recreation, and spending on goods decreased by 0.4%. With household debt at a record high and lower consumer confidence, high interest rates are finally starting to have the desired effect of curbing spending. While demand for workers remains strong, wage growth is slowing. Overall incomes rose by 0.3% in April, with wages and salaries increasing by 0.2%, the smallest gain in five months.
Don’t expect this to change the ‘higher for longer’ narrative any time soon, but J Powell will probably be sleeping a little easier this weekend. One man who you would think would not be sleeping as soundly is Donald Trump, now that he is officially facing a potential jail sentence after he became the first former President to be convicted of a felony. But these are extraordinary times indeed, and if the political betting markets are to be believed, the presidential election campaign shifted sharply in his favour during the trial. This is how RealClear Politics’ average of the probabilities of Joe Biden or Trump winning the election has moved since the beginning of last year, although I suspect it isn’t so clear cut.
Less than 18 months ago, Trump’s political future seemed uncertain after the Democrats’ successful midterms. Despite facing four indictments and a six-week trial in New York, his progress has not been hindered; it may have even been bolstered. Biden’s resurgence post-State of the Union has not dampened Trump’s support, with bettors now giving him a slight edge of over 50% chance of victory. The betting markets and Wall Street figures like Bill Ackman are increasingly backing Trump, reflecting a widespread belief in his potential win. However, the situation remains fluid. Biden, who is currently being blamed for the higher prices, could still turn the tide, especially with the costs of gasoline and food price inflation falling. The www.fivethirtyeight.com polls I follow show a narrow margin of +1.2% in Trump’s favour.
In the last few weeks, we have seen the various market experts, fund manager groups, and investment banks begin speculation about who will win and what that means for markets. As we near the election, expect this only to increase. So far, it would seem that they do think Trump is going to win and that this could be good news for equity markets, less so for bonds, but that much rests on whether the Republicans can also win Congress, as well as the Senate, which looks like a done deal. Here, the Democrats hold the slimmest of leads in the polls. Either way, the size of the national deficit will impose strict fiscal constraints on both parties, so don’t expect any wild tax cuts or national spending programmes. Instead, expect foreign policy changes and an increase in tariffs from both parties.
UK
It is now just over a month before we go to the polls in the UK, and so far, equities and gilts have mostly traded sideways since the announcement of the July 4th election. It still looks like a Labour shoo-in, and strategists have been speculating that a new government could bring stability and remove a longstanding political overhang on the markets. Regardless, markets are pretty relaxed about the election because the outcome seems near certain and the economic and fiscal policies of the ruling Conservatives and Labour are expected to be similar.
With the promise of political stability and the return of global investors, the UK market holds significant potential for high returns. This is evidenced by the following chart, which illustrates a market with attractive valuations, high dividends, and robust buyback policies. These factors, combined with the current political climate, make the UK a compelling investment opportunity.
With nowhere to hide – what’s our positioning?
I will finish this week’s missive on the same note as I started, as last week’s symmetrical move lower in bonds and equities highlights the challenge ahead for multi-asset investors. Once upon a time, back in the good old days, we multi-asset managers could rely on a decent inverse correlation between equities and bonds – when one fell, the other rose. Still, we have entered a period where we expect to see the two primary asset classes move together. The 50-day correlation between the iShares 20+ Year Treasury Bond ETF and SPDR S&P 500 ETF has been positive for ten months, the longest stretch on record. The reason is simple: neither likes inflation, and both would welcome rate cuts.
Unfortunately, recent data suggests the inflation genie isn’t quite ready to hop back in the bottle, and much mischief can happen before it does. Investors are once more grappling with the reality that interest rates will likely remain high for the foreseeable future. If that is the case, Bonds will not offer the inverse correlation of yore, and fund managers will have to seek stability and returns elsewhere. The good news is that cash as an asset class is finally delivering meaningful returns, which are now in excess of inflation. Some absolute return fund managers are also really getting their act together and delivering positive returns with little or no correlation to either equities or bonds.
The chart shows the year-to-date performance of various bond sectors versus cash and the absolute return funds we currently favour. So, whilst the traditional 60-equity/40-bond portfolio might be under the threat of persistent inflation, there are still places to hide, and we have our fixed income exposure just about as low as it has been in favour of cash and absolute return.
Next week is all about the ECB – let’s hope they are the first central bank to cut rates and pave the way for others to follow.
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