Note Apr. 21 2024: Q2/2024 – Capital Markets Sketch Change – In late April 2024, exogenous and internal facets underscore that capital markets have started to sketch change. It will likely be abrupt and rocky. Amid a massive election period and tepid global growth, outright physical and trade wars exist. A missed opportunity worldwide has been that of reducing fiscal lax. Diversification in asset allocation is called for, including cash and precious metals. Quality parameters such as valuation count across equities. Federal Reserve and other central bank positioning as well as currency developments have us maintaining short to medium term in Fixed Income. Capital market risk premiums exist not because of precise knowledge but instead to compensate for known and unknown knowns. It is akin to overengineering in physical projects such as buildings, bridges and the like.
In exuberance over monetary largesse, compression of risk spreads in credit markets and elevation of equity valuation emerged on expectations of a central bank put. Amid a massive global election period and tepid 3% annual global GDP growth, the political temptations remain large for largesse and protectionism. Despite capital market contradictions and a prolonged lag, noteworthy are the rise of precious metals such as gold and of the U.S. dollar against not just the Chinese Yuan but also the likes of the Euro, Yen, Canadian dollar and Australian dollar. Capital markets have overstepped in attempts to incorporate expectations of several rate cuts such as in Fed Funds. Instead as corroborated by current data as well as a reading of experiences of monetary policy of the 1980s, major central banks appear espousing a steady stance.
Equity markets are at the cusp of releases and discussions of results. Momentum markets benefitted from a disposition to celebrate last consensus beats rather than valuation. Also contributing have been quantitative ease and concept euphoria in social media, climate change and most recently, artificial intelligence purveyors. Long term consensus estimates call for 10% + annual earnings growth in S&P 500 operating earnings. In 3% global annual GDP growth, steady interest rates and rising costs such as for energy, we would expect earnings potential to be closer to 5% per annum. Companies have been expressing caution and cutting expenses. At present valuations, volatility is likely to expand.
Momentum has dominated equities since the apex of the credit crisis in 2008. Hypotheses have emerged that not only productivity but also increased efficiency in capital markets would support lower than historical risk premiums. Still and even if ECB rates of 4% were used as benchmark and certainly versus U.S. Fed Funds of 5 ½%, equity risk premiums seem low. A minimalist administered rate argument did not work in Japan from the 1990s/2000s. We expect equity risk premium increases to percolate through geographic market, sector and individual security segmentation by market capitalization. Rather than value versus growth, preferences are likely to be for quality of operations and financial strength.
Communications Services we have underweight expecting restructuring driven by prior acquisition excess and greater regulatory scrutiny such as over cyber security. Consumer Discretionary is underweight on the view that while the U.S consumer has already performed leadership, Europe and Asia remain bifurcated and weak. Consumer Staples we have marketweight on as input costs weigh in and erstwhile emerging regions remain difficult. Energy we have overweight on the basis that legacy businesses in hydrocarbons remain attractive while business strength offers opportunity for expansion into alternate energy. Financials we have as overweight in favoring strong restructuring delivery amid net interest margin and commercial real estate challenges. Healthcare is overweight for us on valuation and in comparison to operating challenges in other defensives like Consumer Staples and high valuation in other growth like Information Technology.
Industrials we have overweight in cyclicals on the basis of rising defense expenditure potential as well as more efficient infrastructure in other consumer and manufacturing businesses alike. Information Technology we have at 25% cap for diversification amid several marquee companies have emerged with high valuations from the artificial intelligence euphoria. Materials we place as over weight on gold bullion and pressure metals for diversification amid potential currency market volatility. Seeming under estimated is the criticality of rare metals, even base metals and food. Real Estate we place at underweight with commercial real estate an especial challenge with industrial space being an opportunity . Utilities we place at underweight on project financing costs a potential challenge.
Asset Mix
In late April 2024, exogenous and internal facets underscore that capital markets have started to sketch change. It will likely be abrupt and rocky. Diversification in asset allocation is called for, including cash and precious metals. Quality parameters such as valuation count across equities. Federal Reserve and other central bank positioning as well as currency developments have us maintaining short to medium term in Fixed Income. Seemingly chronically overlooked, capital market risk premiums exist not because of precise knowledge but instead to compensate for known and unknown knowns. It is akin to overengineering in physical projects such as buildings, bridges and the like.
There has been a decade and half of exuberance over monetary largesse. Compression of risk spreads in credit markets and elevation of equity valuation emerged on expectations of a central bank put. Despite capital market contradictions and a prolonged lag, noteworthy are the rise of precious metals such as gold and of the U.S. dollar against not just the Chinese Yuan but also the likes of the Euro, Yen, Canadian dollar and Australian dollar. Currently it would appear that capital markets overstepped in attempts to incorporate expectations of several rate cuts such as in Fed Funds. Instead as corroborated by current data as well as a reading of experiences of monetary policy of the 1980s, major central banks appear espousing a steady stance.
