Macro

There are worries that “the last mile will be the hardest” in the inflation battle and that, historically, inflation spikes are coming in wavers. We have to be cognizant of the inflation acceleration risks, but the fear that inflation will spike again significantly might be overblown.

Except for the “unknown unknowns”, such as unforeseen supply shocks and pressure from new geopolitical developments, there are no apparent drivers to the inflation upside. The reasoning is that all critical inflationary risks have opposing forces that counteract them or are more balanced than many investors assume.

• Premature interest rate cuts could boost demand further, but given how slowly the economy has responded to the interest rate hikes, it will likely be slow to respond to the interest rate cuts. Furthermore, the financial market has already priced in aggressive cuts. Finally, lower rates mean the monetary policy is just less restrictive and not that it is stimulatory.
•  The resilience of demand – consumer demand remains strong; however, the positive supply-side development (explained at the end of December) should offer a sufficient response to high demand, offsetting potentially inflationary pressures. Also, a lot of inflation is due to sector-specific dynamics where demand focuses on specific areas while the overall inflationary pressures remain subdued.
•  Strength of the labour market – wage growth is strong globally, and for the U.S., there is also a significant increase in labour productivity. Although the U.S. faces a wage-productivity gap, most economists expect that a recent productivity-driven boost to output will positively impact wages due to a tight labour market. However, decreasing vacancies and job quit rates point to loosening the labour market.
•  The escalation of tensions in the Middle East – can disrupt important shipping routes, which are crucial nodes in global trade as the Suez Canal handles 12-15% of global trade. This can cause a shortage of goods or increased transportation costs due to increased insurance costs, and most ships opt for longer but safer routes around Africa. However, the cost of goods is already declining at a very rapid pace. Thus, those increases would have a counterbalancing effect at best. Conflict still affects the non-Suez route to the U.S. West Coast. However, the biggest effect is on the Asia-to-Europe shipments, therefore having a negligible impact on overall inflation in the U.S.

Rates

After the premature suggestion of the end of a tightening cycle, the FED is now pushing back against the rate cuts. As the economy remains robust, FED has the luxury of waiting to cut rates despite high real yields.

Towards the end of last year, we saw dramatic repricing of the yields, with 10Y hitting nearly 5% in October (4.98% on the 19th of October) and then sliding down all the way to below 3.8% by the end of the year (3.79% on the 27th of December).

This year, the market started reconciling its extremely optimistic expectations of the rate cuts, and 10Y begun returning to normal. The focus of the first expected rate cut has shifted from March to May, and it is likely to recalibrate further as many economic releases will occur between now and the first cut. The market and the FED are data-dependent, leading to increased intraday volatility as the market digests new data.

As the market continues to recalibrate and rates rise again, it allows investors to tap into duration exposure and increase their carry. As the war on inflation is nearly over and economic growth deceleration is on the horizon, investors have an excellent chance to lock in higher rates, which will become an essential component of their total return.

Credit

Corporate issuers are rushing into the market to take advantage of the spreads at the lowest point in the cycle. Considering more attractive borrowing terms due to a 100 bps decline in rates since October 2023 and continuous high demand for credit, they are frontloading some of the refinancings. We also see an increase in the issuance of junk bonds as borrowers take advantage of the lower borrowing costs, which, as per Bloomberg’s High Yield US Corporate index, are now below 8%.

This prudent risk-management move, as they are catalysts such as distress in commercial real estate and corporate bonds maturity wall that create a risk of widening spreads later in the year. Furthermore, with a high volume of loans coming due later this year and in 2025, it makes sense to start laddering those issuances earlier in the year.

With the economic deterioration, we will see a significant move in spreads and meaningful decompression across the ratings. Spreads are trading like we are in the early to mid-cycle. As long as the growth picture remains solid, speeds will remain range-bound; however, there is more upside than downside potential.

Equities

The S&P 500 has finally crossed above the 5,000 level. As investors are confident that the FED will cut rates (sooner or later), the ‘buy the dip’ mentality returns to the market. This increase in bullishness is elevating expectations to a level that is easy to disappoint.

Pricing of expected volatility remains complacent as VIX hits new lows while sentiment, flows, and speculation are on the rise. New highs have triggered a surge in FOMO inflows and made valuations expensive. While the valuations are elevating, the short-term risk indicators are rising. 50 DMA has rolled over from overbought as the percentage of companies above their 50 DMA declined from 90% at the start of the year to 60%. now

Rally is driven by the promise of a productivity miracle related to AI technology and all the positive externalities. Technology ETFs are attracting the highest inflows since 2021. Technology stocks (Information Technology, Media, Telecommunication) excluding Magnificent 7 have reached a forward PE of 21.5, the highest level since the Covid peak in 2021. Also, tech relative to ex-tech has the highest valuation gap since the dot com peak of 2001.

As demand for risk has increased, the Emerging Market macro outlook has improved, although EM equities continue to underperform DM. EM investors must remain selective to avoid taking unnecessary political risks like the one we saw materializing in China over the last two years. Geopolitical fragmentation and demographic divergence will remain the key differentiator for selecting country-specific opportunities.