Macro
Throughout the year US economy kept demonstrating its strength through continued strong economic growth. This has been achieved despite the rate-tightening cycle, but economists expect a slowdown in employment, which will have a negative impact on the GDP – a key determinant of the return on capital. Analysts expect that the boost to productivity produced by AI implementations will be at least enough to offset the slowing employment, with the biggest impact seen in the US and the UK.
Economists believe that AI will have a net positive impact on consumer demand in the short as well as in the long run. This is because of expected productivity gains while acknowledging that there is no historical evidence that technological progress fundamentally damages employment.
On the other hand monetary tightening starts to have a major impact on business activities. Demand for loans is falling, while banks are tightening their lending criteria further. We see deeply negative changes in the flow of credit to the private sector. There are also signs of slowing labour demand and easing wage pressures. For most DMs wage growth has moderated, with unit labour cost growth back to around 3%. For the US, the deviation of labour market indicators, including for all key metrics, including non-farm payroll, private quits rate, Job openings rate and NFIB job hard to fill. Economists expect this trend to continue, with the cooling of the labour market conditions to continue in 2024.
Investors start to see the expected cooling of the economy, the worry is that over upcoming quarters economy needs to stop cooling before it gets to the contraction territory.
Rates
Volatility is the front and centre of the bond market, as long-term rates started to rapidly decline since its peak at the end of October. Over the last few weeks, the bond market has lost the economic anchor, the policy anchor and the technical anchor. We can see relative volatility by comparing MOVE and VIX indexes.
Explanation:
- MOVE – Merrill Lynch Option Volatility Estimate Index, measuring an average of the implied volatilities of the selected Treasury options (“VIX for bonds”)
- VIX – Chicago Board Options Exchange Volatility Index – weighted prices of the S&P 500 puts and calls for the next 30 days)
This volatility creates dispersion and dispersion can be monetized by Fixed Income active managers. Also as we are stepping towards a more uneven economic environment, where security selection becomes more important. This setup should translate into more inflows to active funds. Given uncertainty and the that the curve is still inverted more investors find the front end of the curve attractive.
Despite the wave of supply due to a large deficit, expectations have shifted and now more investors expect rate cuts to start to price in the FED cuts from March next year. With the decline in long-term rates, the popular bet of going against the FED and buying TLT (20 Plus Year Treasury Bond ETF with the 4th largest net flows for the year) finally started paying off.
Credit
Since the GFC we have observed the overall improvement of the credit quality, which suggests that this credit cycle will differ from the past credit cycles. However, credit investors need to be cautious, focusing on leverage and severity, and must select bonds individually.
Since the GFC there is a lot less intermediation of bonds, which reduced some of the transparency and price discovery. As interests increased so did the hurdle rate for investments, which is now a lot higher, making many projects unprofitable.
Equities
As the yields fall, tech stocks continue to do well. The recent rally in equities is still driven by the mega-cap tech, but outside of S&P50, investors can find real discounts. They can purchase small caps for 12x forward earnings, mid-caps for 13.4x forward earnings, and large caps for basic materials for 9x forward earnings. If the soft landing is confirmed, these areas should join the rally and help to broaden the bullish trend. Also as the market is slowly climbing the wall of worry the volatility has significantly subsided for all major US equity indexes.
Interestingly 3 biggest S&P 500 ETFs took nearly a 3rd of all the flows this year, which is the record share of flows. The reason for this is explained by performance, with simple buying the market produced a 25% total gain for the year, outperforming nearly every other strategy.
We also see a rally in the EM market, where central bankers hiked earlier and more aggressively and where they are now also pivoting to the rate cuts. With lower valuations for the EM stocks and the recent start of the new momentum, EM ex-China becomes a more attractive proposition.