There is already talk of a Santa rally, a reference to work done by Yale Hirsch (a market analyst), who in the 1970s coined the phrase to describe the tendency of the equity market to finish the year strongly. The original work referred to the last ten trading days, but just like the way Christmas decorations fill up the shops earlier every year, so it would seem the ‘Santa rally’ concept has now crept into November for market pundits. Whatever the reason, it was another good week for both equity and bond markets, with gains across all the major markets. November is currently on course to be the best month of the year, although oil didn’t get the party invite and finished lower again, even after a significant bounce on Friday. The Pound strengthened towards 1.25 against the Dollar, eating into the gains of some of our unhedged overseas assets.
Sticking on the Christmas theme, the primary reason the market rally continued last week was probably more about the early present the Federal Reserve received with the release of October inflation data. Whichever measure of inflation floats your boat, they all pointed lower, and crucially more than was expected.
Just as I am told the Eskimos have more than twenty words for snow, the same is now true for US inflation – along with many others there is;
- Trimmed Mean – From the Cleveland Federal Reserve: excludes the biggest outliers in either direction and taking the average of the rest
- Sticky Price – Atlanta’s Fed index: covering goods and services whose price is difficult to reduce and takes time to move
- Core – excluding volatile food and energy prices
- Supercore – currently beloved of the Fed, which takes only services and excludes shelter.
I am guessing the Fed loves the last one because it is the lowest reading, but leaving aside my cynicism (it is nearly Christmas after all), all are moving seemingly inexorably toward the 2% target. That was emphatically good news and suggests that the optimism that US rates have peaked, is not misplaced.
We also got some good news on UK inflation, with CPI here falling to 4.6% from 6.7% in September. Much lower than expectations but probably more due to base effects (high numbers from a year ago dropping out of the calculations). Working against these disinflationary forces is the strength of pay growth, but there were more signs in the numbers that this may be on the turn, offering another source of reassurance for the MPC. The Eurozone also showed up to the party, now boasting headline inflation below the US at 2.9%, the lowest since July 2021. The 1.4ppts drop in inflation was the second largest on record and built on the 0.9ppts fall in September! Again, this was largely as a result of base effects, but there were really encouraging signs, including food inflation dropping much faster than expected.
As you would expect the bond markets loved the news, with yields heading down sharply, the US 10-year finished below 4.5%, and UK Gilts were in touching distance of 4%. There have been big moves in yields since the auspicious Fed meeting at the beginning of the month, where J Powell seemed to suggest interest rates were unlikely to head higher. Big moves typically take time for investors to digest, so I don’t think we should expect the big drops to continue much more this year. However, if three months ago you had offered me the chance to see US 10-year rates below 4.5% at the end of the year, I would have bitten your hand off.
There is definitely a consensus belief that bonds offer a good bet over the next twelve months. According to the very recent Bank of America survey, there have never been more fund managers expecting yields to fall next year.
You might take that positively and perhaps with such a high number it will become a self-fulfilling prophecy – as after all these are the guys that buy a lot of the bonds – but it does set my contrarian antennae twitching. Perhaps I have been waiting so long for inflation to be properly tamed I am just reluctant to believe that it has actually happened!
Certainly, investors now believe that the next move in US interest rates will be down, and the narrative has completely changed from ‘higher for longer’ to ‘not so high for not so long’ and, whisper it carefully, but talk of a soft landing is back on the table. Bloomberg produce a chart on interest rate probabilities which I have surfaced here, and you can see the pronounced shift in expectations from September 20th (the blue bars) to November 14th (white). If forecasts are accurate, it looks like we might now see the first cut as soon as March of next year and there is zero belief that rates will head higher.
Assuming each cut represents a 0.25% move (I can’t see the Fed cutting more than that in one go), that would equate to a drop of 1.25% next year, and in the grand scheme of things that’s no more than a gradual easing of policy. That’s significant and tells me that it is concurrent with a modest slowing in economic activity. If bigger moves were expected, then that would be more suggestive of a looming recession. So, my simple conclusion is that we have once more priced in a soft landing which probably explains the rampant equity markets.
If we are truly to get to enjoy a proper Santa rally late into the year end, much now rests on the soft-landing narrative holding, and I think it probably will for the next few months. Then, I suspect, the focus might start shifting from, is the economy too hot to avoid more rate cuts – to – is the economy going prove strong enough to avoid a recession? But that’s a question for next year after we get a few more economic data releases. Corporate America, through the latest earnings results and forecasts, has already flagged a slowdown and a sluggish consumer as the primary concerns for next year.
AQ Model Portfolio Changes
As you know, we revisit the asset allocation and fund selection every two months and at the latest November Investment Committee we decided to increase our exposure to risk assets.
From Q2 onwards this year, the risk profile of the AQ portfolios had been moved towards the bottom end of our target range, with cash higher than normal, equity exposure lower and duration in our fixed income weightings a little shorter. This ‘risk off’ approach has worked well, particularly in the October sell-off. But at the start of the month, following some downside surprises in the inflation data, better earnings reports than analysts expected and a change in central bank rhetoric, we became more optimistic for the short-term outlook for risk assets.
Experience has taught us the dangers of getting anchored to a defensive narrative when markets take off, and we believe when the facts change, we should change our minds. We have therefore reduced our cash weightings in favour of equities and extended the duration in fixed income. The net effect is a significant increase in the risk profile of the models, although it should be stressed this only places us back to slightly above neutral, which is typically the position on the risk curve we are happiest to occupy over the long term.
UK Weighting Increased – finally grounds for hope!
One of the significant moves in November was to increase our UK exposure, but also specifically to increase both mid and small cap UK equities. We had been underweight for the last couple of years, a move that had served us well, but we felt that this sector of the market had now become extremely unloved relative to large caps and that there was room for this trend to reverse. The UK equity market is extremely inexpensive on valuation metrics relative to other world markets, so in effect; we are simply buying the cheap sector in the cheap market.
For so long UK equities have disappointed, probably for sound economic reasons, but the softer-than-expected CPI data for October strongly suggests that the Bank of England may have already sufficiently tightened its monetary policy. This development has also led to a scenario where UK base rates surpass the CPI, marking the first instance of positive real interest rates in many years and aligning the UK with other major economies. While this doesn’t necessarily predict a robust surge in economic activity, it does indicate that current market valuations might be excessively gloomy. Additionally, recent media reports hint at potential significant updates in the upcoming budget speech regarding pension and ISA regulations, aimed at boosting investment in the UK’s equity market. These factors collectively diminish the UK’s standing as an economic, political, or inflationary anomaly. This shift could alter the prevalent negative perception of the UK economy among asset allocators, who have shown reluctance in acquiring Sterling-denominated assets, particularly post Brexit.
It raises the intriguing prospect of witnessing a gradual reduction of the discount currently imposed on UK-focused assets. I can still just about remember when the FTSE 100 outperformed the World Index from 1988 to 2003, but for the last twenty years it has been the sick index of the developed markets. Maybe, just maybe it might be time for a reversal.