At the interface between exogenous aspects and market internals, fiscal policies can hardly be presently classified as conservative. Instead as exemplified by the most recent U.S. Congressional Budget Office, large deficits loom over the long term. From the U.S. to Europe and Asia amid a particularly fraught and massive global election period, the political temptations remain large for largesse and protectionism. Similar pressures exist within the major command economies like China facing weak domestic growth combined with credit pressures already existent due to real estate overbuilding. Trade and tariff friction exist even among allies like Japan and the United States. In a marked contrast to the late 1990s/early 2000s, it appears expanding further. Country competition appears intense in newer technologies dependent on leading edge semiconductors and rare metals. Climate change and politics including wars appear exacting costs in crucial agriculture.
Alongside the misalignment of capital market expectations that expected strong central bank ease in 2024 has been political lax in taking advantage of conditions to cut credit era fiscal flab. Other political tensions exist of the south China seas and territorial disputes of many countries with China. They continue to accentuated defense demands. The war in Ukraine shows no sign of abating but instead appear to be boosting defense expenditure demands in NATO countries. The cauldron of the Middle East has been steadily expanding from Libya to Israel and the Palestinian territories to now overt counter blows between Israel and Iran. The trade and crude oil critical Persian Gulf and Red Sea have not been spared.
Meanwhile, capital markets have appeared to ignore the logistical, operating business and personal cost impact of crude oil at close to $80/Bbl. WTI or thereabouts. In prior periods, it would have led to measurable anxiety about spending to stubborn inflation. The U.S. consumer once more has provided yeoman service by expanding activity in the post Covid era. However, the immediately prior cycle and those to come require a robust consumer as well in Europe and Asia, especially China. Instead, bifurcated activities seem likely given the prior scenarios of the OECD and ADB on growth as well as that in the recently released April 2024 IMF World Economic Outlook of around 3% per annum global GDP growth for the next few years. The April 2024 IMF Global Financial Stability Report and other observations such as from the Bank of International Settlements and the U.S. CBO reports in March 2024 highlight debt risks over the medium to long term. These facets have appeared ignored during the erstwhile focus on near term monetary largesse but we detect change that is likely to expand risk premiums. Similar potential changes appear also indicated in the latest internal capital market parameters related to credit risk premiums and equity valuation, delivery and central bank policy.
At the asset level, the unleashing of a torrent of quantitative ease did result in salient effect. It came in monetary flows largesse alongside minimal administered rates from the likes of the Federal Reserve, the ECB and many others. It was also part of accommodative real estate expansion facilitated by the central bank in China. One salutary effect was one of real estate price expansion, equity valuation expansion and credit parameter compression to include sovereign debt including emerging markets as well as into junk corporate bonds. One impact may have been that of inducing complacency.
For a prolonged time until recently, usual stress indicators like currency markets and precious metals seemed becalmed. With the exception of some extremely stressed emerging country bonds, fixed income markets appeared in credit compression. In equities, momentum seemed to dominate with a causal effect of rapid switches from the likes of climate change to social media and most recently to artificial intelligence. The overall backdrop appears to have been an overwhelming consensus assumption that several central bank ease would again be in imminent ease of several tranches. Consensus until recently has in effect been in a replay of the central bank put assumptions that initially buttressed the post 2008 credit crisis recovery. Due to the global breadth of these assumptions, back and forth activity is likely between momentum and valuation across capital markets. Still, we expect capital markets to be sketching long term change.
Noteworthy is the recent concurrent price behavior of a sharp rise in gold and other precious metal prices and other currency weakness against the U.S. dollar. Still, continuation of extended equity and fixed income valuation strikes us as being contradictory. The former would indicate building uncertainty while extended valuations would indicate risk complacency. Rather than the market expectations of several imminent reductions, the Federal Reserve has not been the only major central bank to stress that containing inflation down to 2% per annum could mean stable administered rates for longer than consensus seems to contemplate.
In light of data and a history driven assessment, noteworthy developments have been the slippage of many currencies vis-à-vis the U.S. dollar. At the political economy level, tensions are likely to increase over trade and currency change. It would especially be so during a period of tepid global growth and political angst. Trade pacts have increased. Tension appears in steel between allies such as Japan and the United States as well as between the latter versus China on semiconductors. From sovereign debt to corporate junk bonds, the compression of credit spreads may have run its course. In a steady for longer Fed Funds rate environment, in Fixed Income we would expect increases in preferences for higher credit quality of delivery and favor being in the short to medium term maturities. Long dated maturities still have considerable flow and risk premium risks to work through.
