Keeping the genie bottled up

02-07-2024
Keeping the genie bottled up

Bond markets backing off rate-cut optimism

 

In many ways, it feels like 2023 never ended.

Looking at equity markets, the same names continue to lead the market higher. The so-called “Magnificent 7” may have lost a member after the awful Tesla quarter, but the group continues to head higher on optimism around AI growth. While there is little doubt this is a massive theme that will change the world, the risk is that too much of the good news has been priced into certain shares at these levels, leaving little room for a positive surprise.

One of the more impressive aspects of the rally that markets experienced to end last year was how the contribution of returns broadened out to other parts of the market away from technology. Yet, looking at January returns, we are seeing the performance of the market cap-weighted S&P 500 (SPX) dramatically outperform that of the equal-weighted S&P 500 (SPW) once again. It seems breaking those themes that dominated most of last year will be hard.

What are the ways this will be resolved? The cleanest would be for the other sectors to have a repeat of their November rally and catch up with the leaders. What kickstarted the rally last year was encouraging inflation data showing a clear slowing that would allow for central banks to consider rate cuts. This, combined with increased expectations that the U.S. economy may avoid a recession, led banks, industrials, and consumer product companies to rally. But can we see a repeat of that? Or was that optimism premature, and we have jumped the gun?

The bond market once again will set the tone for future equity market performance and must be looked at for clues. The yield on the U.S. 10-year bond fell from a cycle high of 5% in October to finish last year at 3.85%. Yet once the calendar flipped, bond yields turned higher, ending the month at 4%. The move higher in yields put pressure on the higher-yielding defensive groups, and now the question remains whether, like the technology stocks, the bond market got ahead of itself, expecting a rapid series of rate cuts this year.

Bond futures are pricing in between five and six rate cuts for the year, a fact equity markets have been celebrating. But we should take a hard look at how we could get to six rate cuts; for that to happen, it may be due to some events not to be cheered. For central bankers who have spent the last two years focused on putting the inflation genie back in the bottle, it seems unlikely they will be in a rush to step from the brake to the gas pedal. For that group to feel the need for six rate cuts, unwinding the last year of hikes, something bad would have to be happening in the economy. The combination of both a soft or no landing and aggressive rate cuts seems doubtful.

Investors may need to get used to the idea that markets, both equity and fixed income, may have rather dull performance years and need to digest the volatility we have experienced over the last few years. Equity markets rallied last year on the back of multiple expansion and are now near all-time highs. To move higher will require strong earnings growth. Fixed income, which has become a challenging asset class for investors, is arguably fairly valued around these levels, barring a big move either higher or lower in inflation expectations. What this means is that to add alpha in this environment, investors will need to be nimble, selective, and focused on winning themes.

The winning themes that should be with us for the year, of course, will center around the wonders of AI, but that theme is hardly undiscovered. What may work is being more selective in picking which companies and sectors will best perform in an uncertain economy. After years of passive dominating active, things may be ready to reverse. That would be a significant change from last year and should be welcomed by most investors.

Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.

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