Macro
Inflation data shows that prices are on a steady decline path, supporting the Fed’s easing case. Both PCE and PCE deflator are now almost reaching the level seen before the pandemic. On the other hand, strong spending and stable GDP growth point to a soft landing. These two effects combined created a Goldilocks scenario for risk assets.
Since the FED acknowledged its accomplishment of cooling down inflation in the December FOMC meeting (See Week 50 2023 update), it has shifted its focus from managing inflation to managing the business cycle. With a new focus on the business cycle, the FED might be more concerned about the real yields, which are entering again a very restrictive territory due to declining inflation. On the other hand, with such a strong economy, it could be difficult for the FED to justify any meaningful rate cuts.
The consumer is spending above what they are earning. If they slow down their spending, we may indeed see a slowdown in economic activity. The FED has shifted its focus from the inflation fight to managing the business cycle; therefore, from now on, it will be more sensitive to any data indicating an economic slowdown.
Rates
The market is front-running the FED, expecting 5 rate cuts for 100 bps of cuts this year. This is still aggressive but less aggressive than the 6-7 rate cuts expected at the end of 2023. These cuts are possible, but investors must take into account the accumulative effect of the rate hikes and how the market has adjusted to them. This means that the FED is unlikely to go back to the pre-pandemic rate level as the neutral rates in the current regime are much higher.
The real FED funds rate is getting high right now; thus, the FED might cut at least incrementally to make real rates less restrictive. The FED is motivated to cut due to clear positive developments on inflation, but it may not do it as aggressively as the market expects. They might take time before they start cutting, especially after loosening the financial conditions after their dovish pivot back in December.
We see an interesting dynamic in the yield curve, with 2Y consistently going down since October and now approaching 4.35% and 10Y rising higher from the start of the year and now approaching 4.15%.
Credit
The lower rates and very tight spreads will pull forward some of this maturity wall many investors expected in 2025/26. After many months of low volumes, issuance has grown around the world to take advantage of high demand and low spreads. US IG issuance in January was near a record, while the average high-grade corporate bond spread is now 95 bps.
Companies with solid fundamentals are starting to return to capital markets to access capital at attractive valuations. An example is the recent auction of Procter and Gamble, which issued its bond at the tightest spreads in the company’s history. With the current strong economic backdrop, default rates will remain low, and the IG could remain attractive compared to equity markets.
Because spreads are so tight and rates are relatively high, investors look at credit not only as a spread product but also as an all-in-yield product. The increased total yield environment encourages institutional demand, to the point that even the record volumes we are seeing are not enough supply. This surge in demand causes significant downward pressure on spreads.
Due to the high discount factor, there is more value in credit markets than what is seen on the surface by just looking at the spreads. Discounted bonds drag spreads tighter, and given rate repricing over the next two years; there is a huge amount of discounted bonds on the market. Furthermore, after a volatile 2023, 2024 should come down dramatically, making credit a very attractive asset class from the risk-adjusted perspective.
Equities
US stocks started the year sluggishly but then rallied in the second half of January. Performance is very strong relative to other markets. European and Canadian markets are slightly up in local currencies, but all markets lost money this year when measured in dollars. From a fundamental perspective, the US has a tailwind from the high level of fiscal stimulus, robust labour market and consumption, and improving consumer sentiment.
January’s recovery in US equities was possible due to tech stocks. However, their valuation is becoming expensive. Valuations for tech stocks relative to ex-tech exceeded those in 2021 and are now at their highest since 2021 highs. Small caps’ valuations have shrunk, approaching a historically low portion of the total US market cap.
Consensus Inc.’s sentiment indicator shows that investors are very bullish (reading over 70%) and are allocating their money accordingly. 3M rolling US equity fund flows have turned positive, while the biggest winners are technology funds. Tech ETFs experienced strong inflows in January, reaching the highest share of the overall ETF AUM in history. The concentration of flows is motivated by relative growth, as tech experienced very high revenue growth and strong margins, while growth for the rest of the market was sluggish.