Macro
The US economy is not slowing down, and most point to the increases in budget deficit and fiscal stimulus from debt overlay, which kept going for the last four years. Some go as far as to say that since the pandemic, the government is spending so much money that it’s hard to have a recession. The US debt to GDP ratio is approaching 125%, and at the current pace, the US government is increasing public debt by $1 trillion every 100 days.
In addition, household saving rates decreased, and the propensity to spend increased post-pandemic, which increased aggregate demand and offered further stimulus to the economy. Finally, there is a new catalyst to growth – the FED pivot in December, which has eased the financial conditions and provided a further tailwind to growth.
Although the FED has increased interest rates by 525 bps since Q1 2022, some argue that given this easing in financial conditions, current monetary policy is either appropriate or not sufficiently restrictive. The FED remains painfully data-dependent, and all recent data remains strong. It is getting harder to find data that reflect that the FED is sufficiently restrictive, which removes incentives to cut rates. The super-core inflation has been reaccelerating this year due to an increase in the pricing of services.
The market has been pricing in the unlikely scenario of significant rate cuts in the face of a robust economy with full employment and strong growth. If this doesn’t materialize, there will be volatility ahead. It is speculative to suggest if this will be linked to some of the flareups in regional banks or geopolitical conflicts. Still, disappointment is more likely with the current level of optimism.
Rates
This week, we’ve seen a significant 20 bps peak-to-through movement in 2Y yield. The hotter-than-expected CPI at the start of the week pushed 2Y above 4.7%, then ended the week just above 4.5% after receiving weaker US consumer data, FED balance sheet roll-off warnings, and lower consumer sentiment from the University of Michigan survey of consumers.
Since the end of last year, the market has kept pushing its expectations of the FED rate cuts further into the future. As this continues, rates keep going higher in a bear steepener, which brings higher volatility. At the start of the year, ‘no-rate cuts’ in the 2024 scenario were just a tail risk; the option market implies a 20% chance of this happening.
Although US Treasuries are seeing weaker international demand, European bonds are seeing the highest demand on record, with the average bid-to-cover ratio reaching 5.2x this year. There is a continuous high demand for bonds at those yields, especially compared to other investment opportunities in Europe.
Credit
Investors’ outlook on corporate America remains strong, which keeps credit spreads in IG and HY tightening. Companies are utilizing this opportunity and trying to tap into capital markets before approaching the maturity wall. This led to very high volumes in January and February, making the start of the year the biggest credit issuance in history.
The Option-Adjusted Spread on the Bloomberg Investment Grade Corporate Index is below 95 bps. Another reason for the tight spread is relative allocation. For a long time, investors have been underallocated to credit risk, and now they are moving money out of the money markets and playing catch-up with their long-term allocation targets. Furthermore, credit investors are shifting their focus from spreads to yield and acknowledging that the total return looks very attractive.
This year, a defensive stand in credit exposure would have created a considerable drag. However, if one believes that we are in the late cycle, they should underweight the credit as it usually underperforms in that stage of the cycle. This is because rates kept tightening; however, now they are at the point that many believe to give inadequate protection against the economic weakness. However, reference to historical averages might be misleading as, from the structural perspective, the credit market is of much higher quality today than in the past.
There are ample opportunities for credit pickers, especially if they have a multi-sector diversified income approach and can choose a relative value globally.
Equities
As financial conditions ease, multiples are expanding, and IPO and M&A activity is picking up. As economic surprise indexes have improved, new manufacturing orders have risen, and survey-based recession odds have fallen, the equity outlook remains bullish. Analysts favour the US region and technology as their favourite sectors, followed by the tech-heavy communication services sector.
However, the concern is the concentration in mega-cap tech, which already has very high multiples. There is a good reason for it, as mega-cap tech has been on a growth trajectory for years, consolidating market share in key areas of economic growth. Tech companies have high profit margins, and since they represent such a high portion of the index, the profit margin on the S&P 500 is well above the historical average. In Q4 2023, magnificent 6 (APPL, AMZN, GOOGL, META, MSFT, NVDA) grew its earnings by 54%, while the remaining 494 S&P stocks faced an earnings decline of 10.5%.