Equity Mix
Equity markets are at the cusp of another period of company releases and discussions of results. Value and valuation have appeared subservient to momentum since the apex of the credit crisis in 2008 and subsequent primarily monetary policy responses. Currently and with little subtlety, major central bank balance sheets are being reduced. Stable for longer administered rates appear sketched out, not imminent cuts. Recently, hypotheses have emerged that not only productivity but also increased efficiency in capital markets have been emanating from new processes and would support lower than historical risk premiums. Still and even if ECB rates of 4% were used as benchmark and certainly versus U.S. Fed Funds of 5 ½%, equity risk premiums seem low. A minimalist administered rate argument would be needed to boost up ambient valuation. It did not occur in the real life example of Japan from the 1990s/2000s. We expect equity risk premium increases to percolate through geographic market, sector and individual security selection with preferences being for quality of operations and financial strength.
Rather than the value versus growth interfaces of the past, the present realities are likely to be those of favoring quality of business operations and relative financial strength across geographies, sectors and across segmentation by market capitalization. Consensus estimations often miss salient turning points in earnings. After missing the bottom of the S&P 500 earnings cycle in early 2009 and into well after recovery and into expansion, the consensus modus operandi appears to be one of earnings gain overoptimism then leading to reductions in estimates closer to release. to then celebrated as a beat. Momentum markets benefitted from an estimation disposition to celebrate last consensus beats rather than overall levels. Also contributing have been massive quantitative ease and concept euphoria in the likes of social media, climate change and most recently, artificial intelligence purveyors. As earlier in this cycle and in prior ones, long term consensus estimates call for 10% plus annual earnings growth for each of the upcoming years, to S&P 500 operating earnings levels from 213 in 2023 to 250 for 2024 and 275 for 2025. In an environment of moderate 3% global annual GDP growth, steady interest rates and rising costs such as for energy for companies and individuals alike, we would expect S&P 500 earnings potential to be closer to 5% per annum. At the cusp of earnings and operating releases ,from banking to cyclicals to growth such as Information Technology, companies have been expressing caution and cutting expenses. We expect the switch to quality of operating delivery and stronger balance sheets may be more severe and more abrupt than consensus seems to expect. At present valuations and in the aftermath of the momentum euphoria of recent months, volatility is likely to expand.
Communications Services we have underweight expecting restructuring driven by prior acquisition excess and greater regulatory scrutiny such as over cyber security. Consumer Discretionary is underweight on the view that while the U.S consumer has already performed leadership, Europe and Asia remain bifurcated and weak. Consumer Staples we have marketweight on as input costs weigh in and erstwhile emerging regions remain difficult. Energy we have overweight on the basis that legacy businesses in hydrocarbons remain attractive while business strength offers opportunity for expansion into alternate energy. Financials we have as overweight in favoring strong restructuring delivery amid net interest margin and commercial real estate challenges. Healthcare is overweight for us on valuation and in comparison to operating challenges in other defensives like Consumer Staples and high valuation in other growth like Information Technology. Industrials we have overweight in cyclicals on the basis of rising defense expenditure potential as well as more efficient infrastructure in other consumer and manufacturing businesses alike. Information Technology we have at 25% cap for diversification amid several marquee companies have emerged with high valuations from the artificial intelligence euphoria. Materials we place as over weight on gold bullion and pressure metals for diversification amid potential currency market volatility. Seeming under estimated is the criticality of rare metals, even base metals and food. Real Estate we place at underweight with commercial real estate an especial challenge with industrial space being an opportunity . Utilities we place at underweight on project financing costs a potential challenge.
Asset Mix
Global U.S.
Equities-cash 49 % 54 %
-priv. 6 6
Fixed Income 25 20
Cash 15 15
Other 5 5
Total-% 100 100
Geographic Mix
Currency/ Equities Fixed Cash
Real Income
Americas 61% 65% 67% 55%
Europe 22 20 26 37
Asia 9 13 6 3
Other 8 2 1 5
Total -% 100 100 100 100
Global U.S. Stance
Comm. Serv. 1.5 % 9.2% Under-weight myriad challenges
Cons. Disc. 10.8 10.2 Under-weight favor frugal basics
Cons. Stap. 9.2 5.9 Market-weight for brand pruning
Energy 4.4 4.1 Over-weight favor strong cos..
Financials 17.2 13.1 Over-weight, restructuring
Healthcare 10.3 12.2 Over-weight across segments
Industrials 12.4 8.9 Over-weight, capex suppliers
Info. Tech. 26.7 29.6 Capped for diversification
Materials 3.42.4 Over-weight diverse and prec.
Real Est 1.8 2.2Under-weight, favor ind. ppty
Utilities 2.3 2.2 Under-weight -rate risk.
Total-% 100.0 100.0 E.o.e.